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Californian Carbon Allowance market ripe for impact investors

With investors helping to set record prices, the California carbon allowance market has burst into life this year and become a potential key market for impact investing to drive greater climate ambition.

The state’s emissions trading regulator sells emission permits at quarterly auctions, with a floor price that increases each year. In 2020, as Covid hit industrial output resulting in lower emissions, the auctions in May and August did not sell out. However, demand rebounded quickly, and the most recent two auctions attracted enough buyers to clear in excess of the reserve price.

The market’s latest allowance auction was held on May 19, and was a sell-out with nearly 80m Quebec and California Carbon Allowances (QCAs and CCAs) knocked down at the highest price for an auction since the market launched in 2012. The sale cleared at $18.80/tonne, well above expectations and more than $1 higher than the auction floor price.1

Prices in the secondary market are well above the auction level: the benchmark December 2021 futures contract closed on May 28 at $19.93/tonne, demonstrating the additional value that can be unlocked.2

California Flag - Colour

Californian Carbon Allowance market: ripe for impact investors

The auction was especially notable since sale volumes included more than 14 million unsold CCAs from previous auctions. The fact that these extra CCAs were snapped up demonstrates the market’s growing appetite for long positions, as the regulators begin to tackle the challenge of reforming the market to meet a 40% emissions reduction target by 2030.3

Investors grew their share of this auction to the highest yet, with non-compliance investors buying up 20.1%, or around 14.5 million of the CCAs on offer.4 Market regulars have observed a steady increase in activity by investors in recent weeks and months; in particular, after California’s governor signed an executive order targeting net zero emissions by 2045.5

The strong participation of investors in the May auction is a marked contrast to previous sales when compliance entities accounted for more than 92% of all buying. This suggests that the market’s supply is tightening as pre-existing surpluses are being steadily absorbed, and that speculators expect prices to rise significantly.

Managed money is also a major player in the futures market, where total long positions exceed 67million CCAs, a figure that has doubled since the start of the year.6

The Californian emissions trading market may therefore be well-suited to a strategy of buying physical carbon allowances and withholding them from the market.

By storing physical CCAs rather than trading them, investors can create an artificial shortage that drives prices higher to the point where compliance entities are encouraged to invest in reducing their emissions, rather than simply buying allowances.

This strategy mirrors similar opportunities in the European Union’s emissions trading system, where prices have rocketed more than seven-fold since early 2018, after the European Commission implemented far-reaching reforms to tighten market supply.

Investors in Europe began betting on rising prices almost as soon as the reforms were approved, and this has highlighted the potential value of impact investing as a strategy to further tighten the market supply.

As additional countries pledge more ambitious climate goals, the supply of allowances in carbon markets will continue to tighten and analyst forecasts of prices as high as €100/tonne may not seem as outlandish as they do today.7

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