Severin Borenstein, James Bushnell, Frank Wolak, and Matthew Zaragoza-Watkins “Report of the Market Simulation Group on Competitive Supply/Demand Balance in the California Allowance Market and the Potential for Market Manipulation” (July 2014) | WP-251 | Blog Post

We analyze the demand for emissions allowances and the supply of both allowances and abatement opportunities in California’s cap and trade market for greenhouse gases (GHG). We estimate a cointegrated vector autoregression for the main drivers of greenhouse gas emissions using annual data from 1990 to 2011 and use it to simulate business-as-usual (BAU) emissions during California’s program during 2013-2020, the years for which the rules of the program have been established. We then consider additional price-responsive and price-inelastic activities — such as state’s other GHG reduction programs — that will affect the supply/demand balance in the allowance market. We show that there is significant uncertainty in the BAU emissions levels due to uncertainty in economic growth and other factors. Our analysis also suggests that while many GHG abatement programs are in place, most of the planned abatement will not be very sensitive to the price of allowances, creating a steep abatement supply curve. The combination of BAU uncertainty and inelastic abatement supply implies a high probability that the price in the California [allowance market] will either be at the price floor, or high enough to trigger a safety valve mechanism called the Allowance Price Containment Reserve (APCR). We find similar results for the first two compliance periods within the program — 2013-2014 and 2015-2017 — though with higher probabilities that the price will remain at the floor. However, we also find significant risk that market participants might be able to artificially inflate prices by “banking” allowances for later use. We conclude with recommendations for changes to the market rules that would greatly reduce the risks of extreme price spikes from real or artificial shortages.

We argue for two changes in particular.  The first is a more explicit mechanism for ensuring that the APCR is not exhausted prior to 2020, thereby limiting prices to not exceed the highest tier of the APCR.  The second recommended change is to allow conversion — for a fee — of the vintages of allowances already held by compliance entities.  In this way in-circulation allowances from one compliance period could, at a cost, be applied to other compliance periods.  Vintage conversion would greatly bound the extent to which compliance costs from one period diverge from those of other periods.