UK and California Allowances

In Depth Analysis of UK Allowances and California Carbon Allowances

1. UK Allowances

   1. UK ETS Caps

   2. Challenges Ahead: Limited Abatement Options in UK ETS

2. California Carbon Allowances

   1. Californian Carbon Policy Updates

   2. California's Slow Emissions Decline and Future Challenges

3. Conclusion

UK Allowances

UK Allowances (UKAs), a type of carbon emissions permit used in the UK, have had an interesting year in 2022. While the market showed some strength in the first three quarters of the year, with UKAs outperforming EU Allowances (EUAs) due to increased demand from gas-powered electricity providers in the UK, the trend reversed in the final quarter. UKAs ended the year at £73.25, down 9% from the previous quarter.

One of the key drivers behind the strength of UKAs earlier in the year was electricity exports into continental Europe. As gas prices soared across Europe, gas-powered electricity providers in the UK turned to coal-fired power plants, leading to an increase in demand for UKAs. This, in turn, led to a rise in the price of UKAs relative to EUAs.

However, the trend reversed in the final quarter of the year, with UKAs underperforming EUAs by a large margin, close to 30%. One of the main reasons for this was the ramping up of nuclear reactors in France, which reduced demand for UK electricity exports. Additionally, strong wind power generation in the UK during Q4 led to a decrease in demand for emissions allowances, further contributing to the weakness of UKAs.

Overall, the performance of UKAs in 2022 highlights the importance of understanding the dynamics of the emissions trading market. While UKAs showed strength earlier in the year, this was largely due to external factors such as the increase in gas prices across Europe. As the market adjusted to changing conditions, the relative value of UKAs declined.

Looking ahead, it will be interesting to see how the market for emissions trading evolves in the coming years. With the UK committed to reaching net-zero emissions by 2050, there will likely be increased demand for emissions allowances in the future. However, the market is likely to be subject to ongoing fluctuations and uncertainty, as a range of economic, political, and environmental factors impact the value of UKAs and other emissions permits.

UK ETS Caps

The UK's commitment to reducing greenhouse gas emissions has been a prominent feature of the country's climate policy for some time, and it is expected that the UK ETS will play a significant role in helping the country meet its net-zero target by 2050. The UK ETS was introduced at the start of 2021 to replace the country's obligations under the EU ETS after Brexit, and it has been performing relatively well thus far.

However, policymakers have recognized that the current caps in the UK ETS will need to be lowered in order to align with the country's net-zero target. In a 2022 public consultation, the UK government proposed a decrease of 30-35% of the total emission budget in Phase 1 (2021-2030), with an expected one-off decrease of the cap in 2024 by about 40%. This reduction in emissions caps is expected to be achieved by implementing measures such as expanding renewable energy generation and improving energy efficiency across different sectors.

The proposed reduction in emission caps is significant, and it is likely to have a material impact on the UK ETS market. The reduction in supply will lead to a decrease in the number of allowances available, which will support market prices. This decrease in supply is expected to be most significant in the years 2024-2030, leading to meaningful annual net deficits, which will put upward pressure on prices.

It is worth noting that climate action is relatively popular across the British political spectrum, and the timeline for passing and implementing new policies is quicker in the UK than in the EU. This means that it is possible for the UK to begin the legislative process this year and still revise caps in time for the 2024 compliance year.

Challenges Ahead: Limited Abatement Options in UK ETS

The UK's transition to a low-carbon economy has been underway for some time, and the implementation of the UK Emissions Trading System (ETS) at the start of 2021 was a major milestone in that process. The UK ETS replaced the EU ETS, which the country was part of until the end of 2020. While the market has been relatively tight in the early stages of the UK ETS, with prices hovering around £50 per tonne of CO2 emissions, it is expected that caps in the system will soon be lowered to align with the country's net zero targets.

However, achieving such ambitious goals will be no easy feat. With limited opportunities for inexpensive emissions reductions, policymakers and market participants alike will need to focus on more expensive abatement options to achieve meaningful reductions in greenhouse gas emissions. In particular, the lack of coal-fired generation in the UK and limited electricity interconnection with continental Europe mean that coal-to-gas switching is not a viable option for significant emissions reductions.

Furthermore, the net zero pathway presented to the UK parliament in 2021 expects emissions to fall by 71-76% by 2030 compared to 2019 levels. Such a significant reduction will require prices to rise to much higher levels to incentivize abatement across the economy. As such, it is likely that strong policy support will be required to facilitate higher UK ETS levels and incentivize the development of new abatement options.

California Carbon Allowances

California Carbon Allowances (CCAs), a type of carbon emissions permit used in California's cap-and-trade program, had a strong performance in 2022. CCAs appreciated about 5% over Q4, ending the year at $30.35. This strong performance in Q4 was correlated with increasing auction demand in November, which showed the highest auction bid coverage ratio in recent years, with the number of bids exceeding auctioned allowances by 80%.

One of the key drivers behind the strong performance of CCAs in 2022 was high inflation observed throughout the year. This provided further support for the CCA auction market, as investors sought out assets that could provide a hedge against inflation. Additionally, the 2023 reserve (floor) price rose to $22.21, up from $19.70, and the ceiling price rose to $81.50 from $72.40. This 12.74% increase, which included the baseline 5% plus CPI (7.74%), represented the highest increase in the California cap-and-trade program's history.

These new parameters provide a positive asymmetrical risk/return profile at today's price of $30 while also implying, all else equal, a 12.74% natural upside tailwind without changes in demand/supply. This suggests that there is potential for further appreciation of CCAs in the future, as demand for emissions allowances continues to increase.

Looking ahead, the performance of CCAs is likely to be influenced by a range of economic, political, and environmental factors. The California cap-and-trade program has been successful in reducing emissions and promoting the use of renewable energy sources, and this is likely to continue to be a key driver of demand for CCAs. However, the market is also subject to ongoing fluctuations and uncertainty, as a range of factors such as changes in government policy, technological advances, and geopolitical tensions impact the value of CCAs and other emissions permits.

Californian Carbon Policy Updates

California policymakers are expected to take significant steps to reduce greenhouse gas emissions in 2023, in line with the state's more ambitious climate goals. The California Air Resources Board's recent review of the state's 2022 Scoping Plan suggests that California will adopt a 48% emissions reduction target for the year 2030 compared to 1990 levels, which is significantly higher than the minimum mandated level of 40%. As cap-and-trade covers 80% of California emissions, it is a major policy mechanism to meet the state's increased ambition to reduce emissions.

To achieve this goal, policymakers are expected to tighten emission caps, which would provide support for California Carbon Allowances (CCAs). The California legidslature passed a bill in 2022 that set a 2045 climate neutrality target and an explicit 85% emissions reduction target for that year (California Assembly Bill AB 1279). Policymakers are expected to take steps in 2023 to tighten California's annual emissions caps, which would lower supply by about 8.7% in the impacted years 2025-2030 and lead to meaningful annual net deficits, putting upward pressure on prices in the WCI ETS, where CCAs are trading.

The performance of CCAs in 2022 was positive, with an appreciation of about 5% over Q4, ending the year at $30.35. This strong performance in Q4 correlated with increasing auction demand in November, which showed the highest auction bid coverage ratio in recent years, with the number of bids exceeding auctioned allowances by 80%. High inflation observed in 2022 provided further support for the CCA auction market.

The 2023 reserve (floor) price rose to $22.21, up from $19.70, and the ceiling price rose to $81.50 from $72.40. This 12.74% increase, which included the baseline 5% plus CPI (7.74%), represented the highest increase in the California cap-and-trade program's history. These new parameters provide a positive asymmetrical risk/return profile at today's price of $30 while also implying, all else equal, a 12.74% natural upside tailwind without changes in demand/supply.

In conclusion, California policymakers are expected to reduce emissions caps in line with stronger climate ambitions in 2023, providing support for CCAs. Tightening emission caps will lower supply, leading to meaningful annual net deficits and putting upward pressure on prices in the WCI ETS. With a positive asymmetrical risk/return profile at current prices, CCAs offer an attractive investment opportunity for those looking to benefit from California's climate goals.

California's Slow Emissions Decline and the Challenges Ahead

California is a pioneer in climate change action, and its cap-and-trade program is one of the most ambitious and successful in the world. However, recent data shows that California-covered emissions have exhibited slow declines that are not enough to meet the state's ambitious goals. Moreover, there are no low-hanging fruits remaining in power generation, which makes reducing emissions even more challenging.

One major challenge in California is that emissions from supplied transport fuels dominate the market, making up about half of all covered emissions. Despite ambitious targets to reduce transport emissions, progress towards emissions abatement in this sector is slow. While California targets zero-emitting vehicles to make up 100% of sales by 2035, vehicles tend to last around 12 years. Even with ambitious sales targets, zero-emitting vehicles will make up a much smaller share of the fleet, estimated to be less than 20% of the light-duty vehicle fleet.

Furthermore, reduced caps will add upward price pressure to the market from the supply side, but considerable pressure also exists on the demand side in California. Unlike Europe, where covered emissions can shift substantially from one year to another, California-covered emissions tend not to move very much. In the three years prior to the pandemic, total covered emissions moved by no more than 1% year-on-year.

California has made progress in reducing emissions from power generation, but there are no low-hanging fruits left in this sector. The state has already phased out coal-fired generation, and renewable energy has been growing rapidly. However, achieving further emissions reductions in this sector will be more difficult and expensive.

To meet its ambitious climate goals, California will need to tackle emissions from transport fuels, which is a tough nut to crack. Consumers tend to replace older vehicles with newer ones, and it will take time for zero-emitting vehicles to make up a significant share of the fleet. Policymakers will need to explore other options, such as incentives for public transportation, biking, and walking. With demand-side pressures adding to supply-side pressures, there is a strong policy support for higher California ETS levels to achieve ambitious goals.

Conclusion

The UK ETS has undergone significant changes since the country's departure from the EU ETS. The government has committed to aligning the emission caps with the 2050 net zero target, resulting in expected reductions of 30-35% of the total emission budget in Phase 1 (2021-2030). However, with no easy abatement options, prices will need to rise to incentivize abatement, and policymakers will need to act quickly to revise caps in time for the 2024 compliance year.

In California, covered emissions have exhibited slow declines due to emissions from supplied transport fuels dominating the market, making up about half of all covered emissions. While the state has ambitious targets for zero-emitting vehicles, consumers typically purchase new vehicles to replace older ones, and these vehicles tend to last around 12 years. With no low-hanging fruits remaining in power generation, policymakers must look for innovative solutions to incentivize emissions reductions in the transport sector.