California holds its first cap and trade auction

The first auction of allowances for California’s cap and trade market took place on Wednesday November 14 and the results were released on Monday. The state auctioned off allowances for vintage 2013 and 2015 (an allowance can be used in its vintage year or any year after that).  The price floor for both auctions was $10.

All of the vintage-2013 allowances made available were sold and the market clearing price was $10.09.   In the vintage-2015 auction,   the supply made available was about seven times greater than the total number of bids at $10 or above. As a result, the market for those allowances cleared at a price of $10.00.

The results are somewhat surprising to me.

It is worth pointing out that the rules of the market increase the price floor at the rate of inflation plus 5% per year (starting with 2014),  so if you bought a permit today, you should be able to sell it for at least $10.50  in 2014 and $11.03 in 2015 (after accounting for inflation). That’s a lot better than the return you can get on a CD these days.  So, why doesn’t demand for these allowances as investment vehicles push prices higher?

Some people, no doubt, are going to argue that the low prices for both auctions and low demand for the vintage-2015 allowances signals a lack of confidence that the market will be around that long, possibly due to the ongoing legal challenges.

That may be part of it, but I think the full answer is more complex.  This was a uniform-price auction. In a competitive uniform-price auction every participant has an incentive to bid his or her true valuation of the good. Though if you are risk-averse, you might spread your bids out over prices around your best guess of your valuation (known as “laddering” among some emissions market participants).   If your true valuation of the good were below $10, your best bet would be to not bid at all.

So then is it just coincidence that the market ended up clearing a few cents above the price floor?  It seems improbable that so many independent evaluations ended up with a price in this range.  I don’t have a good explanation, but I look forward to reading comments from those who think they do.

NOTE FOR CARB CAP AND TRADE AUCTION MAVENS: There has been some confusion in interpreting the auction results released by CARB. In particular, it reports that “Submitted Bids” for 2013 was more than three times the “Allowances Available for Sale” and yet the “Median Price” in the bid summary is $12.96, higher than the market clearing price. This is a mathematical impossibility if the Median Price refers to the same set of bids as the Submitted Bids. CARB has clarified the issue: the median price is for all bids that were submitted including the ones that were rejected because they exceeded the procurement limits or holding limits for the market participant,  or failed to meet the requirements for bid collateral. The distribution in the Bid Price Summary Statistics and the market clearing price reflect only the bids that were not rejected.

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7 Responses to California holds its first cap and trade auction

  1. Emily D says:

    Maybe the demand for allowances as an investment vehicle was held down by the same rules that encouraged 97% of the allowances to be bought by compliance entities? Were procurement limits different for non-compliance participants?

    Or is there an information advantage to be gained by successfully buying allowances? Learning by participation?

  2. Chen says:

    This is strange, one would think the 5% would set a higher clearing price. Perhaps, maybe from risk aversion, there was simply not enough money at the table? That is, the total cash allocated to all trading desks was too low since firms didn’t want to gamble in a new market. Maybe there is a legal provision or hidden fixed cost…

    As an aside: it seems Caltech was a bidder?!

  3. Stephen Salant says:

    Severin notes that under the AB-32 rules “the price floor will increase at the rate of inflation plus 5% per year (starting with 2014), so if you bought a permit today, you should be able to sell it for at least $10.50 in 2014 and $11.03 in 2015 (after accounting for inflation). That’s a lot better than the return you can get on a CD these days. So, why doesn’t demand for these allowances as investment vehicles push prices higher?”

    Since he invited readers to offer their own tentative explanation for this puzzle, here is mine—based on my (hopefully correct) reading of AB-32. The word “floor” is misleading and once it is understood the puzzle disappears.

    As I understand the AB-32 rules, the “floor” is not a floor like a minimum wage which the law requires must be offered to employees or like a commodity price or exchange rate floor (the bottom of a price “band”) enforced by a standing offer of the government to purchase anything offered for sale at the floor price. Either kind of floor insures that the market price never falls below the floor and would thus insure that a purchaser of a permit could get at least the $10.50+ floor price next year. Under this kind of floor, there would indeed be a puzzle to be explained (and one possible explanation, even under risk neutrality, would be regulatory uncertainty that the permits would be declared worthless in the future).

    However, the AB-32 floor is, as I understand it, a floor on acceptable bids at the auction, not a floor on the market price. A less confusing term is an auction reserve price. The market price can easily fall beneath the auction reserve price. Thus, there is no reason to expect that someone who purchased a permit last week can get $10.50 in a year. If the market price in a year is lower than the auction reserve price prevailing then, it will be cheaper to buy permits on the market than at auction and no one will buy permits at the auction.

  4. Severin Borenstein says:

    @Steve Salant: I think that your logic is correct, Steve. But absent legal uncertainty about the continuation of the program, I think this is unlikely to be a plausible explanation. It is indeed the case that the “price floor” is just a minimum acceptable bid for the allowances that the State will offer in these auctions.The market price would fall below that minimum bid price, however, only if the market believes there is a credible possibility that the demand in future auctions will be zero at the minimum bid price. Otherwise, someone holding an allowance at the time of the next auction should always be able to sell for one cent less than the minimum bid in the auction.
    SB

    • Stephen Salant says:

      Agreed. For my explanation to be correct, the market price at the next auction must, given current information, be expected to be smaller than the future reserve price. On the other hand, for there to remain a puzzle it must be expected, given current information, that people will bid at least the reserve price for permits at the next auction; then there ought also to be people willing to buy permits carried over from last week’s auction at a price just below the reserve price of next year’s auction.

      Question: Is there any basis for market participants’ believing that the program might not continue or are you just covering all the logical possibilities? An asymmetric risk that permits might become worthless would of course cause the market price to be depressed and, in the absence of such a realization, would cause the price to grow by more than the rate of interest.

      • Severin Borenstein says:

        There are entities out there who are continuing to try to stop California from moving ahead with cap and trade, including filing lawsuits. One was filed the day before the auction. I’m not in a position to know whether the legal arguments being made have much shot at success.
        SB

  5. Greg San Martin says:

    Very timely post Severin. ARB has since responded with the release of additional auction summary information.

    I have one correction or clarification to what you wrote. You stated that the rules of the market increase the price floor at the rate of inflation plus 5% per year (starting with 2014). The regs were updated in mid-2012 to allow the reserve price to be adjusted beginning in 2013 (rather than 2014). CARB recently announced a floor price of $10.71 (5% per year plus inflation). The mid-2012 adopted amendments to the cap and trade regulation became effective on September 1, 2012. For those of us who are used to going to the ARB cap and trade web page and clicking on “Regulation Documents” on the left margin to access the current version of the regulations, the link still points to the prior version of the regulation so look for “2012 amendments” instead.

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