Tuesday, January 29, 2013

Mystery unveiled, California and how it trades its caps.

"Let the Hunger Compliance Games begin!"

What is California’s Cap and Trade and what makes California believe it can achieve something the nation could not?  For starters, you may be asking, what is all the hoopla about cap and trade? Well, the basics of cap and trade are simple; it uses the power of the marketplace to reduce pollution, in theory doing so at the lowest possible cost. In the Golden State system, government regulators set an annual limit (cap) on the GHG emissions produced by the state’s factories, power plants and oil refineries. The cap will decline about a percentage point for the first two years and three percent each year after that.

The basic premise of cap-and-trade is that government doesn't tell polluters how to clean up their act. Instead, it simply imposes a cap on emissions. Each company starts the year with a certain number of tons allowed—a so-called right to pollute. The company decides how to use its allowance; it might restrict output, or switch to a cleaner fuel, or buy a scrubber to cut emissions. If it doesn't use up its allowance, it might then sell what it no longer needs. Then again, it might have to buy extra allowances on the open market. Each year, the cap ratchets down, and the shrinking pool of allowances gets costlier. As in a game of musical chairs, polluters must scramble to match allowances to emissions.

Companies will buy and sell allowances to emit carbon dioxide and other heat-trapping gases (GHG). Now, each allowance represents one ton of Carbon Dioxide (CO2). The minimum price starts at $10 per allowance (ton of Co2) and will slowly increase over time. The number of allowances that a company must hold is determined based on the standard emission from their type of business or facility. Companies that cut their emissions quickly will have spare allowances they can sell to other businesses that are having a hard time making reductions. This is easy to see if we look at emissions through an industry specific looking glass, as it would be difficult to conceive of a cap and trade program working without allowances being industry specific.

In the beginning were the electric utilities. The utility companies will be getting all the allowances they need for free (for a while anyhow).  The utilities will be required to sell allowances at state-organized auctions that occur four times each year. The money the utilities make must be used to benefit their ratepayers, possibly through a credit on customers’ bills or maintenance on equipment and transmission lines that would offset rate hikes much like the one the CPUC just approved. Most manufacturers will receive 90 percent of their allowances for free in the first two years, dropping to 75 percent in 2015.

The first auction happened last November and had 23,126,110 tons of 2013 vintage Co2 allowances up for sale on an electronic trading platform. Companies and traders who registered in advance submitted sealed bids specifying how many allowances they wanted to buy, and at what price. The bids were ranked from highest price to lowest until all the allowances have been allocated. The lowest price at which allowances were allocated became the price that all participants paid, regardless of their original bids. In November’s auction, the allowances sold for $10.09 with the reserve price set at $10 and the maximum price submitted was at $91.13 mean price was $15.60 and the Median price was $12.95. Where is Effie Trinket when you need her? Now, as far as the secondary market, companies and traders can continue trading outside the auctions, but each allowance has a serial number, and all transactions must be recorded in a central tracking system.

There was also an advance auction of 2015 vintage allowances that sold 5,576,000 of 39,450,000 available allowances for sale at the price of $10.00 with a maximum bid of $17.25 and the mean of $11.07 and Median price being $10.59, the maximum price submitted was $17.25 and the minimum was $10.00 and therefore all 2015 vintage allowances were sold at $10.00. The drawback of buying vintage 2015 allowances is that your funding source is tied up two years in advance; the benefit is that you pay a much cheaper price for allowances purchased today that will be used in 2015, when the number of allowances will be dropping to 75 percent. In layman’s terms, if you know your company will need allowances in 2015 and it has the capital to purchase allowances today, the price will be rock bottom today ( hence the $10 price tag) vs. purchasing them in 2015 when every industry will need them and the price is much higher. How about this for a business venture, buy up all the 2015 allowances you can and sell them when 2015 comes around for three to four times the price they were originally purchased for.  Sounds like a great way to make it rich to me.

See the air resource board for a complete list of qualified bidders and a more detailed account of the November 2012 auction. Below is a sampling of what you can expect to find:

Companies can also buy offsets, credits generated by forestry projects and other endeavors that either remove greenhouse gases from the atmosphere or reduce emissions. But the offsets must be generated in the United States and can account for no more than 8 percent of all the allowances that a company needs. To me, offsets should be limited to the state of California (for this specific situation) as other states and federal entities are not participating and thus, should not be allowed to participate in an offset program?

Market manipulation?
The Air Resources Board has set limits on the percentage of available allowances that any individual company or trader can hold, to prevent anyone from cornering the market. Consultants will also monitor the auctions, looking for unusual trading behavior. We can all see this one happening or at least someone trying to make this happen.

Where does the money go?
Amazingly enough, this hasn't been decided; by law, money the state raises by selling allowances must be used to help reduce greenhouse gas emissions and cannot simply be dumped into California's general fund as if it were tax revenue. But the Legislature has not yet hammered out the details.

Important information
Hirschman-Herfindahl index (HHI):  The HHI is a measure of the concentration of allowances purchased by winning bidders relative to the total sale of current vintage allowances in the auction.  The percentage of allowances purchased by each winning bidder is squared and then summed across all winning bidders.  The HHI can range up to 10,000, representing 100% of the current vintage allowances purchased by a single bidder (i.e., 100x100=10,000).

Read more:

Photo Credit: Jacobsen, Nina and Kilik, Jon (Producers) & Ross, Gary (Director). 2012. The Hunger Games [Motion picture]/ United Sates. Lionsgate, Color Force. 

Photo Credit:  http://www.flickr.com/photos/cecmtl/5594631871/

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