The California carbon market outlook is bearish, but there are safeguards to ensure a quick recovery.
The covid19 pandemic has brought economic growth to a halt. China saw its industrial output decline by double digits in January and February. Volatile is an understatement for the fluctuations and declines the DOW Jones Industrial average has experienced for the past month. The California Compliance market, which has been resilient to economic declines over the years, is now experiencing similar declines. This is despite the recent good news that a judge denied the Trump administration’s motion for summary judgement on two of the four claims the US DOJ brought against California’s cap and trade market’s linkage with Quebec.
The price for an allowance started and stayed relatively constant for the first two months of the year at around $18.60. This was well above California’s $16.68 floor price which is the minimum acceptable bid at the state’s auctions for 2020. However, because allowances are a fungible asset, they are also traded in a secondary market. This is where we’re seeing prices dropping precipitously. The week started with secondary prices near the floor and have fallen to more than $3.50 below the floor as the week as progressed.
It’s largely financial entities that are driving the decline. In the past three quarterly auctions financial buyers have accounted for roughly 10% of the auction purchases. These entities entered the market in a significant way on the premise that allowances were underpriced. We believe they are now selling those positions in an effort to stem their losses and or meet clients’ liquidity needs.
Nobody knows where the bottom is, but our thinking is that much of the recent activity is between firms trying to minimize their losses and firms buying low. Prices should stabilize as more compliance entities enter the market, since they can now buy allowances at a much lower price in the secondary market than through the state’s next auction slated for May.
California will convene three more auctions for allowances later this year. The minimum – or floor – price for allowances will be $16.68 Those auctions are unlikely to sell out for the first time in several years. This will trigger the state taking those unsold allowances off the market, which will decrease supply and should accelerate a price recovery in the secondary market.
While the market for allowances and offsets is going through some pain right now, the dynamics of the market and design are such that prices should recover relatively quickly.