California carbon trading to benefit from future tougher regulation

California Carbon Allowance futures have gained ground over the last three months and the front month has now settled into a range of $29.1-$29.4. Stricter emissions regulations are expected over the next two years, a reduced supply of allowances and a potential link-up of carbon trading with another US state will provide support for prices going forward.

Bigger picture

California has long been the leading US state in climate policy. Since it first introduced its carbon emissions regulations in 2006 the state has been periodically increasing its requirements for emissions reductions. The current target is to cut emissions by 40% below 1990 levels by 2030 and by 80% below 1998 levels by 2050. When the California Air Resources Board (CARB), which develops and updates the regulations every five years, reassesses the rules in 2025 it is expected to make requirements even stricter.

The state operates a cap-and-trade system and allocates carbon allowances to different industries, either directly or through auction. What is traded in the market is a physically delivered greenhouse emissions allowance issued by CARB representing one metric tonne of CO2 equivalent. This is a system very similar to the one used in the EU, and, like in the EU, the amount of those allowances decreases every year.

Up until 2020 California cut the amount of allowances by 3% every year. Going forward the reduction will be 5% every year until 2030. However, unlike in Europe, various US states have their own climate-related regulation and emissions trading systems. This fragmentation means that each trading system is still relatively small but as they become more established they are increasingly looking to connect into a bigger unit.

California has joined its cap-and-trade system with Quebec, and Washington State will make a decision this summer on whether to join the WCI-linked California-Quebeccap-and-trade market in 2025.

NewYork is also looking to link up its trading into a bigger group although this may not be with California.

“Years of oversupply”

“California carbon markets have suffered from years of oversupply. As a result of achieving the 2020 target several years earlier than mandated by law, there are still unused allowances in circulation,” says Nitesh Shah, Head of Commodities and Macroeconomic Research at ETF provider WisdomTree.

CARB estimated the amount to be approximately 310 million allowances after the third compliance period which run between 2018–2020. Because of the oversupply auctions in 2020 were undersubscribed and prices up until 2021 barely lifted off the reserve price.

“However, since 2021, with the new Scoping Plan being debated and then announced in November 2022, CCA prices have moved decisively above the reserve price. The auction in February 2023 saw all allowances sold,” said Shah.

Going forward, CARB is expected to lower the market caps by 2025 and follow this up with an extension of the cap-and-trade program beyond 2030. The agency is also expected to address the existing oversupply in the market with an additional supply adjustment mechanism and to further tighten requirements for the inclusion of carbon offsets.

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