US carbon trade surviving below the radar

As the Trump administration refuses to address climate change both at home and abroad, a growing number of states are taking the lead, but will this enthusiasm reignite US environmental trading markets?

June 26, 2018 marks nine years since the passage of the American Clean Energy and Security Act 2009, also known as the Waxman-Markey Bill, in the US House of Representatives. While the bill ultimately failed to reach a full Senate vote, it would have introduced a national cap-and-trade scheme for carbon emissions in the US.

The Obama administration subsequently attempted to use the executive branch to create alternative regulations to reduce national greenhouse gas (GHG) emissions. But the results of its efforts – the Clean Power Plan for reducing carbon emissions from power plants passed in August 2015 and the international climate change deal negotiated in Paris the following December – have been roundly rejected by the Trump administration, leaving US environmental markets without backing at the federal level.

However, the lack of White House support has not deterred these markets. If anything, it has created more momentum to address environmental issues at a state and regional level. “It’s had an unexpected effect in that some states are now even more adamant to get into a carbon pricing programme,” says Anthony D’Agostino, director of emissions markets at Royal Bank of Canada. “The administration’s attitude may have slowed things down a little, but I think carbon trading is moving forward on more of a grassroots basis.”

The Regional Greenhouse Gas Initiative (RGGI), a mandatory market-based programme to reduce GHG emissions from power plants in nine New England and mid-Atlantic states, has just conducted its 40th quarterly auction. It is also currently being courted by two more states that wish to join (Virginia) or rejoin (New Jersey) the cap-and-trade scheme.

On the west coast, California, which is part of the Western Climate Initiative (WCI) – a multi-sector cap-and-trade initiative under which it holds joint auctions with Quebec and, until very recently, Ontario – has just extended its carbon cap-and-trade scheme through 2030.

And across the rest of the country, 29 states and the District of Columbia have established requirements relating to renewable or alternative energy use, typically called renewable portfolio standards (RPSs). Renewable energy certificates or credits (RECs), which represent one megawatt-hour of renewable energy, can be used to satisfy RPS requirements. RECs are traded – quite actively in some cases, such as New Jersey Solar RECs (SRECs) – within and even between different state programmes.

“There is a real benefit to a regional effort; it helps reduce the chances of emissions leakage and economic leakage,” says Maryland environment secretary Ben Grumbles (pictured), who is also secretary of the RGGI’s board of directors. “And there is also strong support among many states, including Maryland, for an overall national strategy to help reduce leakage among outside regions or states that don’t have a cap on carbon emissions.” He adds that while some form of federal leadership is usually needed, there is also “a great opportunity for state and regional progress”, at the moment.

“I’m very excited about what is happening on a state level,” says Richard Sandor, Chicago-based chairman of Environmental Financial Products and of the American Financial Exchange. “It’s a rosy picture, if you’re looking at the data rather than listening to political rhetoric.”

Sandor founded the first environmental exchange, the Chicago Climate Exchange, in 2002 and was instrumental in the development of the first national cap-and-trade programme in the US, the Acid Rain Programme, which covers emissions from large electricity generating units that burn fossil fuels for sale. It has since led to emissions reductions of 91% for sulfur dioxide (SO₂) and 81% of nitrogen oxides (NO_x) from power plants from 1990 levels, according to the latest Progress Report from the US Environmental Protection Agency, which covers 2016.

So, while a national carbon cap-and-trade scheme has so far eluded the US, experts see state-based efforts to develop such solutions as more than sufficient, at least for the time being. “It’s important to remember that US carbon politics are Washington politics and Washington doesn’t necessarily reflect the will of the people in different states,” Sandor adds. “[Supreme Court justice Louis] Brandeis referred to the states as ‘laboratories of democracy’ and that has already been seen in agricultural trading. The Chicago Board of Trade really invented grain standards, the private sector developed them and it took 50 years for the federal government to adopt them. So, under that model, we could continue to see growth and success in [regional] carbon trading until, ultimately, the federal government has a de facto national system and then it will be very easy to do what they did before and just pass a law adopting the best practices.”

I’m very excited about what is happening on a state level. It’s a rosy picture, if you’re looking at the data rather than listening to political rhetoric

Richard Sandor, Environmental Financial Products, American Financial Exchange

Outside interest

But is such optimism shared beyond the confines of the primary markets for environmental allowances? Many banks established and then promptly shuttered or sold carbon trading desks as the fortunes of the Waxman-Markey Bill rose and fell nearly a decade ago. Although many of these players have not returned to the US market, there are non-compliance participants in all three sectors, including banks, trading houses and hedge funds.

Intercontinental Exchange (Ice) covers contracts based on allowances from both the RGGI and WCI, as well as RECs. According to its latest monthly report on the US environmental markets (May 2018), open interest in US environmental products “continues to reach new highs”, indicating that more money is coming into the market. Open interest surpassed the December 2017 peak of 543,517 lots in mid-May 2018 and, by the end of the month, had reached 569,235 lots, compared with 482,270 lots at the end of May 2017. One lot equals 1,000 California Carbon Allowances (one CCA equals one metric tonne of CO₂ equivalent) or 1,000 RGGI allowances (one RGGI allowance equals one short ton of CO₂ emissions) and either 10 or 100 RECs, depending on the type of REC.

Interest and activity is not spread evenly among these markets, however, with CCAs and RECs traded more heavily than the RGGI allowances. So far in 2018, for example, volumes traded on Ice have reached 211,443 lots for CCAs and 299,910 lots for RECs, versus 41,761 lots for RGGI. This can be attributed to the fact that the RGGI is primarily seen as a compliance scheme for the north-eastern power sector, making it of less interest to outside entities that are not active in the region’s power markets.

“We see less activity in RGGI than we used to, so I wouldn’t call it an expanding market,” says Izzet Bensusan, founder and chief executive of Karbone, a New York-based environmental brokerage and advisory firm. “We also don’t see project activity that is RGGI-geared. For example, we see a lot of project activity for RECs and SRECs, and for CCAs, but no one builds a project to generate credits for RGGI, which shows that it’s more of a compliance allowance mechanism than anything else.”

Financial players are certainly becoming increasingly active in environmental markets in other parts of the world. A recent price rally in the European Emissions Trading System (EU ETS) was attributed to speculative trading by almost a third of participants in a survey of 370 carbon market players conducted earlier this year by Thomson Reuters. European Union Allowance (EUA) prices rose from €4.78 per tonne of carbon emitted on June 26, 2017 to €16.41 per tonne on May 29, 2018.

Following growing activity in the EU ETS, European Energy Exchange (EEX) – the main auction platform for the EU ETS and a secondary marketplace for its allowances – announced on April 23 that its US power exchange, Nodal Exchange, would launch a series of environmental products in the US in the second half of this year. While Nodal has yet to reveal any details, a new entrant could take market share from Ice with the right fees, liquidity levels and cross-commodity offering.

“Ice has gained market share [in the US environmental markets] partly because many gas and power contracts are also traded on the exchange and so cross-commodity trading can be conducted on the same platform,” says Adam Raphaely, Connecticut-based head of emissions and renewable energy at Mercuria Energy. “So Ice is in a good position now, but I don’t see any reason why new entrants couldn’t take market share away.”

Although secondary market interest and activity is generally considered an important element of these markets, proponents are unlikely to base success or failure on outside interest alone. For example, Bensusan is quick to emphasise the fact that the RGGI is fulfilling its original aim to reduce emissions. “I do think RGGI has been successful and I would also say that such schemes create additional positive momentum,” he says. “Success should never be about the product itself, but whether it has made the impact it needs to, and the answer [in the RGGI’s case] is yes, I think it has.”

Success should never be about the product itself, but whether it has made the impact it needs to, and the answer [in the RGGI’s case] is yes, I think it has

Izzet Bensusan, Karbone

And Grumbles says the RGGI’s members have reduced covered emissions by more than 50% compared with 2005. “The [primary aim] of RGGI is environmental – reducing greenhouse gas emissions – but over the 10 years and 40 auctions that have been held, we’ve not only demonstrated a track record of reducing emissions, but also of providing benefits to each of the participating states relating to revenues [from cap-and-trade allowance auctions] for energy efficiency and energy conservation and other matters that are important to these states, their environments and economies,” he says.

While RBC’s D’Agostino admits RGGI trading has been “fairly quiet” over the last year or so, he says new participants could change that. Discussions are ongoing with two potential new members: the state of Virginia and the state of New Jersey. The latter would actually be rejoining the initiative under new governor Phil Murphy after his predecessor Chris Christie exited the scheme in 2011. New state participants will obviously broaden the market, but D’Agostino believes the price effect will be fairly neutral. “New states will probably have their own supply and demand of allowances, which will be added to the overall programme, so I don’t think this will be a [major] boost to prices,” he says.

The Ontario fix

One recent dropout from the WCI, however, has caused detectable problems in the market. Following Ontario’s official entry into a joint trading scheme under the WCI with California and Quebec in January 2018 and the first joint auction the next month, the election of Doug Ford as premier in June 2018 saw the province promptly exit again.

Ford had campaigned on a promise of taking Ontario out of the WCI and ending its cap-and-trade programme, and he made good on that promise as soon as his election win was announced, casting a shadow of uncertainty across the market as participants pondered the likely exit strategy.

Anticipation of Ford’s success “definitely put a dampener on the market” in advance of the election, D’Agostino says.

“Prior to the Ontario election, the market was actually trading about where it is now,” adds a Houston-based power and emissions trader. “The market dropped [by 10 cents] the morning after the election and the big unknowns were when he was going to exit and what mechanism he was going to use.”

However, the effect was short-lived. The market’s recovery followed a rapid and successful salvage operation by the remaining participants. Traders were concerned that Ontario entities could flood the market with an estimated 150 million allowances in a bid to get some value before Ontario’s exit. However, the California Air Resources Board (Carb) – which operates the WCI alongside government entities from Quebec and, until recently, Ontario – quickly shored up market confidence on June 15 by announcing it would “prevent transfers of compliance instruments between entities registered in Ontario and entities registered in either California or Québec”.

“The Carb basically shut off the tracking system [that facilitates the transfer of allowances between traders] from receiving any allowances from Ontario entities, essentially safeguarding against such entities dumping allowances and putting downward pressure on the market,” Raphaely explains.

“First thing the following Monday, the [WCI] market traded up about 10 cents,” the trader recounts. “It is now near levels traded prior to the election, and the whole market knows Ontario allowances are not going to flood this market, regardless of when Ford pulls out of the scheme, so it should be trading on the fundamentals of California and Quebec only and some stability has returned. So that was positive news.”

Long-term certainty

Another boost to US environmental market certainty has come in the form of legislative moves to extend states’ schemes. In the REC market, New Jersey increased its RPS to 50% by 2030 in May 2018, Maryland is also expected to attempt an increase next year and Massachusetts legislators have floated a bill to increase its RPS by 3% per year for Class 1 resources (which refers to eligible renewable energy units that began operating after January 1, 1998), up from 1% per year. “That’s a market that stands oversupplied in the current year, so this provides a better price outlook and supports higher prices for new plant development down the curve,” says Peter Zaborowsky, a co-founder of brokerage Evolution Markets and head of its environmental markets desk.

While market experts believe RPSs are unlikely to be enacted in any more states, there is plenty of optimism about the development of existing REC markets, particularly given the likely phase-out of the federal tax credits on which much of the renewable energy development in the US has traditionally depended.

“Renewable energy is really driven by state initiatives. Any federal initiatives have been tax credit-based,” Zaborowsky says. “The current administration has [shown] no interest in extending or increasing tax credits for renewables but, even before the new administration came into office, there was a plan to phase out ITCs and PTCs [investment and production tax credits] for new renewable projects over time, anyway.”

Renewable energy is really driven by state initiatives. Any federal initiatives have been tax credit-based

Peter Zaborowsky, Evolution Markets

As such, Zaborowsky sees a bullish picture for RECs in the long term. “Look at the cost to build a new project and the likely revenue streams: electricity, RECs and tax credits,” he says, adding that the phase-out of tax credits and the fact that low natural gas prices are preventing electricity prices from rising are also important to the outlook. “If all else including project costs remains unchanged, it should put upward pressure on RECs.”

In fact, the PJM Tri-Qualified Class 1 market has already seen such a rally, according to Zaborowsky, with prices for the spot market rising from a recent low of $3 on October 2, 2017 to $7.65 as of June 22, 2018. “If you look at 2019, 2020 and 2021 as a three-year average price strip, the price is at $9.50 as of June 22, 2018,” he adds.

In the US emissions markets, both the California cap-and-trade scheme and RGGI have recently been extended to beyond 2030 and 2020, respectively. The RGGI completed a programme review in December 2017 designed to strengthen the scheme and provide more certainty for market participants post-2020. In addition to increasing the size and trigger price for its cost containment reserve (which holds allowances in reserve in case prices exceed predefined levels), RGGI will also introduce an emissions containment reserve to enable states to withhold allowances from circulation if emission reduction costs fall below projected levels.

Raphaely believes such efforts have supported market certainty. “The caps will obviously decline for emissions and so we may see volumes decline [in the long term], but at the same time new states will opt in,” he says. “By the end of this year we could see Virginia and New Jersey finalise their plans for linking and rejoining RGGI, which could collectively add more than 50% growth to the existing market as it relates to the caps.”

And according to D’Agostino, the strengthening of the RGGI has the potential to be “an even bigger price driver” than the addition of new state participants. “The post-2020 phase of the scheme … will introduce an emissions containment reserve and adjust the bank to get rid of some excess allowances/supply. That’s probably the biggest kicker right now in the RGGI market.”

Acting globally

When it comes to carbon cap and trade, optimism about the future of state schemes and regional groupings is encouraging, but most experts believe a global effort is necessary to really make a dent in GHG emissions. Initiatives are already under way in other parts of the world. The Chinese government released details of the framework for its national emissions trading scheme last December. It will focus initially on power generation, extending over time to seven other sectors, including cement and steel. The EU ETS, which covers large power stations, industrials and European flights, was in talks about co-operation with both China and California late last year.

Sandor, whose Chicago Climate Exchange established the first Chinese environmental exchange alongside China National Petroleum Corporation and the city of Tianjin in 2008, believes the participation of China in global efforts to tackle GHG emissions will be a boost to other emerging and developed markets. “I think there is a real opportunity to change the minds of anyone who thinks a market-based solution isn’t valid, so I’m very optimistic about [the development of carbon trading in China],” he says.

In fact, Sandor believes the necessary mindset is already taking over, not only politically (outside the US anyway), but in other spheres of influence as well. Pointing to the recent investment in the Tianjin Climate Exchange by Alibaba’s Ant Financial Services Group, he says: “You have the biggest oil company in China and the Amazon of China owning a climate exchange – what does that tell you?”