The gap between the price for allowances and offsets appears to be closing. Is this a long term trend or a short term phase?
Later this year, ARB will announce the 2019 Allowance (CCA) price floor which is calculated using a 5% real price increase, plus the 2018 inflation rate, to determine next year’s allowance floor price. Like most in the carbon offset industry, we track CCA prices closely. In particular, we track the discount between CCA and offsets (CCOs).
We have noticed a trend in the discount between the two that may (or may not) having staying power. The reason for our hesitation in calling this a trend, is two-fold: carbon offset markets are relatively young; and the end of the second compliance period is November 1, so making pronouncements about trends is fraught. Nevertheless, here’s what we are seeing.
From January 2013 to last month, the average discount between allowances and offsets had been about 21%. This is based on spot prices for each. The rationale for the discount is that offsets carry invalidation risk (allowances don’t), and therefore, should be worth less. However, with invalidation rates at less than .1%, this logic is being tested. As important, the July 2017 extension of the cap and trade program to 2030 means that cap and trade is here to stay for those needing to meet emissions targets. Offsets represent a cost-effective way to meet those targets. In fact, California’s Air Resources Board has reported that offsets have halved compliance costs to date. Lastly, an industry has sprung up around offset development that offers expertise, transparency and economies of scale to compliance buyers.
The current discount is about 8% – it’s lowest since January 2013. And this is where the trend comes in. The discount averaged 23% before cap and trade was extended in July 2017. Since passage, the average discount dropped to 14%. In the last six months, the discount dropped to 11%. In the last three, 9%.
Is this narrow discount a temporary condition because of the November 1 deadline, with entities putting pressure on the offset market to ensure they have enough compliance instruments to meet their targets? Or will the trend continue, and offsets will track allowance prices more closely longer term? As we get closer to 2021, when offset usage drops to 4% and the in state/out of state limits kick in, we will likely see a divergence in the discount wherein California-based offsets will presumably trade at a lower discount than outside of California offset. But until then, this is a trend worth watching.