In the European cap-and-trade the cap is established on the volume of allowances and, unfortunately, not on the price. But as the experience shows there are interesting concepts, how to mitigate not only the impact of climate change, but also the price risks inherent in the scheme. Direct quarterly sales of allowances from the Allowance Price Containment Reserve and the fixed Auction Reserve Price cause (providing that the Reserve won’t be prematurely exhausted) that in the California cap-and-trade the regulatory-fixed price range from 10$ to 75$ per metric ton of CO2 can be specified in the perspective 2012 – 2020 (with appropriate modifications in each year of the period).
The California Cap-and-Trade Program (see: California Environmental Protection Agency Proposed Regulation to Implement the California Cap-and-Trade Program PART I Volume I Staff Report: Initial Statement of Reasons, Release Date: October 28, 2010,
http://www.arb.ca.gov/cc/capandtrade/capandtrade.htm, last visited 10.02.2011) scheduled to start in 2012 envisages pivotal cost containment mechanisms. Some of them are similar, or equivalent to those present in the EUETS, but others seem to be original in their design.
Flawed application of the auction reserve price in the EU ETS
The fundamental feature of the European Union Emissions Trading Scheme relative to management of price risk as regards allowances follows from Article 16(3) and (4) of the Directive 2003/87 and consists in that any operator who does not surrender sufficient allowances by 30 April of each year to cover its emissions during the preceding year shall be held liable for the payment of an excess emissions penalty which amounts to EUR 100 for each tonne of carbon dioxide equivalent emitted for which the operator or aircraft operator has not surrendered allowances. The pivotal element is that the payment of the excess emissions penalty shall not release the operator from the obligation to surrender an amount of allowances equal to those excess emissions when surrendering allowances in relation to the following calendar year (the excess emissions penalty relating to allowances issued from 1 January 2013 onwards shall increase in accordance with the European index of consumer prices). Consequently, the amount of 100 EUR is not a cap on the price of EUAs in the EUETS and theoretically, the possibility of price movement of EUAs beyond 100 EUR is not excluded. This uncertainty influences on the investments decisions with respect to the choice of the fuel for the future power plants and seems to be the one of the main reasons, why the share of renewables in the European electricity production sources have risen recently so sharply, and the planned coal – fired power plants face big difficulties in the drafting of business plans.
The Directive 2003/87 provides for some mechanisms in the event of excessive price fluctuations of allowances (see: box), but these provisions are intended to increase the quantity of allowances available on the market (and in this way indirectly influence on the price) rather than directly put restrictions on free price discovery by the market itself.
Cost Containment Mechanisms in the California Cap-and-Trade Program
As the staff of the California Air Resources Board (hereinafter referred to as ARB) mentioned in the above-cited Initial Statement of Reasons, the proposed cap-and-trade program includes a number of mechanisms designed to minimize the costs of reducing GHGs “without compromising the environmental integrity of the program”. Some of the mechanisms that staff proposes in the cap-and-trade regulation are three-year compliance periods, banking, offsets, the Allowance Price Containment Reserve, and linkage to other trading systems.
Article 29a(1) and (2) of the Directive 2003/87:
"Measures in the event of excessive price fluctuations
1. If, for more than six consecutive months, the allowance price is more than three times the average price of allowances during the two preceding years on the European carbon market, the Commission shall immediately convene a meeting of the Committee established by Article 9 of Decision No 280/2004/EC.
2. If the price evolution referred to in paragraph 1 does not correspond to changing market fundamentals, one of the following measures may be adopted, taking into account the degree of price evolution:
(a) a measure which allows Member States to bring forward the auctioning of a part of the quantity to be auctioned;
(b) a measure which allows Member States to auction up to 25 % of the remaining allowances in the new entrants reserve..."
The specification of the compliance periods does not seem extremely original, taking into account that the EUETS as well as the Kyoto Protocol used such a concept. The differences in the length of the specific compliance periods (EUETS: first - 3 years, second (convergent with Kyoto Protocol) - 5 years, third – 8 years, California cap-and-trade: 3 years, first starting in 2012) are of minor importance. There are however differences in the proportion of emissions against which allowances must be surrendered in each year of the compliance period (annual compliance obligation consists in that a covered entity is be required to surrender compliance instruments in each of the first two years of a compliance period equal to 30 percent of its verified emissions for that year. For a covered entity that reports emissions in April, the proposed surrender will be due by May 15 of the same year. For a covered entity that reports in June, the surrender will be due by July 15 of the same year). Comparing these provisions to that in the EUETS, the differences are visible in timing (30 April as a uniform surrendering date for every compliance unit in the EUETS) and the volume of yearly settlement (100% in the EUETS against 30% in California cap-and-trade).
According to the staff of the ARB three-year compliance cycle is to help smooth out annual variations in production, and to provide sources with greater flexibility to reduce emissions.
Equally similar to EUETS are the provisions on banking of allowances (which allows participants to hold spare allowances and use them for compliance in a later period), staff of the Californian ARB proposes to allow banking of allowances without restriction.
As a result, California compliance instruments do not expire. This allows an entity to hold the instrument until it is needed - across compliance periods. In the EUETS banking was not allowed as regards transition from the first compliance period (2005-2007) to the second (2008-2012), because the first compliance period had a “trial” character.
Contrary to the European Union Emissions Trading Scheme allowances issued in the California cap-and-trade for a future year cannot be used for surrender in an earlier compliance period (borrowing). The one exception is an allowance purchased from the Allowance Price Containment Reserve, which may be used as soon as it is bought. According to the staff of ARB, this approach is proposed to prevent the threat of “cascading borrowing.” This situation occurs when entities are able to use future allowances for current compliance, and it creates a growing shortage of instruments in later compliance periods.
In the EUETS allowances issued, for instance, in the year 2011 (in February 2011) may be used for surrendering as regards CO2 emitted into the atmosphere in 2010 (with the settlement date 30 April 2011). In the EUETS it can really lead to the cascading borrowing with the “point of truth” on 30 April 2013 (final settlement date for the entire second period).
California cap-and-trade envisages specific provisions on offset credits (which in themselves are instrument of providing necessary price elasticity). In the Californian model provisions on offsets are different from EUETS, it is sufficient to mention, that only American projects seem to be eligible to participate (apart from many other differences in the design), in this article the intention is only to mention this issue.
California cap-and-trade seems to be strongly designed to link in the near future with WCI (Western Climate Initiative) partner jurisdictions. In this article I mention the linkage to other greenhouse gas emissions trading systems as an instrument of providing the price elasticity, but the issue is generally worth of separate considerations.
Direct Quarterly Sales of Allowances from the Allowance Price Containment Reserve
ARB proposes to establish an Allowance Price Containment Reserve which seems to be the one of the most interesting features of the California cap-and-trade as regards price containment mechanisms.
Pursuant to the above-cited Initial Statement of Reasons the Reserve is an account that is filled with a specified number of allowances removed from the overall cap at the beginning of the program. Covered entities may purchase reserve allowances at specified prices during direct quarterly sales. Covered entities gain flexibility through access to the Reserve if prices are high or entities expect prices to be high in the future. Staff proposes that the Reserve be filled with 123.5 million allowances out of the total of approximately 2.7 billion issued for the years 2012 to 2020. A greater percentage of allowances come from later years of the program to provide more flexibility in the early years of the program. The Reserve will be filled with 1 percent of allowances from each year from 2012 through 2014, 4 percent of allowances from each year from 2015 through 2017, and 7 percent of allowances from each year from 2018 through 2020. This is equal to approximately 5 percent of total allowances in the program from 2012 through 2020.
Price-Containment Reserve Sales 2013–2020:
- First sale: March 8, 2013,
- Subsequent sales occur on the first business day six weeks after each quarterly auction
- Three fixed-price tiers (in 2013: $40, $45, and $50),
- Prices adjust annually for inflation and 5% real appreciation,
- 12 days prior: Bid guarantees due (bond, cash, or letter of credit),
California’s Cap-and-Trade Program: Program Basics and Requirements for Electrical Distribution Utilities, May 2012, (http://www.arb.ca.gov/cc/capandtrade/meetings/052312
Covered entities will have the option of buying from the reserve pool at fixed prices. The reserve allowances will not be available to voluntarily associated entities. Sales from the Reserve will take place three weeks after each quarterly auction. The Reserve will be organized into three equal tiers. Allowances in each tier will be available for purchase at fixed prices. Reserve allowances will be sold at prices of $40/metric ton for the first tier, $45/metric ton for the second tier, and $50/metric ton for the third tier in 2012. These prices will escalate by 5 percent plus the cost of inflation each year, such that the reserve prices are approximately $60/ metric ton, $67/ metric ton, and $75/ metric ton in 2020.
Covered entities will place bids for the number of allowances they wish to buy from each tier. The Reserve administrator will award allowances from each tier until the tier is exhausted. Empty tiers will not be refilled. If too many bids are submitted for a tier, the Reserve administrator will prorate the available allowances to the bidders.
Purchases from the Reserve will be subject to the Holding Limit (further mentioned). In addition, allowances purchased from the Reserve will be transferred by the administrator directly to the purchasing entity’s Compliance Account, from which it cannot be removed until it is surrendered. It is to ensure that allowances are only purchased to meet compliance needs, not to provide a supply of allowances for speculative activity.
The mechanisms similar to those as the Reserve are absent in the European Union Emissions Trading Scheme. There is New Entrant Reserve but it has different purpose. The European legislators intended probably that the market should be the one that discovers the price for CO2 allowances and that market forces shouldn’t be restricted in that process (excepting provisions of Article 29a of the Directive 2002/87 mentioned at the beginning).
But it seems that providing a little certainty with respect to the price risk in the EUETS would have a positive impact on the EU economy as a whole. Providing, that the Reserve won’t be prematurely exhausted, in the California cap-and-trade there is specified price range from 10$ to $75 per metric ton of CO2 in the perspective 2012 – 2020 (with appropriate modifications in each year of the period) and this regulatory specification is of important value in every investment projections. Unfortunately, in the EUETS even such general price range can’t be construed taking into account the text of law only.
Auction purchase limit
Staff of ARB proposes to implement a limit, known as a purchase limit, on the amount of allowances that a single entity and its affiliates are able to purchase at any single auction to ensure that all entities with a compliance obligation have fair and equitable access to allowances sold at auction. Each covered entity and opt-in covered entity can purchase of a maximum of 10 percent of the total number of allowances offered for each budget year. Each voluntarily associated entity can purchase a maximum of four percent of the total number of allowances offered at each auction. ARB believes this purchase limit, together with direct allocations to covered entities and the option to use offset credits, would allow covered entities to obtain a sufficient part of their compliance obligation at auction. In addition, ARB proposes to exempt the investor-owned utilities from the purchase limit because entities do not receive a direct allocation that they can use for their own compliance needs.
In the EUETS pursuant to the Article 56(2) of the Auctioning Regulation the maximum bid-size may either be expressed as a percentage of the total number of auctioned allowances in any given auction or a percentage of the total number of auctioned allowances in any given year. In the EUETS the maximum bid-size is generally intended to mitigate an actual or potential discernible risk of market abuse, money laundering, terrorist financing or other criminal activity, as well as anti-competitive behaviour and may be imposed by any auction platform after consulting the Commission and obtaining its opinion thereon. The Commission may consult the Member States concerned and the auction monitor and obtain their opinion on the proposal made by the auction platform concerned. The imposition of restrictions on the bid-size in the EUETS relates to the same group of undertakings including any parent undertakings, its subsidiary undertakings and affiliate undertakings.
Comparing the designs mentioned above it is worth considering that, contrary to the California cap-and-trade where there are fixed auction purchase limits expressed as a percentage of the total number of allowances offered for each budget year (10% and 4%) in the EUETS imposition of the maximum bid-size is only an option which may be struck by the auction platform in specific circumstances and after conducting a required procedure. The design of the EUETS seems to be more confident in the market forces, but the American model gives the investors more certainty as regards shaping market position.
To combat the tactic to “corner” a market, in the California cap-and-trade there is a proposition to use a holding limit, which is the maximum share of available compliance instruments that an entity or group of affiliated entities may own. Holdings by affiliated entities will be evaluated as if they belonged to a single entity. This issue deserves a broader description and in this article is only mentioned.
Safeguards to limit the excessive downwards price movements
It is also useful to point out that the safeguards are provided in the Californian cap-and-trade, to limit the excessive downwards price movements. The reserve price has been proposed in the auction design at 10$/per metric ton for auctions in the 2012. For all years following 2012, this reserve price will be increased by 5 percent plus a consumer price index.
In this context the Article 7(6) of the Commission Regulation No 1031/2010 of 12 November 2010 on the timing, administration and other aspects of auctioning of greenhouse gas emission allowances pursuant to Directive 2003/87/EC of the European Parliament and of the Council establishing a scheme for greenhouse gas emission allowances trading within the Community could be recalled which reads:
“Where the auction clearing price is significantly under the price on the secondary market prevailing during and immediately before the bidding window when taking into account the short term volatility of the price of allowances over a defined period preceding the auction, the auction platform shall cancel the auction”.
The obvious question emerges on the ground of the Auctioning Regulation in the EUETS – what does it mean price “significantly under” the secondary market, but the answer is not simple, because Article 62 of the said Regulation treats the methodology as confidential.
As opposite, there is nothing confidential as regards the auction reserve price in the California cap-and-trade because it has been set at 10$/per metric ton for auctions in the 2012 with the increase by 5 percent plus a consumer price index for all years following 2012.
From the point of view of the predictability and certainty of market rules the Californian design in that field seems to be more transparent.
This is the mere, cursory overview of the subjectively chosen features of the California cap-and-trade and the EUETS. It is apparent that the first of them is currently under construction and characteristic of it’s main components may change over time. But the comparison of the constituent elements of both systems may lead to interesting conclusions as to the theoretically possible designs of the cap-and-trade schemes as well as facilitate the potential future linkage.