Cap and allowance supply in the Western Climate Initiative

In the California cap-and-trade program, the state’s Air Resources Board (ARB) sets allowance supply equal to the emissions cap for the corresponding year. As noted in Figure 1, the emissions cap for 2023 is 294.1 MtCO2e and, under current rules, is set to decline ~4% annually to reach a 200.5 MtCO2e cap in 2030. This rate of reduction represents the business-as-usual scenario for allowance supply in the California ETS program.

CA Allowance Supply 2013-2030

When allocating annual supply, the ARB first distributes allowances to compliance entities that are eligible for free allocation - notably electric power utilities, natural gas suppliers, and industrials. Electric power utilities receive the highest share of allowances at a level set by regulators through 2030. Natural gas suppliers will receive allowances equal to ~12% of that year’s allowance supply. Allocation to the remaining industrial entities is calculated using the latest production data for each entity and the cap adjustment factor for that given year. In addition to free allocation, the smallest portion (10.4 million in 2023) of allowances are set aside and put into the state’s Allowance Cost Containment Reserve (APCR) at 

yearly quantities already determined by ARB regulators

 through 2030. The remaining allowance supply is then offered for sale at quarterly auctions.

Our supply forecast shows that auction allowances will see the greatest average annual reduction (8%) followed by reductions to allocation for natural gas suppliers (5%), electric utilities (2%), and industrials (3%). A steeper reduction in state-owned allowances at auctions will play a central role in pushing up auction settlement prices in the next few years as demand continues to outweigh supply, leading to more aggressive bidding behavior. This may be mitigated in part by the increasing number of allowances being consigned to auctions as the consignment requirements for freely allocated allowances to natural gas suppliers increases 5% annually.

Although decreasing annually, the quantity of allowances freely allocated to natural gas suppliers, electricity distribution entities, and industrials entities remains relatively stable through 2030. Although free allocation plays a pivotal role in minimizing the risk if carbon leakage and protecting ratepayers, the decreasing share of fossil fuels in the state’s energy mix and the ambitious decarbonization targets in place should entail a greater reduction in free allocation levels.

Like the California ETS, the Quebec program has a predetermined, declining emissions cap through 2030. Figure 2 outlines Quebec’s allowance supply through 2030. The current 2023 cap is set to 52.88 Mt CO2e and declines at an annual rate round 2.2% to reach a cap of 44.1 Mt CO2e by 2030.

Quebec Allowance Supply 2013-2030

Quebec regulators first freely allocate allowances under the cap to distribute to those determined to be emission-intensive and trade-exposed (EITE) entities, using criteria calculated by taking into account production data, emission intensity targets, and assistance factors. A predetermined quantity of allowances (calculated out to 2030) are also put into the province’s APCR. The rest, and largest portion, of the allowances are then put into the quarterly auctions.

Our supply forecast model shows a slower rate of allowance reduction through 2030 compared to that of California. Although still maintaining the largest share, auction allowances see the steepest decline, averaging 2.8% from 2024-2030, followed by Reserve allowances (2.56%), and allocated allowances (2.2%).

The 2022 Scoping Plan increased California’s GHG reduction target by 8% (from 40% to 48%) and accelerated its timeline to achieve an 85% GHG reduction by five years (to 2045). The current cap and pace of reduction of allowance supply does not incentivize the level of abatement necessary to keep the state on track with the new 

. Understanding this deficit, ARB regulators called for a series of meetings to increase the ambition of the ETS. The meetings have, so far, resulted in 

 that incorporate the adjusted 2020 emission deficit and all have a 2021 starting point.

CA Allowance Reduction Scenarios 

In Figure 3, we have illustrated the three scenarios that have been proposed by the ARB in their 27 July regulatory meeting. We have also included the current business-as-usual (BAU) case described in the previous section and Figure 1, to provide a reference to the scale of supply cuts associated with each proposal. The first, which we label the “headway scenario”, maintains the previous 40% GHG reduction target for 2030, but with the adjusted 2020 deficit, still results in a reduction of 115 million allowances over 2021-2030. The second, “spot-on scenario” incorporates the newly-adopted 48% GHG reduction and entails a cut of 265 million allowances. The last, “full-throttle scenario” represents an upper bound of a 55% GHG reduction and equates to 390 million allowances being cut from the 2021-2030 supply.

The regulatory and public backing of the 48% GHG reduction target that was adopted earlier this year, in conjunction with compliance entities’ current emission and abatement levels, make the spot-on scenario the most likely to be adopted. The upper bound, full-throttle scenario is unlikely to foster the resources and backing needed to be implemented but was introduced in response to the recent (and unsuccessful) regulatory efforts by environmental groups to accelerate the 2022 Scoping Plan’s GHG reduction target to 55%. The California ARB will conduct the next meeting regarding its regulatory reform in October. ARB regulators aim to complete the rulemaking process by the end of this year and implement the changes in 2025.

Not only will allowance supply change notably from the BAU scenario, but the updates will drive prices upwards. With greater program ambition and less allowance supply, compliance entities will have to trigger more expensive abatement options. Consequently, carbon prices will increase to over double what they are today – with allowances currently trading just above USD 37.00/t. It is likely that ARB regulators will finalize a rulemaking by the end of this year or early 2024 with implementation likely in 2025. Despite the updates not taking effect until 2025, readjusting supply starting from the updated 2021 emissions level mean that the impact on allowance prices will be felt immediately. The timeline in which CCAs begin to reach levels in range to those seen in the EU ETS today (USD 86.90/t on 19 September) will, therefore, be dependent upon which scenario is adopted – with the spot-on and full-throttle scenarios accelerating the price jump before the end of the decade.

Although total emissions are significantly lower than in California, Quebec’s decarbonization target for 2030 is more than 10% lower (37.5%). As California is in the process of strengthening its cap-and-trade program to better align it with the climate targets set out in the 2022 Scoping Plan, Quebec regulators have also begun the process of updating its own program to maintain a level of ambition more in line with that of its partner. No concrete actions have been decided upon yet; a decision on program updates will likely come this winter and implemented in the summer of 2024. These updates will come in the form of tightening offset regulations and cutting allowance supply. In the case that regulators tighten allowance supply, newly implemented free allocation rules prescribe that cuts will come predominantly from auctioned allowances. In 2022, regulators introduced new measures to allowance allocation that outline consignment requirements for compliance entities which reduce supply by 3.8 million from 2023-2030. The new regulation would achieve an allocation quantity totaling 17.2 million in 2030 – down from the previous scenario of 21 million.

Although the current BAU allowance forecasts show tighter allowance budgets over the next several years, they do not yet reflect the ambition of their jurisdictional decarbonization targets. As the California and Quebec joint cap-and-trade programs cover 75% and 77% of their jurisdictional emissions respectively, they must evolve with policy and better align themselves to achieve these targets.

As emissions caps tighten over the next several years, compliance entities will face greater pressure to lower their emission output. The success of entities’ decarbonization efforts will be largely dependent upon the scale at which renewables are rolled out, and, subsequently, the rate at which fossil fuels are phased-out. The onboarding of zero-emission fuel sources will be dependent on the success of policy implementation, the utilization of resources and incentives from the Inflation Reduction Act, and weather patterns over the next few years. Although California’s power-sector emissions for 2023 have fallen with increased hydro generation due to a wet winter, the factors that influence renewable generation will make their growth in the power sector irregular. The major hurdle to decarbonization in the state, however, is the transportation sector that accounted for over 48% of program emissions in 2021. Its decarbonization is therefore contingent upon the wide-scale implementation of electric vehicle (EV) infrastructure and the success of the Low Carbon Fuel Standard (LCFS).

The degree and timing of bullish pressure on CCA prices stemming from declining emissions caps is contingent upon which allowance supply scenarios are implemented by regulators. In the BAU scenario, a lack of sufficient reduction in allowance supply will lead to an insufficient price signal for compliance entities to abate, which may lead to a more gradual increase in allowance price as demand remains strong and supply decreases. The implementation of any of the three scenarios outlined by ARB regulators and updates from Quebec regulators will catalyze the rate at which contract prices increase, likely doubling in price over the next few years.

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Within the California and Quebec joint cap-and-trade programs, the two jurisdictions have their corresponding emissions caps declining annually at a rate previously determined to help achieve their decarbonization targets. Although the two markets are linked, the scale of the programs and their sustainability portfolios vary significantly. The allowance supply forecasts for both the California and Quebec market prove bullish for California Carbon Allowance (CCA) contract prices in the long term – stemming particularly from declining allowance offerings in the program’s quarterly auctions. When considering the respective jurisdictions’ climate targets, however, the allowance and electricity generation forecasts show a gap between the current level of ambition and that needed to achieve the programs' goals. Proposed updates to the two ETS programs to fill this deficit, however, will exert even greater bullish pressure on allowances prices as emissions caps tighten and ambition grows.

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More ambition, fewer allowances: Towards a tighter future in the Western Climate Initiative

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