RGGI Secondary Allowance Market in the Fifth Compliance Period

The Regional Greenhouse Gas Initiative is a carbon dioxide control program in the Northeastern United States.  Starting in January 2009 the program is now in its fifth three-year compliance period.  This technical post explains why the ownership of allowances held in this compliance period will be unique and how that may be a problem.

I have been involved in the RGGI program process since its inception.  I blog about the details of the RGGI program because very few seem to want to provide any criticisms of the program. The opinions expressed in this post do not reflect the position of any of my previous employers or any other company I have been associated with, these comments are mine alone.

Background

RGGI is a market-based program to reduce greenhouse gas emissions. It is a cooperative effort among the states of Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, Vermont, and Virginia to cap and reduce CO2 emissions from the power sector.  According to a RGGI website:

“The RGGI states issue CO2 allowances which are distributed almost entirely through regional auctions, resulting in proceeds for reinvestment in strategic energy and consumer programs. Programs funded with RGGI investments have spanned a wide range of consumers, providing benefits and improvements to private homes, local businesses, multi-family housing, industrial facilities, community buildings, retail customers, and more.” 

Proponents tout RGGI as a successful program because participating states have “cut carbon pollution from their power plants by more than half, improved public health by cutting dangerous air pollutants like soot and smog, invested more than $3 billion into their energy economies, and created tens of thousands of new job-years”.  Others have pointed out that RGGI was not the driving factor for the observed emission reductions.  My work supports that point and points out that the cost-effectiveness of the investments from this carbon tax reduce CO2 emissions at a cost of $858 per ton which is far greater than the social cost of carbon metric.  In other words, this is not a cost-effective way to reduce CO2 emissions.

I first became involved with emissions trading pollution control programs at the beginning of the Acid Rain program in 1995.  That program introduced a system of allowance trading that uses market-based incentives to reduce pollution.  The Acid Rain Program is considered a success because it delivered greater emissions reductions at a lower cost than expected.  I think the success caused a problem inasmuch as nowadays emissions trading programs of any form are considered the best approach whatever the circumstances.  First and foremost, trading programs for CO2 have fewer control options.  In the Acid Rain Program there were compliance options such as add-on controls at the affected sources and more fuel-switching options than are available to reduce CO2 emissions.  For existing sources the main control approaches are fuel switching and running less.  Also, with respect to RGGI the idea that a “little” tweak to auction the allowances rather than award them based on past operations presumed that RGGI would get similar results.

Rather than awarding allowances to affected sources the RGGI allowances are made available at quarterly auctions.  Anyone who meets the financial requirements is eligible to participate in the auctions.  Affected sources are required to surrender allowances equal to half their annual emissions at the end of the first and second years of the compliance period and then surrender allowances to cover the rest of their emissions in the compliance period at the end of the third year.  When allowances are awarded to affected sources the excess allowances after reconciliation are surplus and affected sources are confident that they can be sold or traded without impacting compliance.  Thus, the allowance bank in these systems is primarily allowances that have been earned because the affected sources developed a control strategy that exceeded the cap requirements.  Selling all the allowances in auctions enables investors with no compliance obligations to play the market.  That is a big and mostly unacknowledged difference.

I believe there is a major gap between the academic theory how emissions trading works and reality.  Academics believe that the affected sources treat allowances as a storable commodity and a profit center.  However, the reality is that affected sources treat allowances as a compliance instrument and very few companies buy and sell allowances for profit.  Moreover, it is the nature of the generation business today to have a very short-sighted business plan.  As a result, I believe that affected sources only purchase allowances on an expected need basis mostly at the auctions, but also from the market.  Note that this approach means that the size of the banked allowance pool at affected sources is small and used for short-term compliance goals.  At this time the bulk of the current allowance bank consists of allowances purchased by investors without compliance obligations.

During the development of the RGGI rules the possibility that entities could cause anti-competitive behavior was discussed.  In response, RGGI has an independent auditor (Potomac Economics) checking to see if that has been observed and evaluating other aspects of the market (reports here).  In the Environmental Protection Agency market-based pollution control programs there is complete transparency and the ownership of all allowances is available.  However, in RGGI only the independent auditor knows the identity of auction bidders and allowance holders.  In the remainder of this post, I explain why the majority of allowances held by investors rather than affected sources in this compliance period will be unique and how that may be a problem.

Secondary Market Report Allowance Holdings

A couple of months after each auction Potomac Economics prepares a report on the secondary market.  The most recent report on the secondary market summarizes the allowance status of the CO2 allowance holdings at the end of the second quarter of 2021:

• There were 143 million CO2 allowances in circulation.
• Compliance-oriented entities held approximately 52 million of the allowances in circulation (36 percent).
• Approximately 61 million of the allowances in circulation (43 percent) are believed to be held for compliance purposes.

The RGGI market monitor, Potomac Economics, only describes three categories for allowance owners.  Figure 1 from their recent report describes the relationship between the three categories they use.

Figure 1: Classifications of Participant Firms in the RGGI Marketplace

The Potomac Economics description of firms participating in the RGGI market states:

• Compliance-oriented entities are compliance entities that appear to acquire and hold allowances primarily to satisfy their compliance obligations.
• Investors with Compliance Obligations are firms that have compliance obligations, but which hold a number of allowances that exceeds their estimated compliance obligations by a margin suggesting they also buy for re-sale or some other investment purpose. These firms often transfer significant quantities of allowances to unaffiliated firms.

• Investors without Compliance Obligations are firms without any compliance obligations.

These three categories form the basis for two overlapping groups.

• Compliance Entities – All firms with compliance obligations[1], and their affiliates[2]. Combines the first and second of the above categories.
• Investors – All firms which are assessed to be purchasing primarily for investment rather than compliance purposes. Combines the second and third of the above categories.

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[1] Before New Jersey announced on June 17, 2019 that it would participate in RGGI beginning in January 2020, firms owning Budget Sources in New Jersey but not in currently Participating States were not treated as compliance entities. However, since the announcement, such firms are treated as compliance entities in our reports.

[2] Affiliates are firms that: (i) have a parent-subsidiary relationship with a compliance entity, (ii) are subsidiaries of a parent company that has a large interest in a compliance entity, (iii) have substantial control over the operation of a budget source and/or responsibility for acquiring RGGI allowances to satisfy its compliance obligations.

The assessment of whether a compliance entity holds a number of allowances that exceeds its compliance obligations by a margin that suggests they are also buying for re-sale or some other investment purpose is based on: (a) the entity’s forecasted share of the total compliance obligations for the entire RGGI footprint through 2026, (b) the total number of allowances in circulation, and (c) consideration of the pattern of the entity’s allowance transfers to unaffiliated firms versus affiliated firms. Since the designation of a compliance entity as an investor is based on a review of its transactions and holdings, the designation of a particular firm may change over time as more information becomes available. Therefore, some of the quantities in this report may not match previous reports because of changes in the classification of particular firms.

The number of allowances that are believed to be held for compliance purposes includes 100 percent of the allowances held by compliance-oriented entities and a portion of allowances held by other compliance entities (i.e., entities with compliance obligations that are not included in the compliance-oriented category).

The anonymity of the allowance holders raises a couple of issues.  In the first place, the classification of the owners is subjective and has not been independently reviewed so the classifications might not reflect the likely behavior of the owners.  There also is the possibility of another category of allowance holders.  Potomac Economics presumes that the all the allowances are held by investors who would be willing to sell their holdings if the price was right.  However, if there are owners who regard the RGGI allowances as carbon offsets they would not be willing to sell at any price.  Given the opaque ownership information I have no idea whether there could be enough offset holders to affect the market.

Projected Allowance Holdings

In the fifth RGGI compliance period allowance holdings ownership will become an issue.  In order to illustrate possible scenarios, I estimated the allowances that might be held by entities holding them for compliance purposes and investors with no compliance obligations through the end of the compliance period in 2023.  RGGI does not provide a consolidated source for the allowances in circulation data listed in the Potomac Economics reports.  Because I have been unable to replicate the numbers and the discussion of the calculations is so complicated, I have prepared a documentation report if anyone is inclined to find out how the following numbers were derived.

In brief, I used the second quarter 2021 Potomac Economics allowances in circulation and allowances held for compliance purposes combined with the auction for the third quarter 2021 report that provided an update of the allowances in held for compliance purposes.  For the rest of the auctions, I used the estimated adjusted allowance allocations.  The biggest question mark is the number of allowances that are allocated to states but not put in the allowance auctions.  There are CO2 emissions data available for the first two quarters of 2021 and I used those data to project future emissions.

I prepared three scenarios of the status of the number of allowances available to entities with compliance obligations at the end of 2023.  In all the scenarios I assume that all the auctioned allowances are purchased by compliance entities.  The first scenario assumes constant emissions consistent with the first two quarters of 2021 and allowances allocated to auctions are reduced consistent with the ratio of total allowances available to allowances auctioned in 2020.  In that scenario compliance entities will have to purchase 20 million allowances from investors without compliance obligations to meet their compliance requirements in the fifth compliance period.  The second scenario assumes that all the allowances allocated to each year are auctioned off with the same emission assumption.  In that case, the compliance entities will have to purchase 6 million allowances from investors without compliance obligations to meet their compliance requirements.  Of course, projecting future emissions is difficult but important to the results.  The third scenario reduced emissions in 2022 and 2023 by 3%, consistent with the allowance allocation reductions.  In that scenario compliance entities still have to purchase nearly 19 million allowances for investors without compliance obligations to meet their compliance requirements.

Cost Containment Reserve

There are factors that could significantly change the allocation results.  Additional allowances can be added to the auctions.  The RGGI states have established a Cost Containment Reserve (CCR), consisting of a quantity of allowances in addition to the cap which are held in reserve. These are sold if allowance prices exceed predefined price levels, so that the CCR will only trigger if emission reduction costs are higher than projected. The CCR is replenished at the start of each calendar year.  The CCR trigger price is $13.00 in 2021 and will increase by 7% per year thereafter. The size of the CCR is 10% of the regional cap each year.  If the auction price triggers the CCR in 2021 then an additional 11,976,778 allowances will be added.  In 2022 11,617,475 allowances and in 2023 11,268,951 allowances will be added if the CCT trigger price is exceeded.  Of course, if additional states join the program, then the allowance allocations will increase.  Finally, if investors without compliance obligations purchase allowances that makes it that much more difficult for affected sources to purchase allowances needed for compliance.

Discussion

In the background section I explained that the allowance bank in the RGGI cap-and-auction program is different than the allowance bank in traditional cap-and-trade programs.  At this time 54% of the allowances in the bank are held by investors without compliance obligations.  If the CCR is not triggered, at the end of the fifth compliance period it is likely that the affected sources will have to obtain allowances from entities who purchased the allowances as an investment.  This is unprecedented.

During the development of the implementing RGGI regulations the Integrated Planning Model was used to predict how the market would act.  One of the bigger problems with the model results is that the model had perfect foresight.  It knew how many allowances would be needed for its estimates of emissions and projected that affected sources would rationally act in their best interests with that information by, for example, purchasing allowances early to cover shortfalls later in subsequent compliance periods.  However, affected sources don’t know what their future emissions will be and don’t purchase allowances except on a shorter time horizon.  Throw in the vested interests of investors and we cannot possibly expect that the market will behave “perfectly” as predicted in the model.

One other aspect of the modeling that was not addressed was the relationship between compliance entities and investors without compliance obligations.  No market-based pollution control program has ever reached the point where non-compliance investors owned most of the banked allowances.  Table 1 estimates when affected sources that keep allowances in hand to cover emissions will need to go to the investors.  It starts adding allowances and emissions to the current allowance ownership categories but does not include the allowances surrendered to meet 50% compliance obligation at the end of the first and second years.  Using the assumptions of Scenario 1, the margin between emissions and total allowances for compliance obligations category indicates that affected sources will have to rely on non-compliance entities starting in 2022. 

Table 1: Fifth Compliance Period Projected Allowances and Emissions – Scenario 1

		Allowances	Allowances for	Constant	Compliance
Year	Quarter	in Circulation	Compliance Purposes	Emissions	Margin
2021	Q2	143.0	61.0	49.9	11.1
2021	Q3	165.9	76.3	74.9	1.4
2021	Q4	188.6	99.0	99.9	-1.0
2022	Q1	210.5	120.9	124.9	-4.0
2022	Q2	232.5	142.9	149.9	-7.0
2022	Q3	254.5	164.9	174.9	-10.0
2022	Q4	276.5	186.9	199.9	-13.1
2023	Q1	297.8	208.2	224.9	-16.8
2023	Q2	319.1	229.5	249.9	-20.4
2023	Q3	340.4	250.8	274.9	-24.1
2023	Q4	361.7	272.1	299.9	-27.8

I think that the investors without compliance obligations are in for a windfall.  At some point it is inevitable that affected sources are going to have to purchase allowances from these investors. It is naïve to expect that their selling price will be anything less than near the CCR trigger price because those investors don’t have to sell until their price is met but affected sources will have to buy whatever the cost.  This will reduce societal benefits.  For example, consider the Quarter 3 2021 auction. The closing price for 22,911,423 allowances was $9.30. which earned the RGGI states $213,076,234 which will be invested for “reinvestment in strategic energy and consumer programs”.  Compliance Entities purchased 52 percent of the allowances sold so non-compliance entities ended up with 10,997,483 allowances.  At the end of the fifth compliance period if the allowance market price is $14.85, just under the CCR trigger of $14.88, and compliance entities have to purchase allowances for compliance then the profit for the investors would be $61,036,031. None of those funds will go toward strategic energy and consumer programs.

It will be fascinating to see how this plays out.  I expect that allowance prices will increase when this ownership shift occurs but will they increase enough to trigger the CCR and add allowances to the system?  If allowances are added to circulation, it will delay the leverage that investors without compliance obligations have on affected sources who need allowances to operate.  At this time, it appears to be extremely unlikely that the CCR will be triggered in 2021.  Given the large gap in prices it might not even be triggered in 2022 but given that affected sources will have to go to the market to purchase allowances necessary to cover emissions triggering the CCR is more likely.  I frankly will be surprised if the CCR is not triggered in 2023.  If that happens allowance prices will be over $14.88, 11,268,951 allowances will be added to circulation, and, assuming emissions decrease by 3% per year, the allowances available to the affected sources would approximately equal the compliance obligation.

The biggest unknown in all this is future emissions.  The primary CO2 reduction mechanism is fuel switching and the original nine states in RGGI have already switched fuels at many sites.  I have no experience with Virginia’s emissions so there might be a possibility of significant fuel switching and lower emissions.  In New York the retirement of 2000 MW of nuclear generating capacity will surely increase state CO2 emissions.  The important takeaway is that the worst-case situation is if there are insufficient allowances that affected sources will be unable to run.  In theory, when there is a shortage of allowances the prices will go up and trigger additional allowances from the CCR.

Conclusion

This post explains that RGGI is approaching the situation where the majority of allowances will be held by investors rather than affected sources.  Speaking as an investor, I purchased allowances in auction 40 in June 2018 and sold them earlier this year when I needed the money, I would certainly be setting an “ask” price close to the CCR trigger price.  Investors who have held on to them for this long can afford to wait a couple of more years when affected sources will have to purchase allowances.  As long as quarterly emissions exceed the allowances available it is only a matter of time until that occurs.  This is a problem because consumers will end up paying the allowance costs that get incorporated into the electric system bid costs but they will not reap any benefits on the difference between the auction cost and the sales cost.

The opaqueness of the RGGI allowance bank makes it necessary to rely on the market monitor to tell us the categories of the allowance holders.  The expectation for all three categories, compliance entities, investors with compliance obligations and investors without compliance obligations, is that allowances will be sold at the right price.  However, if there are owners who regard the RGGI allowances as carbon offsets they would not be willing to sell at any price.  It is not clear that there are any allowance holders in this category but it is possible.  Another question is whether carbon offset allowance holders would have an impact on RGGI emissions.  In my opinion that is unlikely because the scarcity of allowances would drive up the price and trigger the release of additional allowances.