Have Carbon Prices Broken Containment in Washington State?

What is the best way to limit carbon price volatility?

While it may not be making national headline news, the carbon market in Washington State has generated some newsworthy outcomes. Washington’s carbon market, which is called a “cap-and-invest” system, began this year and has been notable for prices considerably higher than other markets in the U.S., although still lower than the European Union’s ETS.  

These prices are starting to draw attention for what they are doing to gasoline prices. Recent reports that California has been relegated to 2nd place in the “state with the worst gas prices” sweepstakes frequently point to carbon pricing as a big factor.

What is most interesting about the Washington story is that the state, like California, had put in place policies intended to stabilize carbon prices. At their best, these “cost-containment” policies can be an important,  perhaps the most important, element of carbon market designs.  

The most recent price surge in Washington, however, has evolved even as those policies have swung into action.

An Ambitious Policy

Washington’s first allowance auction set a price over $48 per metric ton in early March. By contrast, California (which shares a carbon market with Quebec) auctioned allowances for around $27/ton in February –  just below its all-time high of $31/ton last May –  and prices in the eastern U.S. RGGI market have barely crossed $12/ton. It turns out that March was only the warm-up (no pun intended), however, as Washington’s prices in the second quarterly auction in late May rose over $56/ton and recently had reached over $66 a ton in the secondary market.  

 The $48 price in February raised some eyebrows, but, from what I can tell, was not unexpected.  After all, the state’s goal is to cut covered emissions in half by 2030, and there isn’t much low-hanging fruit. A June 2022 study by contractor Vivid Economics projected prices over $55/ton. In most carbon markets, electricity generation provides a key margin of price-responsive abatement.  Washington’s carbon emissions are dominated by transportation fuels and, to a lesser extent, industrial emissions.  Its electricity supply is already so clean, there isn’t much more that can be done in response to a rising CO2 price.   

As we have commented in the past, a carbon market with inelastic abatement supply is quite likely to experience price swings in the face of the random ebb and flow of CO2 emissions that can be influence by the economy, world energy prices and even the weather. Volatile emissions prices can increase costs, undermine public support for emissions reductions, and dampen innovation.  This is why cost-containment measures are so important.

Cost Containment in Cap and Trade Markets

 As we have described in the California context, markets such as Washington’s are not really “caps,” so much as hybrids of carbon caps and carbon tax mechanisms. Carbon prices are supposed to be modulated by the state through the injection (in the case of high prices) or withdrawal (in the case of low prices) of  allowances. In this way the caps are elastic, expanding if prices rise to unacceptably high levels and contracting if prices are surprisingly low. The way the price ceilings are supposed to work is that, shortly after an allowance auction where prices exceed trigger levels, there is a 2nd auction of “reserve” allowances (from the Allowance Price Containment Reserve (APCR)) with a minimum trigger price that effectively sets the market ceiling. The volumes provided in the second auction hopefully satisfy demand and stabilize prices at that ceiling.  

 While the price floor has played an important role in California’s market over the last decade, the price ceilings in the Golden State have not been tested.  Washington, by contrast, triggered its price ceiling on just its second try, during the May auction. This brought into play the question of how many allowances from the reserve should be sold. During the last decade, California adopted a fully “front-loaded” policy that would make the entire allowance reserve available if-and-when a price ceiling was reached. [1] In addition California now has a “hard” price ceiling, adopted in 2017, that would put a cap on prices even if all the allowances in the reserve are exhausted. 

The Vivid study of Washington’s market examined a scenario where Washington’s reserve would also be at least somewhat front loaded, and it implied lower prices in the early years of the program. However, Washington’s Dept. of Ecology  announced on June 9th that it would make only about 1 million out of the 18 million tons in the reserve available when it taps the reserve on August 9th.  Only half of that, about 520,000 tons, would be available at the first price-trigger level of $51.90/ton, with the second batch being available only for a minimum price over $66/ton. The announcement seems to have been quite a surprise.  Futures prices on Washington Carbon Allowances (albeit thinly traded) jumped about $10/ton the day of the announcement. Today they sit around $63/ton.  

The idea of having two (or more) price-ceilings always struck me as a little strange. Setting these levels is more political, than economic, science. In California’s current policy these price tiers are colloquially known as “speed bumps” – a reference to the idea that they would slow down price increases. The only point of having multiple price tiers is for there to be some prospect of prices settling at the lower tier. This seems plausible if all of the reserves at the lower tier were sold before tapping into the reserves in the higher tier. I would think that selling only some of the low-price allowances now, while holding the rest back for later would increase price volatility, while the whole point of price-containment reserves is to dampen that volatility.  

Should We Worry About Speculators?

Also surprising, to me at least, is the justification offered for setting the sale quantities where they did. Among the three factors determining the quantity of reserve allowances to be sold, the June 9th announcement lists “The total supply and percentage of allowances purchased by non-covered entities (general market participants) in the preceding quarterly auction that triggered the APCR.” The term “non-covered entity” refers to a firm that buys permits but does not need them for compliance (aka financial firms or  “speculators”). In other words, it appears that the volumes sold in the APCR, in which only covered entities can participate, are linked to the volumes of allowances bought by financial firms in the regular auction.  

During their formation, many emissions markets go through a debate about the role of financial (non-compliance) participants. One side proposes banning such participants, usually based upon somewhat ill-defined concerns that financial entities could artificially inflate or otherwise manipulate prices. The other side argues that purchases by non-compliance entities could aid in price discovery and liquidity, and that a “ban” on financial participants would only concentrate market power in the hands of a smaller number of compliance entities.  

Usually, financial participants end up being allowed, if for no other reason than it can be hard to distinguish between a financial and physical position anyway. If a covered cement plant buys up 10 times the number of the permits it thinks it needs, isn’t that speculating, as some worry a financial firm could?  

Linking the quantities of allowances sold in a reserve auction to volumes purchased by financial participants could create an odd dynamic. After all, these are the allowances that are most certain to be sold again at some point. Financial firms have no other use for them. The typical argument for price containment reserves is to help smooth the market through a shock to the level of actual physical emissions, rather than to offset the level of financial demand.  

The Long View

The level of actual emissions in Washington, or California, in any given year is not going to make or break the climate. A relatively stable and transparent carbon price that will better support the types of long-term investments and innovation that these markets were intended to induce. 

The goal really should be to smooth prices in the face of volatile emissions. Time will tell if Washington’s market works out the kinks and deploys its containment reserve in a way that enhances price stability.

 

 

 

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[1] Very early on, there was some concern that California’s reserve still might not be big enough, but those concerns quickly faded, along with the economy, in the aftermath of the financial crisis.

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Suggested citation: Bushnell, James “Have Carbon Prices Broken Containment in Washington State?”, Energy Institute Blog,  UC Berkeley, June 26, 2023, https://energyathaas.wordpress.com/2023/06/26/have-carbon-prices-broken-containment-in-washington-state/

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