The California Air Resources Board (CARB) conducted a practice auction for the state's landmark cap-and-trade program today, August 30, 2012. The practice auction provided a dress rehearsal for CARB, covered entities and other market participants to test the auction platform in preparation for the first real auction under the cap-and-trade program, which is scheduled for November 14, 2012. While CARB will not be releasing the auction result (i.e., clearing price), to avoid sending false price signals to the active market in forward contracts for California Carbon Allowances (CCAs), this event marks another important milestone in California's establishment of an economy-wide cap-and-trade program, since the passage of the California Global Warming Solutions Act (AB 32) nearly six years ago.

Background

After years of development since AB 32 was signed into law in 2006, CARB's cap-and-trade program regulation was finalized last year. The program establishes an overall limit on greenhouse gas (GHG) emissions from capped sectors in California, and entities subject to the cap (covered entities) must surrender "compliance instruments" equivalent to their GHG emissions to CARB. Compliance instruments include both allowances, which are allocated by CARB or obtained from auctions or secondary markets, and offset credits, which represent GHG emissions reductions achieved in sectors that are not subject to the cap.

First Auction Delayed

Under the regulation finalized last year, the first auction of GHG allowances was slated to occur on August 14, 2012. (This was after the first compliance year was already pushed back to 2013, so CARB could "road-test" the system before active trading of allowances began.) However, on March 27, 2012, CARB's Chairman, Mary Nichols, announced in a legislative hearing that the August 2012 auction would only be a practice auction, wherein no real money or allowances would change hands, and that the first real auction would occur in November 2012. CARB subsequently finalized amendments to the cap-and-trade regulation to reflect this change in date of the first auction and those amendments are awaiting approval by the Office of Administrative Law.

Last month, CARB determined that additional time was needed to set up the auction system and, accordingly, delayed the practice auction from August 14th to August 30th.

Practice Auction

The purpose of the practice auction was to provide market participants an opportunity to interface with the web-based auction platform and related application and bid guarantee systems. It was not intended as an actual market simulation that would generate a projection of actual allowance prices. Thus, CARB will not be announcing the settlement price or number of allowances that cleared at the auction, which consisted, in total, of both 20 million current (vintage 2013) allowances and 40 million (vintage 2015) allowances, each available in lots of 1,000 allowances (with an allowance equal to one metric ton of GHG, expressed in carbon dioxide equivalents (CO2e)).

Participants were invited to participate earlier this month and, starting earlier this week, begin utilizing the online auction platform to simulate completion of the auction application, attestation as to their qualification to participate (that they have not been subject to investigation related to an alleged violation of any law related to any commodity market, exchange or by the Securities Exchange Commission or Commodity Futures Trading Commission) and posting a bid guarantee in the form of cash, letter of credit or bond with the Financial Services Administrator (Deutsche Bank National Trust Company).

Today, between the hours of 10:00 am and 1:00 pm PDT, invitees were finally allowed to test out the bidding platform, either by submitting bids manually or by uploading bid schedules on a preformatted spreadsheet. To avoid sending false signals to the market, CARB will not be releasing information on the auction clearing price, which will be set at the higher of the next highest bid above the reserve price ($10) or the last highest bid that clears. In addition to communicating the simulated auction result to participants next week via email, CARB will also be soliciting feedback on the practice auction through a survey in the coming week. CARB staff intends to debrief the Board on the outcome of and lessons learned from the practice auction later in September at the regular Board meeting.

First Real Auction Scheduled for November

Like the practice auction, the November 14, 2012 auction will include both current (2013) and future (2015) allowances, with the number of current allowances available to be determined by how many allowances the publicly owned utilities should choose to have deposited directly into their compliance accounts for use in satisfying their own compliance obligation. (The publicly owned utilities are required to inform CARB of this by September 1.)

Both the publicly owned utilities and investor owned utilities are otherwise required to monetize all the allowances allocated to them in any given year by consigning them to CARB for auction on their behalf. For the first auction in November, the utilities must consign one third of their 2013 allowances to CARB for auction.

The proceeds from CARB's auction of consigned allowances are then to be used, consistent with the goals of AB 32, for the benefit of ratepayers in accordance with the direction of the municipal utilities' boards and, for the investor owned utilities, the California Public Utilities Commission (CPUC). The proceeds from CARB's sale of its own current vintage allowances and all future allowances sold at auction will be deposited in CARB's Air Pollution Control Fund, awaiting appropriation by the Legislature.

Trading on Secondary Markets and Exchanges

Market participants have already been engaged in robust trading of forward contracts for physical delivery, with the price for 2013 CCAs on the Intercontinental Exchange trading at nearly $17 at close last week, well above the auction reserve price (of $10).

Market participants are limited in the number of allowances they can purchase at any auction, with associated covered entities limited to 15% of current vintage allowances available, utilities limited to 40% of current vintage allowances and all other market participants limited to 4% of such allowances.

In addition to forward trades, once the first auction occurs, parties will be able to purchase CCAs through bilateral contracts and secondary markets. Procurement from secondary markets or through futures or forward contracts is not limited by CARB, although investor owned utilities are subject to limitations on procurement imposed by the CPUC. Additionally, the number of allowances associated entities can hold in their holding account at any given time is limited to, for 2013 allowances, just under 6 million. The practice auction was reportedly designed to test the auction platform's capability to reject bids that would result in violation of either the auction purchase or holding limit.

Conclusion

Despite the delay in the first real GHG allowance auction, the successful completion of the practice auction represents a long awaited milestone and one that can only increase the confidence of market participants that CARB is indeed ready to launch the trading platform later this year. Today's event was closely watched, not only by those who have been recently preoccupied with completing all the necessary steps to participate in the auction, but by those who might question the wisdom of California in proceeding in such a grand experiment on its own. For CARB, however, it represents nothing less than an affirmation of its readiness to begin trading literally billions of dollars on a program it created out of thin air.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.