Why Investors Should Be Paying Attention To California's Carbon Auction

After numerous attempts to stop its cap-and-trade law (AB32), and more than one delay of the law’s implementation, California is finally preparing for its first carbon auction. The results of that auction–there will be a “practice” auction in August, with the first real auction scheduled for November–are likely to determine the fate of carbon regulation in the United States and, perhaps more importantly, the value placed on carbon in the U.S. marketplace.

Under AB32 the state will dole out so-called carbon allocations to utilities and various other carbon-emitting companies. The number of allocations distributed will be based on the amount of carbon or carbon equivalent (a ton of methane, for example, is equal to 23 tons carbon) emitted in 2012. Investor-owned utilities are required to sell their allocations into the market and use the money to benefit ratepayers, while other utilities and companies can opt to either use or sell their allocations. A utility that’s given 10 allocations, equivalent to 10 tons of carbon emissions, but has made efficiency improvements and only emits eight tons of carbon or carbon equivalent, can sell its remaining allocations. Any un-used or un-sold allocations expire at the end of the auction’s initial two-year period. The price floor set for carbon in the auction is $10 per ton, but many are predicting that the price will level out at $15 per ton. The Governor’s office is predicting revenue of at least $1 billion from the initial auction.

Over time, the number of companies included in the cap-and-trade program, and the auctions, will increase, and the number of allocations allotted will be driven down, necessitating further emissions reductions and/or the purchase of more allocations on the market. Some companies and utilities will be looking to buy advance allocations as well–these are allocations priced at today’s market rate, but which cannot be used until 2015. Those companies that know they will need to buy more allocations and want to lock in today’s carbon price may opt to stockpile advance allocations. This could be particularly true not just for more expected players, such as utilities, but also for the high-tech sector, where emissions of sulfur hexafluoride (SF6), which is used widely in the semiconductor industry, could prove to be quite expensive. SF6 has a carbon equivalent of 23, 900, so even emitting a relatively low amount of the stuff could have a major impact on a company’s bottom line.

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There is one remaining political squabble: Under California’s Proposition 13, anything that could reasonably be described as a tax must be approved by two-thirds of voters. AB32 was passed by voters, and Proposition 123, which aimed to kill AB32, was voted down by 62 percent of the state’s voters, but it did not get two-thirds of voters’ approval. That means any money raised by the bill will need to be tied directly to greenhouse gas reductions or else risk being frozen by opponents to cap and trade. While some of the Governor’s initial plans to use the auction revenue to help fund high-speed rail may pass muster, others–namely using the funds to beef up the state’s ailing General Fund–would certainly not.

Irrespective of what happens with the auction’s revenues, however, California is likely to set the stage for federal carbon regulation, no matter who wins the next election or which party controls Congress. “California has put into place the first real market system that lashes the markets to climate change solutions,” says Larry Goldenhersh, CEO of environmental ERP software provider Enviance, which is working with companies such as Valero, Chevron, and PG&E to prepare for the shift in California. ”The results will determine whether we have federal cap and trade in the next five years. It doesn’t matter who’s elected.”

That’s true whether the auction and the cap-and-trade program exceed all expectations or fail spectacularly. Current revenue projections are based on the assumption that most, if not all, of the allocations that are auctioned off will sell, but there’s no guarantee that will happen. Should cap and trade flop in California, federal regulators will nonetheless learn from the experiment, and either work toward a revised cap-and-trade idea or revive the notion of a carbon tax.

“There’s been a whole raft of greenhouse gas emissions regulations passed in the last few years and if Obama is elected I think we can expect to see the drumbeat of ever-increasing greenhouse gas regulatory pressure continue,” Goldenhersh says. “By mid-term, industry will demand a national solution that puts a market solution in place. If you were to poll utilities right now, I think you would find that most of them want a price on carbon so that they can pass it on to their rate payers and make a financial plan around this stuff.”

The California experiment will have an impact if Romney is elected, as well, according to Goldenhersh. “If Romney wins I think you’ll see a reluctance to reverse any of the greenhouse gas regulations already in place,” he says. “If you research Governor Romney, yes he said recently that the EPA is out of control and appears to be a tool to crush private enterprise, but he also launched greenhouse gas legislation in Massachusetts, which set a short term goal of reducing greenhouse gases to 1990 levels by 2010 and which  he labeled as  the ‘no regrets policy towards climate change.’ He is also on record as saying mankind has contributed to climate change and we need to do something about it. Romney is conflicted on climate.”

Either way, with many U.S. companies already dealing with a price on carbon in California, plus a patchwork of federal greenhouse gas regulations, Goldenhersh is hearing from his customers that they want some sort of federal, market-based solution. “When Congress gets pushed for a solution, what will they be looking at? They’ll be looking at the way the 8^th largest economy in the world has managed this issue. And I think that will accelerate the development of a federal carbon market.”

That’s good news for data management companies like Enviance (and others, such as SAP and OsiSoft), which will be tapped to help companies track and analyze their emissions. Back in 2005, Enviance helped American Electric Power build the world’s first cloud-based system for managing greenhouse gas emissions. At the time, AEP was reputed to be the largest CO2 emitter on earth. The Enviance system enabled AEP executives to see the greenhouse gas emissions attributable to every  ton of coal burned at any of their plants, and helped them begin to size the impact greenhouse gas regulation would have on their business.

“Tracking emissions is the first step toward figuring out how much it will cost you when you have to start paying for carbon,” Goldenhersh says. “It gives your CFO information like at $10/ton we will have $350 million in carbon  exposure by 2013, so what do we do about that?”

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