Holding limits don’t constrain banking in California’s cap-and-trade program
California’s cap-and-trade program is the cornerstone of the state’s strategy to limit greenhouse gas emissions to 40% below the 1990 level by 2030 as mandated by state law. However, cap-and-trade may not deliver the emissions cuts expected of it because of a problem known as oversupply. In every year to date, the supply of emissions instruments in the program has been much larger than the emissions covered by the program. Market participants are buying up this excess supply.
Once held, or banked, these excess instruments can be banked indefinitely. If market participants continue buying up excess instruments and banking them, oversupply will continue to grow. Some degree of banking is useful for smoothing out year-to-year fluctuations, and for encouraging emitters to take stronger action early on.
However, if a large bank of instruments builds up in the early years of the program, that can cause a problem in later years. In the future when the program’s caps tighten, emitters could use these banked instruments to remain in compliance while covered emissions overshoot the program caps. The larger the bank, the larger the overshoot that’s possible, and the greater the risk that the state’s total emissions exceed the limit set by state law.
Two arguments that have been offered in response to this concern are (1) that the cap-and-trade program has holding limits that prevent unlimited banking by each market participant, and (2) that market participants don’t want to tie up capital in a sizeable bank over multiple years.
Neither of these arguments are consistent with publicly available data and the behavior of market participants to date. As we detail below, the holding limits don’t provide a meaningful constraint on system-wide banking; practically speaking, system-wide banking is limited only by participants’ willingness to spend capital for this purpose. To date, participants have been willing to bank billions of dollars’ worth of instruments.
California’s cap-and-trade regulations specify “holding limits”—that is, the number of excess allowances each market participant can bank at any given time. For 2018, that limit is 12.3 million “current-vintage” allowances (from 2018 program years or earlier). Holding limits decline each year, in line with program caps. (The limits are the same in Quebec’s cap-and-trade program, which is linked with California’s.)
However, covered emitters can hold far more allowances than the maximum implied by the holding limits. In order to ensure that emitters are able to acquire sufficient instruments to comply with their obligations in each multi-year compliance period, they are granted a “limited exemption to holding limits.” Companies that use this limited exemption can hold the allowances they need for compliance plus an additional 12.3 million current-vintage allowances in 2018.
By the end of 2017, we calculate that market participants had already banked about 106 million instruments—current allowances as well as offsets—beyond what was needed for compliance in the same period. This is based on our analysis of banking published in September, updated using data on actual covered emissions in 2017 that was released last month. So we know that substantial banking of excess supply has already occurred. Now the question is: How much bigger might the bank get?
In California and Quebec, there are around 440 covered emitters. Each of them can bank allowances up to the holding limit beyond what’s needed for compliance, allowing them to collectively bank up to about 5.4 billion current allowances. That’s over 50 times as much as the excess instruments privately banked through the end of 2017, and over 15 times higher than Dr. Chris Busch’s high-end oversupply projection of 340 million allowances in 2020.
In addition, there is a separate holding limit that applies to each future vintage of allowances purchased in advance auctions. Furthermore, the holding limits apply only to allowances, not to offsets, so an unlimited number of offsets can be banked. Both of these stipulations further increase the number of instruments that can be held by each entity (or corporate association) at a given time.
The maximum theoretical limit on banking is even higher because other market participants can also bank allowances up to the holding limits. There are over 300 non-compliance entities in California alone, which could bank up to 5 billion current allowances (and unlimited offsets).
Of course, there is no reasonable scenario in which all entities would seek to own the maximum number of allowances possible. There simply aren’t enough allowances in the program. But the absurdity of this scenario is precisely the point: the holding limits do not constrain banking at a system level.
In fact, it would take only a small number of entities to enable a significant amount of banking. Only 9 entities would have had to max out their holding limits to enable the banking of 106 million instruments, as we calculated for the end of 2017. In order to absorb up to the high end of the range of market oversupply through 2020 estimated by Busch—340 million allowances—it would require 28 entities to max out their holding limits.
Again, we estimate that market participants at the end of 2017 had banked about 106 million instruments—current allowances as well as offsets. In 2018’s auctions, all the current allowances available were sold—including about 60 million allowances from older vintages that went unsold in 2016-2017 and were reintroduced to auction this year. These sell-out auctions mean the bank at the end of 2018 is going to be considerably higher—but exactly how much higher depends on covered emissions in 2018, and how many offsets are issued in 2018. We can’t say exactly how large the bank at the end of 2018 will turn out to be, but based on our open-source model of the cap-and-trade system, it could easily be over 200 million instruments.
In addition to the banking described above, market participants can purchase allowances in “advance auctions,” which sell allowances with vintages three years in the future. Allowances purchased in advance auctions tie up capital for at least four years before they can be used to satisfy a compliance obligation. For example, vintage 2018 allowances were offered in the advance allowances in calendar year 2015; the earliest these allowances can be used is in the compliance event that will occur in November 2019. Emitters have not yet been able to use for compliance the allowances sold in advance auctions in 2015 through 2018, in which vintages 2018 to 2021 were offered. The advance auctions in those years sold a total of 105 million allowances. This again shows participants’ willingness to tie up large quantities of capital in emissions instruments—even for allowances that must be held for several years before they can be used.
The two sets of banked instruments—the approximately 106 million excess instruments banked at the end 2017, and the 105 million advance allowances that participants are holding—are worth, at current prices, over $3 billion. These large quantities of instruments banked, tying up large quantities of capital, suggest that many market participants currently see banking instruments as a sound financial investment.
Neither capital availability nor market holding limits have prevented market participants from banking excess allowances so far. Other cap-and-trade systems—the European Union’s Emissions Trading System, and the Regional Greenhouse Gas Initiative (RGGI) on the U.S. East Coast—likewise suffered from large quantities of allowances banked. Both systems acknowledged the problem and have adopted reforms to address it. It’s California’s turn to acknowledge the problem of oversupply, as a first step toward devising remedies.