ACES: Pricing and Trading
Implications
Praveen Kumar, Ph.D.
Bank/Tenneco Professor
C.T Bauer College of Business
Executive Director, GEMI
Markets in the CT System
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Primary Markets: Allowances (See Presentation by Professor Flatt)
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Auctions
• Roughly 20% of allowances auctioned cumulatively 2012-2025
• This proportion doubles (40%) for 2012-2050
• Allocations:
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Proportion of free allocations rises in 2012-2016, stays about flat till 2026, and then declines at a
accelerating pace to attain its lower bound in 2036
Major sectors: Distribution of allocations is 35% for power sector, 15% for trade-exposed
industrials, 9% Natural Gas sector
Primary Markets: Offsets
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EPA Approval of recommended projects from the Offsets Advisory Board
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Markets in the CT System
• Secondary Markets:
• Spot market in allowances;
• Spot market in offsets;
• Derivative markets in allowances;
• Derivative markets in offsets (?)
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Important Aspects
• Section 721(a): Vintage year emission allowances for 2012-2050,
with provisions for regulatory revisions (i.e., not a “property
right”)
• No restrictions on Banking (i.e., allowances generally do not
expire)
• Borrowing on Section 721(a) allowances, up-to 5 years ahead, no
more than 15% of compliance obligations and subject to interest
• Market participation in Auctions and secondary markets not
restricted to covered entities
• Emissions allowances, compensatory allowances and offset
credits can be sold, exchanged, transferred, held for compliance,
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or retired
Basic Issues
 Pricing Drivers: Factors underlying pricing in spot and derivative
markets?
 Price Discovery: Low pricing errors in the primary and secondary
markets through efficient aggregation of dispersed information on
allowance values
 Liquidity: Relatively low-transactions costs in effecting trades,
facilitating price discovery and dampening volatility
 Volatility: Excessive volatility can have major economic costs by
affecting (real) investment planning of capped entities
 Market Manipulation: Possibilities of cornering, squeezes,
strategic linked-positions (spot and futures)
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Pricing Drivers
 Net demand (demand – supply) of
allowances will depend on factors that
are:
Fundamentals-related
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–
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Level of economic activity (+)
Oil and gas price levels (+)
Cost of emission reduction (+)
Technological innovation in reducing GHG emission
in production (-)
– Availability of reliable, high-performing offsets (-)
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Pricing Drivers
 Trading-related
– Expectations of supply constrained allowance market (+)
– Frictions in borrowing allowances (+)
– Attempts to corner or squeeze markets in anticipation of
market disruptions (+/-)
•Regulation-related
– Regulatory discretion to increase allowance allocations (-)
– Expectations on Liberalization of Standards for Offsets (-)
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Implications: Allowances
•
The demand and supply for allowances for a regulated entity (at
any given time) in the secondary market depends on:
– Marginal cost of reducing emissions or meeting the cap by
alternative methods;
– Trading price;
– The stock of allowances outstanding (depends on the stock of
non-surrendered allowances plus permits banked from
previous years plus permits borrowed from future years);
Implications: Allowances
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The Cap starts at 97% of 2005 emissions and declines to 17% of
2005 emissions by 2050
Consumer emissions of electric and gas LDCs will be included as
part of their emissions
Although overall emissions declined in 2006-2008, certain high
GHG-emitting industries, such as upstream O&G, are at a higher
level in 2008-2009 because of higher drilling activity etc.
With the economic recovery in 2010+ time-frame, the cap may
become binding for many sectors:
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Electricity LDCs and Merchant Coal Generators
Oil (upstream and downstream)
Gas LDCs
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Implications: Allowances
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Substantial free allowance allocation to these sectors will lower
their immediate cost exposure but forward projection will indicate
difficulties in controlling emissions in the short-to-medium run
For a gas LDC, emissions will fall only if either customers use
less gas or there is a significant increase in energy consumption
efficiency
Resumption of economic growth and customers switching from
coal to gas will actually increase gas consumption (higher
emissions) while increased consumption efficiency has an
uncertain trajectory
ACES has no provision as of now to incent customer investment
in consumption efficiency or provide a rate recovery mechanism
for investment by LDCs
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Implications: Allowances
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For the O&G industry, ongoing economic recovery of India and
China, and anticipated acceleration of recovery in US in 2010,
raises expectations of resumption of drilling activity and
increased capacity utilization in refining plants
Availability of technologies to substantially reduce GHG
emissions in E&P and refining at reasonable costs appears
unlikely even in the medium term
Upshot: Likely allowance banking (hoarding) initially (2012-) by
firms in the major regulated sectors
The decline in the cap will therefore imply a tendency toward a
supply-constrained market, based on the fundamentals-related
factors
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Supply constraints on allowances may be relaxed if:
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Rapid progress in technological innovation and development of
offsets leading to sharp declines in costs of reducing emissions
Amendments in the legislation substantially increase allocations to
“non-merchant” power sector: public power companies, electricity
coops etc.
Legislation puts caps on rate increases across the board (effectively
equals additional allocations)
Regulators are forced to revise rules for accessing the strategic
allowance reserve fund to lower costs (political pressure), dampen
volatility etc.
There is substantial participation in the auctions by non-regulated
entities and there is (occasional) forced liquidation of holdings
The economic recovery is anemic and the slump is much longer and
deeper than being currently projected
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Pricing Trends: Allowances
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Initial price discovery in the auctions process and eventually in
the futures markets (the Treasury bill market is a good model
here)
Futures markets lead price discovery in the EU ETS system
Possibility of over-pricing early on because of limited information,
over-estimation of supply constraints, and the winners curse
problem
Winners curse: Winners in auctions ignore less optimistic signals
of other bidders ( “I’ll never join a club that accepts my
membership”…Groucho Marx)
Possibility of a (minor) “bubble and burst” price trajectory in the
initial phase of the program
However, underlying trend likely to be positive in the medium-run,
2012-2025
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The EU Experience: Phase I
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Phase I covered January 2005-December 2007 and all 15 member
countries participated
Covered about 12,000 installations, representing approximately
40% of EU CO2 emissions, covering energy activities, production
and processing of ferrous metals, mineral industry (cement
clinker, glass and ceramic bricks) and pulp, paper and board
activities
Price of allowances increased (almost steadily) to a peak level in
April 2006 of about €30/ton of CO2
Prices collapsed in May 2006 to under €10/ton when revealed
registries indicated that caps in most countries were generous
and allocations were often in excess of business-as-usual
emission levels
Excess (potential) supply of allowances in Phase I continued
through 2006 resulting in a trading price of €1.2/ton in March 2007,
declining to €0.10 in September 2007
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The EU Experience: Phase II
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Phase II covers January 2008-December 2011
Expands participation to some non-EU states (e.g.,
Norway) and expands coverage: Aviation industry is
the major new industry to be covered
Based on the Phase I experience, emission caps
tightened, and each country has to get its allocation
scheme approved by EU
Introduced auctions (up-to 10%)
Prices rose steadily during 2008 and have tracked
expectations on economic recovery in 2009
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Comparison with the ACES System
The ACES has allocation and auction targets that are based
on much more aggressive emission reduction targets (17%
reduction of 2005 levels by 2025, 83% by 2050) compared to
the EU Phase I
Moreover, the linkage of allocations and auction
proportions to these targets is much more transparent than
was the case in EU Phase I
The coverage under ACES also much broader than the EU
Phase I coverage
Thus, lower likelihood of a major “bubble and bust” in the
US allowance markets, unlike the May 2006 experience in
EU ETS
However, ACES gives significantly greater role to offsets
than EU ETS
Regulatory uncertainty is greater in the implementation of
ACES
Pricing of Offsets
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Basics: Buying an offset is buying a long-term asset that
has risky payoffs:
– The “payoff” from the offset in any given year is the
incremental saving meeting the emission target/cap through
the credit from the offset versus
– Meeting the cap through (costly) activities at the business
level or
– Buying an allowance in the future spot market;
Pricing of Offsets
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Example: Greenhouse Galore, Inc. has bought offset in 2011. In
2012, the offset is expected to provide a credit of 100,000 metric
tons of CO2 equivalent;
The company amortizes the purchase price of the offset so that
cost per ton of credit in 2012 is $12.
The company expects that the average price of allowances in the
spot market in 2012 to be $20/metric ton of CO2 equivalent;
Also in 2012, the estimated cost of reducing emissions internally
is $35/metric ton of CO2 equivalent;
The “opportunity gain” of having the offset for 2012 is
= 100,000 x (20-12) = $8,00,000
Pricing of Offsets
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The value of an offset can be generally given as follows.
Suppose that the if held to “maturity” the offset is supposed to last T
years;
G(t) = Expected opportunity gain from having the offset in year t…note this
requires estimating the average allowance price + the marginal cost of
meeting the cap by activities outside the cap & trade system;
R(t) = Risk-adjusted discount rate for receiving the benefits/gain from
offset in year t;
Price of Offset: =
T
P0 = ∑
t=1
G(t)/(1 + R(t))t
Pricing of Offsets
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The risk-adjusted discount rate captures:
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$-value of waiting (risk-less interest rate);
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The return from investing in an asset that has the
same risk-profile as the offset ;
In practice, expect
R(t) = Cost of Capital (for the company) + Risk-Premium
Pricing of Offsets
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The Risk-premium will depend on:
The non-insurable or non-diversifiable failure risk from the offset;
Note: If the firm has to buy insurance or do costly hedging against failure
risk, then those expenses have to be deducted from G(t) ;
Risk-premium depends on:
Uninsurable performance risk of projects (+);
Regulatory risk (changing rules ex post) (+);
Presence of strong legal framework to protect against
performance risk (-)
Effects of Offsets on Allowance Prices
• Offsets
and allowances are imperfect substitutes for
meeting emission compliance obligations:
• Unless
there is significant ex-post (after issue)
regulatory revisions, allowances can vary only in market
value
• Offset
projects may typically require on-going
monitoring and investment
• Insignificant
the event of performance failure, there may be
legal and administrative costs
• cash
Hence, offsets pose not only market value risk, but
flow risk (e.g., unanticipated monitoring,
investment or legal costs during tight cash flow periods)
• Generally,
expect allowance markets to be more liquid and
have better price discovery (e.g., from the futures markets)
compared to offsets markets
Effects of Offsets on Allowance Prices
• But
the offsets market will be subject to much greater
“regulatory revisions”
• Expansion of lists of acceptable projects
• Changes in the approval process
• Modifications
in the liability-incidence (who pays for
performance failures etc.) in response to legal challenges and
decisions
• fungibility
Expansion/modification of cross-border (international)
of offset credits as cap and trade markets are
established in an increasing number of countries
• Possibility
of frequent significant mis-alignment of
expectations and outcomes in the offsets market
• Regulatory
uncertainty in offsets likely to be a major driver
for price volatility in allowance markets
Market Manipulation Scenarios
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The possibility of manipulation and “market gaming” increases if :
– Assets that are economically similar (in terms of cost of
access and revenue potential, for example) are differentiated
by regulatory fiat:
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Assets in certain geographic areas are inadmissible
Early emission reductions are valued more (e.g., California)
Offset value caps (e.g., 3.5% limit on offsets against cap in RGGI)
Cap allocation based on complex rules (firm history, industry location
etc.)
– Market regulators are known to have ex post discretion to alter
trading rules based on specified market developments (e.g.,
bailouts or loan forgiveness when markets are stressed);
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