Description

California Carbon Allowances (CCAs) for VIC

OK it’s not a stock. But it is a tradable instrument with a large and liquid market.  It’s beautifully uncorrelated to SPX and everything else you own.  It has unique structural downside protections - i.e., an Auction Reserve (“floor”) Price that rises by 5% + CPI each year.  And there are many reasons (discussed below) why CCAs will more than double within a couple years from current levels.  

[Note: This write-up will focus on the thesis for owning CCAs.  Later we will touch upon ways to express this trade through stocks, funds, ETFs and Futures contracts.] 

What are CCAs?  CCAs are tradable carbon emissions permits under the California Cap-and-Trade system. Each Allowance represents the right to emit 1 ton of greenhouse gasses into the atmosphere.  Cap-and-Trade covers about 60% of all statewide emissions, making it one of the largest and most diversified markets for carbon reform.  “Covered emitters” (think utilities, refiners, dairy farms, industry, etc.) must acquire and turn in one CCA for each ton of carbon emissions during defined measurement periods.  They acquire CCAs either for free from the State (30%) or buy them at quarterly auctions from the State (70%).  They can also buy or sell in secondary transactions or through listed ICE futures contracts that actively trade. 

In a beautiful marriage of capitalism and policy, CARB (California Air Resources Board) authorizes certain financial players or non-compliance entities to hold CCAs, subject to a holdings cap that is currently 11mm Allowances, or about $230mm at market.  In this way, CARB seeks to create a market-derived equilibrium in the price of CCAs that will drive optimal results in terms of lowering carbon emissions. Those authorized to hold CCAs are more than just financial speculators - they support CCA auctions and they bring investors to awareness of climate issues, among other things.    

The current CCA program was launched in 2013 to follow through on a bipartisan mandate to achieve a 40% reduction in carbon emissions versus 1990 levels by 2030.  California has since expanded its long-term mandate to include complete carbon neutrality by 2045; however, the current Cap-and-Trade law creates the CCA market running through 2030.  California raises billions each year selling CCAs at auction and those funds support all of its other critical climate programs.  

Why are CCAs destined to rise? The core of our CCA thesis is that the program is very ambitious and there are significant impediments to successful de-carbonization by industry in the near term.  Therefore, significantly higher CCAs prices will be needed to drive any meaningful progress toward California's climate goals.  

The path to CARB’s 2030 goal is reduction of emission by about 4% per year, when industry has been struggling to reduce emissions at all, despite significant incentives to invest in clean energy.  Thus, even with the temporary emissions reprieve caused by the COVID lockdowns, California is by most accounts falling behind on its goals. 

In the early years of Cap-and-Trade, CCA supply is relatively plentiful and the Auction Reserve Price (ARP) is low.  This allows covered emitters to ease in and gradually get used to the system. Then each year the “Cap” (new supply granted and offered at auction) is reduced and the Auction Reserve Price is increased.  Not surprisingly, CCAs have traded close to the ARP since the program’s inception, and annual returns through 2020 have been aligned with the annual ARP increase of 5% + CPI.  

[Note: CCA Futures prices did breach the ARP floor for a period in 2016 (after Constitutional challenges brought by the Trump administration) and a period in 2020 (upon the outbreak of COVID). Some quarterly auctions were less than fully subscribed during these periods.  Yet, Prices soon stabilized above the ARP and auctions began to clear at ARP premiums in both cases.  Today, at $21.50, CCAs trade about 21% above the 2021 ARP of $17.71.]

However we have reached the “middle innings” where demand for CCAs is likely to outstrip supply ahead.  Thus the outstanding “bank” of CCAs is peaking and beginning to contract.  The issue will grow more and more acute in the later years of the program. Nonetheless, we expect the market to react to the oncoming shortage in the near term as speculative interest increases and buyers adjust their behaviors.  

We expect CCA prices are beginning to trade, less with reference to an ARP floor and more and more with reference to a “ceiling” price.  CARB has established two “Reserve Tiers,” where additional supply can be sold to ease shortages, and a “Price Ceiling,” at which unlimited supply can be sold.  The lower Tier 1 Reserve price is currently $41.40 and rising each year by 5% + CPI.  Thus if you look out to 2024, it can be said your downside is minimal (2024 ARP is expected to be at least the current price) and your upside could be close to the 2024 Tier 1 Reserve level or $51, up more than 100% from today’s price.  That is a beautifully skewed risk/reward in our opinion.  

We are also closely watching CARBs 2022 Scoping Plan process.  This once-in-five year review of the Cap-and Trade system is an opportunity for CARB to adjust supply and tinker with the ARP and/or Reserve Tier thresholds.  We expect CARB will be advised by various committees that they are not on track to achieve carbon reduction goals and will be encouraged to tighten supply.  A release by CARB of proposed rules for such adjustments could be a market-moving event of early 2022 and could impact our thesis and price objectives.  

What could go wrong? We break the risks down into five buckets and discuss why we find each highly-unlikely to derail our thesis. The risk buckets are: 1) California adversely amends, 2) Federal pre-emption concerns, 3) Businesses leave CA, 4) technology breakthroughs lower emissions, and 5) market concerns (liquidity, etc.).  

1. California is not likely to back off or adversely amend the CCA program.  As discussed, we consider a tightening of supply and higher prices a reasonable probability, but we think it is very low likelihood that California acts adversely.  They have a demonstrated history of taking the lead on climate reform and strengthening their objectives.  The Cap-and-Trade law is settled legislation with bipartisan support.  The revenues from the program are critical and growing larger and more important to the budget over time.  CA has fought through constitutional challenges and industry outcry and only deepened its commitment to ambitious climate objectives, like the 2045 carbon neutrality order of 2018.

2. There are no plans for the federal government to impose a carbon tax.  Biden’s May announcement of intentions to have a federal carbon reduction goal was applauded by the CCA market with most of the year's gains happening since then.  It is well settled with policy makers that federal follow-through on this point will be complementary, not pre-emptive of California Cap-and-Trade.  We expect many more states to either petition California to join their market (on terms at least as strict as current) or to form their own carbon allowance markets modeled after California. 

3. High tax states like CA and NY are nothing new and there is some reasonable premium that businesses and consumers bear for locating there.  Cap-and-Trade can certainly push the boundaries here down the road, but ultimately businesses don’t have enough mobility in the short term to materially affect our near term supply/demand models.  

4. Similarly, it doesn't seem possible in the near term for technological breakthroughs to meaningfully alter the path to CCA shortage.  We have stress tested models for 2x faster adoption of EVs than expected and the impact is not significant in our trading horizon.

5. Currently, the CCA market is large and liquid and dominated about 5 to 1 by “covered emitters” versus financial participants.  There are hundreds of millions of CCAs outstanding which bank, as mentioned, is peaking.   ICE Futures trading volumes of the front month contract routinely exceed $2 billion per month and transaction costs are low.  Market participants are limited in the amount they can bank and CARB controls the number of market participants.  Liquidity is thus super-adequate at present to build, adjust and monetize holdings of CCAs, but it’s certainly something to keep eyes on over time.  

How to play CCAs.  This write-up is posted under the ticker KRBN, which is the KraneShares Global Carbon ETF.  This ETF currently has $440 million assets and trades about $5-10 million per day, with lots of those assets and volumes arriving over the past couple months.  KRBN tracks the return of the IHS Markit Global Carbon Index.  KRBN is not a pure-play on CCAs. Through long-dated futures, KRBN has established positions in the Euro Union Allowances (73%), California’s CCAs (19%), and RGGI (US Southeast) Allowances (7%).  Current trends suggest it will keep attracting assets.  When China establishes a carbon allowance market, KRBN will most likely add an allocation to that.

KRBN is up over 40% year-to-date and over 90% in a year, primarily due to the strength of the EUA.  This market, which is larger but different in many respects than the CCA market, has seen allowances increase about 3x from the lows of COVID, to over 50 euro per ton.  There is no floor mechanism in the EUA and it covers fewer industrial sectors than the CCA market.  Much of its great gains followed a 2020 decision by EUA authorities to increase their 2030 carbon reduction goals, though rulemaking has not yet followed that decision.  

Another more pure-play way to own CCA exposure is by joining one of the many private investment funds formed to hold Allowances or related futures positions.  They are typically structured like hedge funds with quarterly liquidity and fees akin to co-investment vehicles. Some are more trading oriented and/or leveraged vehicles while others have a longer and more tax-efficient horizon.

Additionally, one could engage the ICE Futures market.  This site, ICE Report Center - Data, lists the CBO - California Carbon Allowance Vintage 2022 (December) Future as closing on 6/21/21 at $23.22, only 7.6% higher than the front-month June 2021 contract.  Open interest is listed at 52,593 contracts.  EDF Man is a leading broker in the space.  Collateral requirements to hold futures are typically 20-30%.  

Lastly, there are various public stocks that might be beneficiaries of rising carbon allowance prices and the proliferation of other allowance markets or carbon taxes.  Suffice it to say, we’re quite bullish that overall allowance levels and carbon emission taxes will continue to rise.  Experts agree that the social cost of carbon gas emissions is multiples higher than today’s CCA price per ton and rising over time.  

Legal Disclaimer: This communication is neither an offer to sell nor a solicitation of an offer to buy any securities. No such offer or solicitation will be made other than with transmission of formal offering documentation when requested by the recipient. The author and its agents have no obligation, express or implied, to update any statements made herein. Actual results of any investment may differ materially from any performance results discussed herein.

Catalyst

Investor interest in carbon markets and government mandates for carbon reductions are picking up significant steam globally.