October 19, 2014 by Rahul Rana
CaliforniaCarbon.info, October 19, 2014: Starting from 1 January 2015, emissions from transport fuels will for the first time be regulated under the California cap-and-trade program, and will double the size of the existing market. A recent white paper commissioned by the Western States Petroleum Association (WSPA) and authored by Jean-Philippe Brisson, a carbon market legal expert at Latham and Watkins, identifies five design flaws that could make the market vulnerable to a ‘meltdown’.
“Market design flaws […] may lay dormant for a period of time when markets are not under stress, providing a false sense of security to industry and regulators. When a program comes under pressure because of unforeseen conditions or simply because the program becomes increasingly stringent over time, latent market design flaws can significantly derail an environmental program, undermining both industry’s and regulators’ investments to achieve environmental objectives”, states Mr. Brisson in the white paper.
Five flaws have been identified in the report, along with recommendations to remedy them:
The current structure of the holding limit: In order to minimize the risk of market manipulation, ARB restricts the amount of allowances an entity can hold in liquid form. For the first compliance period, the limit is set to slightly over 6.4 million allowances. The holding limit reduces liquidity in the market, since entities may opt to retire excess allowances into their compliance accounts and make these allowances unavailable to the market. The report points out that this could shrink the market size by as much as 33%.
The paper recommends re-adjusting the holding limit to reflect compliance entities’ individual obligations, which would eliminate the need to move allowances into the compliance account ‘lockbox’.
Frequency of auctions: Quarterly auctions are one of the three methods by which ARB distributes allowances but, unlike the other two methods – direct allocation and industrial assistance – auctions play a key role in the flexibility of compliance strategies, and also allow for price discovery. The paper recommends increasing the frequency of auctions to bring more liquidity to the market, enhance their price discovery role, and mitigate some of the negative effects of the holding limits.
Allowance Price Containment Reserve: ARB implements an Allowance Price Containment Reserve (APCR) containing 40,611,000 allowances in three tiers with different prices: $40, $45, $50 in 2013, rising 5% annually over inflation (so $42.39, $47.68 and $52.98 in 2014). Since these prices are not subject to market forces, the strategic reserve helps constrain compliance costs. The report argues that this measure is sensible but insufficient, especially given that the reserve is finite. Brisson echoes the recommendations of other experts and groups with regard to the limited reserve, and these include a solid price cap, more flexibility with the use of offsets, borrowing from future vintages, etc.
The report also points to the apprehension of market participants following the removal of $50 million worth of Clean Harbors offset credits from holders’ accounts without forewarning. A final concern in the market design, pointed out in the white paper, is the misalignment with the Environmental Protection Agency’s (EPA) Clean Power Plan. EPA’s rule applies only to power sector emissions, whereas California’s program places an economy-wide cap on emissions; accounting for a separate cap for the power sector may require some re-strategizing, while EPA’s plan also does not recognize the use of offsets for the purposes of compliance with given targets.