California Air Resources Board-Commissioned Report Recommends Ways to Avoid Price Volatility in California's Cap and Trade Market

Concerned about the potential for price volatility in its cap and trade program, the California Air Resources Board (CARB) commissioned the Market Simulation Group (MSG) at the University of California Energy Institute to look at the issue and make recommendations.  The MSG issued its report last month, entitled “Report of the Market Simulation Group on Competitive Supply/Demand Balance in the California Allowance Market and the Potential for Market Manipulation.”

Using market simulations, the MSG found that allowance prices would remain close to the auction reserve floor price under most scenarios.  However, the modeling also indicated significant risks that allowance prices could spike to the auction reserve price ceiling.  It also showed that firms could amass excessive holdings of allowances that could support profitable withholding strategies if allowance prices are allowed to exceed the price ceiling.

To address these risks, the MSG makes three main recommendations to the CARB:

1. Increase the pool of allowances available for the purpose of mitigating allowance price volatility;
2. Allow market participants to “convert,” at a price, future year allowance vintages for current year compliance; and
3. Provide the market with timely information on the concentration of allowance holdings.

Each of these recommendations is summarized below.

Reinforce the Viability of the Allowance Price Containment Reserve

The Allowance Price Containment Reserve (the “Reserve”) is a pool of allowances held by CARB for sale to market participants in the event that the market price approaches a pre-set price ceiling.  The MSG market simulations identified a risk that, over an 8-year period, the Reserve could become exhausted, causing allowance prices to exceed the price ceiling.  Accordingly, the MSG recommends enhancing the Reserve by expanding the pool of allowances available for sale if allowance prices spike to the price ceiling.  The MSG proposes two alternative means of expanding the allowance pool:

 (i) authorize CARB to draw upon post-2020 vintaged allowances for sale for compliance use in prior years, and

 (ii) allow market participants to use compliance instruments from other carbon allowance markets, such as the European Union Emissions Trading System or the Regional Greenhouse Gas Initiative.

Allow Conversion, at a Price, of Future-Year Vintaged Allowances

Currently, market participants are not allowed to use allowances of later vintages for compliance in earlier phases of the program.  MSG believes that this prohibition could contribute to shortages of allowances available for compliance in an earlier phase.  To alleviate shortages and dampen price volatility, MSG recommends that market participants be allowed to convert future year allowances into current period allowances, subject to a conversion price which could be implemented through a 25% haircut on the amount of allowances converted or by payment of a conversion fee for each converted allowance.

Provide the Market with Information on Allowance Holding Concentrations

The MSG believes that the current lack of publicly available information on allowance holdings could enable participants to acquire large concentrations of allowances without the awareness of CARB or the public.  To address this, MSG recommends enhancing the timeliness and quality of publicly available data on allowance holdings and electricity imports.

If implemented, these data-transparency recommendations could dampen price volatility and lessen the profitability of allowance withholding strategies in the event that shortages would otherwise drive allowance prices toward, or even through, the price ceiling.