Why are the world’s cap-and-trade markets struggling to keep prices up?

Since 2011, California has used a greenhouse gas cap-and-trade market as one of its programs aimed at reducing carbon emissions over time.
Since 2011, California has used a greenhouse gas cap-and-trade market as one of its programs aimed at reducing carbon emissions over time. Getty Images file

The cost of sending a ton of greenhouse gas emissions into the air isn’t what it used to be, at least not in the handful of markets that are putting a price on climate change.

Similar to California’s weak May auction for carbon credits, the world’s two other greenhouse gas cap-and-trade markets are notching falling prices this year.

One in Europe is still adjusting to a glut of emission allowances it handed out before the recent recession drove down energy use.

The other, a collection of nine states in the northeast called the Regional Greenhouse Gas Initiative, is recording low prices while energy producers await a Supreme Court decision that could shape its future.

Defenders are quick to say that all three markets are doing their job compelling industries to reduce their use of fossil fuels, but the markets’ recent lackluster performance is raising questions about how they can be reformed.

The precedent they set matters in no small part because other countries from China to Mexico are at different stages of developing their own greenhouse-gas-reduction plans.

Worldwide, about $52.8 billion worth of trading took place in carbon markets last year, according to a Reuters report. The World Bank and other economists project growth in years ahead as more governments create new systems.

“The important thing is that all of them still trade and the environmental targets are being met,” said Dirk Forrister, the chief executive of a Geneva-based organization that advocates for cap-and-trade markets called the International Emissions Trading Association.

The recent downturn in the domestic emissions market shows that the California’s Air Resources Board and its counterparts in the Regional Greenhouse Gas Initiative still have work to do in refining pioneering programs they set in motion a decade ago.

Here’s a look at what’s holding down prices at the world’s first cap-and-trade markets.

Looming court decisions

Unexpected news in the form of a natural disaster or a surprising court order can startle any financial market. Both domestic cap-and-trade markets experienced the latter this year.

In California, the shock came in April when a state appeals court issued a series of questions to the California Air Resources Board in a long-running lawsuit from the California Chamber of Commerce that challenges the state’s ability to collect revenue through cap-and-trade.

Those questions may have signaled to utilities and industries regulated by the Air Resources Board that the court could favor the chamber’s lawsuit and strike down parts of the program.

Shortly after the ruling, investors stayed on the fence when the board hosted a May auction for carbon credits. Just 11 percent of the available allowances traded hands, generating $10 million in revenue. All the credits sold at the price floor of $12.73.

Previous auctions had raised hundreds of millions of dollars. From 2012 to 2015, the state raised $3.5 billion through those auctions, according to a January report from the Legislative Analyst’s Office.

Similarly, the U.S. Supreme Court in February issued a ruling that delayed implementation of an Obama administration proposal to slash greenhouse gas emissions called the Clean Power Plan.

That plan had been expected to drive interest in the northeast market by rapidly lowering caps on carbon emissions and enticing more states to join the nine-state system.

Since the court order, the cost of carbon credits in the northeast market dropped from $7.50 per allowance in December to $4.53 in June.

“While there are many and complex reasons for the muted response to California’s most recent auction of emissions allowances, uncertainty over the future of the state’s climate policies created by litigation and legal concerns was unquestionably a factor,” said state Sen. Fran Pavley, a Democrat from Agoura Hills who wrote the greenhouse gas law that led to today’s cap-and-trade market.

Complementary but competing policies

California’s cap-and-trade market is one piece in a small arsenal of statewide policies that aim to cut greenhouse gas emissions.

At the same time that the Air Resources Board developed its cap-and-trade market, the state also set standards requiring utilities to generate a greater share of electricity from renewable fuels.

Another measure required auto manufacturers to develop dramatically more fuel-efficient cars. Other programs offer incentives to people who buy zero-emission vehicles or put solar panels on their homes.

Those endeavors all share the same goal of cajoling people to wean themselves off fossil fuels, but economists say they may be diminishing demand for the cap-and-trade program by cutting emissions.

For instance, in a standalone carbon market, a business would be free to choose the least-expensive way to cut its greenhouse gas emissions. In the hybrid system favored by California, companies may also have to invest in technologies recommended by the state in addition to participating in the cap-and-trade market.

“Right now, carbon markets are hamstrung by a growing medley/cacophony of policies that drive allowance prices down. If we want to see carbon markets really work, we need to give them more work to do,” wrote Meredith Fowlie, a UC Berkeley environmental and resource economics professor, in a June essay that asked whether it is “time to unleash the carbon market” by scaling down some of the policies that compete with cap-and-trade.

An emission surplus

The three big cap-and-trade markets gained momentum in the boom years leading up to the Great Recession. Those good times encouraged market makers in Europe and in the northeast to overestimate the amount of greenhouse gas emissions they’d need to regulate.

Later, cheap natural gas prompted northeast power companies to shift from using coal to the cleaner-burning fuel, further diminishing the need for utilities to buy carbon credits in the cap-and-trade market.

As a result, the two markets had a surplus of unneeded carbon credits.

Both the European Emissions Trading Scheme and the Regional Greenhouse Gas Initiative have sharply reduced their emissions caps. In the northeast, that decision drove the price of emissions credits up from about $2 in 2013 to as high as $7.50 last year.

Despite the recent chill in the market, carbon credits are still more expensive today than they were before the reforms in the Regional Greenhouse Gas Initiative.

“They had overallocated because they were doing their best forecast, but the circumstances changed,” said William Shobe, a University of Virginia professor who watches the cap-and-trade markets. “In a sense, that was good climate news because it turned out to be much cheaper to achieve reductions.”

California is still going it alone in the West

A decade ago, California lawmakers and air-quality regulators envisioned a multistate cap-and-trade market that would create a level playing field for industries across the West.

In that scenario, California companies would face the same economic pressure as their competitors in other states to offset the impacts of carbon emissions.

It didn’t happen.

So far, Washington’s Democratic Gov. Jay Inslee has been rebuffed by Republican lawmakers in his campaign to bring a carbon market to the northwest. Other states aren’t showing signs that they want to join California, either.

Expanding the market could drive up demand for carbon credits. It also would ease worries among California businesses that the cap-and-trade market puts them at a competitive disadvantage with rivals.

“There’s this constant concern that we are paying what our competitors are not,” said Dorothy Rothrock, president of the California Manufacturers and Technology Association.

Unpredictable lawmakers

Pavley’s 2006 law that laid a foundation for the state’s cap-and-trade program explicitly runs through 2020, and the California Air Resources Board believes it has the authority to continue running the program after that year.

Lawmakers are not so sure.

A January report from the Legislative Analyst’s Office noted “legal uncertainty” about whether the cap-and-trade program can continue into the next decade, and whether the Air Resources Board can enforce more stringent emission reduction targets favored by Gov. Jerry Brown.

Investors and businesses may be holding back in today’s market, waiting to see if they’ll need to buy more emission allowances to use after 2020, said UC Davis economics professor James Bushnell.

“People should still expect to buy permits sooner or later, but it appears they want to do it later,” he said.

Pavley this summer is carrying a bill that would set more aggressive targets for greenhouse gas reduction, although it doesn’t explicitly renew cap and trade. Other lawmakers have different priorities, including Assemblyman Adam Gray, a Merced Democrat who wants an audit of how the state is spending revenue from its cap-and-trade auctions.

He wouldn’t say whether he thinks the Legislature needs to renew the program for it to continue. Instead, he’s waiting for the state appeals court decision on whether cap and trade can continue in its present form.

“There doesn’t seem to be any agreement,” he said.

Adam Ashton: 916-321-1063, @Adam_Ashton