CaliforniaCarbon.info, June 22, 2015: Over-the-counter (OTC) prices for California carbon offsets (CCOs) – the secondary compliance instrument in the state’s cap-and-trade program after the California carbon allowance (CCA) – have noticeably risen in the past week, amid signs that compliance entities seeking to make maximal use of their offset budgets (8% of each compliance year’s obligations) are exerting more pressure on a supply-constrained market.

While the allowance market is comfortably long (through 2019, according to our forecast) in the program’s present configuration, there have been serious concerns that offset supply may not keep up with demand, particularly from 2016 when (1) the first surrender under the expanded compliance period 2 would be due, and (2) no more early action credits can list to convert to CCOs. To date, just shy of 19.9 million CCOs have been issued, with 1.81 million of these held in the buffer for forestry reversals. 1.69 million CCOs were retired against compliance obligations for the Nov 2014 annual surrender (1.16% of 2013 aggregate obligations), and after deducting for prior invalidations, a further 16.3 million CCOs remain available for future compliance use.

Last year’s offset usage is believed to have been kept artificially low by the unavailability of 4.35 million ozone depleting substances (ODS) credits frozen as part of the Clean Harbors investigation, with 81% of all credits used coming from forestry projects. 9.91 million CCOs could still be used this year in fulfilment of 2013 obligations, while, under our baseline estimate for emissions, 11.4 million CCOs would be needed to satisfy a full eight-percent demand scenario for 2014. What is presently available only meets 76.5% of this total, assuming that no entities have decided to store offsets for use against their CP2 obligations.

Notwithstanding supply issues, full offset usage is unlikely, given that compliance entities face greater informational and transactional costs to participation in the CCO market, and may also be unwilling to take on invalidation risk. Furthermore, the generous allocations provided to several trade-exposed sectors may act as additional disincentive, while several publicly-owned compliance entities have alluded to a preference for purchasing state-owned allowances rather than privately-owned offsets.

Even so, a steady upward trend in bid and ask prices reported through OTC brokers throughout 2015 for all three CCO breeds supports the notion of increasing demand-side pressure. The Golden CCO – which sees the seller retain liability for replacing an invalidated credit – has gained nine cents from $11.35 to $11.44 in the last ten days. This instrument was trading at $11.15 at the start of April, $10.94 at the start of January, and $10.50 this time last year. To put things in perspective, all V2014 CCAs cleared through the auctions last year were bought for $11.48-$11.50.

The CCO-3 – which remains liable to invalidation for three years after issuance (EA) or activity completion (ARB) – rose from $10.32 to $10.49 Friday to Friday. It traded at $10.14 at the start of April, and $9.93 at the start of January. We were also informed verbally of a CCO-3 trade which had been struck at $10.85 last week – higher than the Goldens were trading just six months ago. The CCO-8 – which sports the full eight-year liability period – has gained from $9.90 to $10.13 in the last two weeks. It traded at $9.57 at the start of April, $9.28 at the start of January, and $9.00 at this time last year.

The slowdown in CCO issuances in recent weeks may be contributing to shortage fears. With ARB’s offsets team possibly tied up with final work on the rice cultivation protocol set to be voted upon at this week’s Board meeting, no new CCOs were issued at the first announcement two weeks ago, while in no calendar month have more than 1 million compliance-eligible CCOs been issued since February this year. This could be causing compliance buyers to bid up, while aggregators and CCO providers raise their ask prices against their own exposure to unsecured deliveries.

The early action pipeline does have sufficient credits to meet full demand usage, with up to 8.1 million CCOs-in-waiting. However, the backlog of desk reviews awaiting approval has lengthened rather than shrunk in recent months. There is a similar number of ROCs awaiting full CCO issuance, 7.0 million of which come from four improved forest management projects which will expect subsequent reporting periods to generate significantly smaller volumes. It remains to be seen if the price rise will continue after these projects see issuance.

The spread between the Golden CCO and the benchmark CCA traded on the InterContinental Exchange (ICE) stands at an all-time low of 10.1%. Such slim margins may prevent smaller entities, or those with less efficient solutions to managing administrative burdens and invalidation or delivery risk, from finding value in the offset market. While to a small extent this might help relieve compliance-side pressure on the offset market, this compromises the effectiveness of the offset program in providing compliance cost savings to participants as a whole.

Steven Neoh (steven.neoh@climate-connect.com)

Rahul Rana (rahul@californiacarbon.info)

For access to our price center, emissions forecasts, and various data suites, please contact our sales team (Nitin Tanwar; nitin@californiacarbon.info; +1 415 349 5777).