RGGI Roars Back to Life With Record Carbon Prices

Left for dead for years, the Regional Greenhouse Gas Initiative (RGGI) soared to record heights after a major overhaul of the program gave market participants new confidence in its longevity. RGGI could receive another major boost if the US Environmental Protection Agency decides that the cap-and-trade program can be used for compliance with its upcoming greenhouse gas regulations for existing power plants.

13 March 2014 | While many of the hopes and dreams of carbon market advocates in the US were squarely focused on California’s developing cap-and-trade program in 2012, officials in the Regional Greenhouse Gas Initiative (RGGI) were busy plotting its comeback.

The Northeast carbon trading market had been weighed down for three years by an overabundance of allowances that forced credits to trade at the market’s floor prices. But the participating RGGI states, with the exception of New Jersey which pulled out of the program at the end of 2011, committed to overhauling the program, an effort that appears to be paying off in a big way.

In the first auction since the planned changes went into effect, held on March 5, RGGI allowances sold at a record $4 per ton. This surpassed the previous $3.51/t high, set during the March 18, 2009 auction, the first auction held during the program’s initial compliance period (2009-2011). Also noteworthy was the fact that RGGI exhausted its back-up supply of allowances for 2014 after triggering their sale by hitting that magic $4 mark.

“I think it’s a true market at this point,” Collin O’Mara, Secretary of the Delaware Department of Natural Resources and Environmental Control and Vice-Chair of the RGGI, Inc. Board of Directors, told Ecosystem Marketplace. “The market is functioning as a true market.

The $4/t price for RGGI allowances, while low in comparison to the roughly $11/t prices seen in the now-linked California and Quebec cap-and-trade programs, represents a more than doubling of the allowance price before the February 2013 announcement of the planned changes. And for long-time followers of the RGGI program, it sends an important message: RGGI is real and is here to stay.

“The main takeaway is growing confidence in the RGGI market,” said Peter Shattuck, director of market initiatives for NGO Environment Northeast.

The Comeback

The winter that refuses to end, with the infamous Polar Vortex, may have played a role in driving the robust demand for allowances seen in the latest auction. But the biggest factor in reviving the RGGI program has been the lowering of the emissions cap.

After thoroughly reviewing the program in 2012, RGGI officials decided to reduce the 2014 emissions cap by 45% to 91 million tons, with additional cuts taking into account the bank of allowances that had been acquired by private entities during the program’s down years. This decision sparked renewed interest in the market last year, with allowances selling for $2.80/t in the March 13, 2013 auction, well above the $1.93/t floor price the allowances cleared at the previous auction. Allowance prices dipped up and down for the rest of 2013 as the RGGI states all had to go through their respective regulatory or legislative processes to officially implement the proposed cap adjustment.

“You could say there was some uncertainty to whether that change was actually going to get made,” Shattuck said. “This is the first auction since the change was fully in effect and prices have continued to come up.”

Deflating the Cushion

The triggering and exhausting of the program’s cost containment reserve (CCR) was a historic and unexpected development. Cap-and-trade programs for greenhouse gases (GHG) often include mechanisms – a CCR being one such mechanism – to add flexibility or establish price certainty in response to concerns that the costs of complying with the program will spiral out of control. After conducting the program review, RGGI officials decided to add a new mechanism that would release more allowances if auction prices reached a certain point, set at $4/t in 2014. That price point was triggered in the March 5 auction, which emptied out all five million of the CCR allowances available for sale in 2014.

“It operated exactly as it was intended – it suppressed prices,” O’Mara said. “It’s a very nimble mechanism for mitigating price impact, particularly as a lot of entities were buying for future use, not just the immediate quarter.”

If fundamental factors begin to shift, for example, if a warming weather trend takes hold over the summer or natural gas prices rise significantly, shifting more electricity back to coal sources, market participants will not have a CCR to cushion them from major price spikes for the rest of the year.

“I think some parties view a $4 price as a relative bargain right now,” said William Shobe, an economist and professor at the University of Virginia who helped design the original RGGI program.

Return of the Players

When RGGI was languishing at the floor price, traders and bankers were not buying allowances. But these market speculators have returned to the program with a vengeance. The latest auction results showed that compliance entities and their affiliates purchased only 45% of the available allowances, meaning that market speculators and other entities actively participated in this auction.

“My take on that is that there are plenty of players out there who think that the price is going to continue to rise,” Shobe said. “It’s good for the market. There are going to be plenty of counterparties for trading for the compliance entities. But it also indicates that there are people out there who think this is a good investment for the future.”

Rising RGGI allowance prices also beg the question of whether there could finally be development of carbon offset projects for RGGI compliance, which has not occurred to date with prices hovering at the floor for so long.

“With the firming of the price, you would expect to see some activity for generating offsets,” Shobe said. “The very fact that the cost containment reserve is gone is a signal to people who might invest in offsets that there is going to be more opportunity to sell offsets into this market than might have been expected before this auction.”

RGGI officials developed a new protocol that aimed to replace the afforestation project type included in the original RGGI model rule. Some of the participating RGGI states have adopted the new forest protocol, which covers improved forest management, avoided conversion and reforestation activities.

The idea was to bring RGGI’s forestry protocol in line with the Western Climate Initiative (WCI), the program under which California and Quebec have linked their cap-and-trade programs. But that could mean that project developers interested in selling into a compliance market would remain focused on the WCI because prices in the program are still nearly triple RGGI allowance prices.

“We don’t anticipate offsets coming into the market until a time, if ever, allowance prices are significantly higher,” O’Mara said. “We’re not anticipating the results of this auction having a significant impact on RGGI offset activity, at least for the near future.”

Offset project developer Environmental Credit Corp would not be inclined to even look at the RGGI program until allowance prices exceed $10/t, which is unlikely in the next couple of years because of the price points that trigger the CCR, said CEO/CFO Derek Six. Even if the market reached $10/t for the allowances, there are obstacles that would make offset development difficult such as technical problems with the RGGI protocols and the state-by-state administration of offset projects in the program, he added.

A Bright Future

In June 2013, US President Barack Obama directed the US Environmental Protection Agency (EPA) to propose rules to regulate GHG emissions from existing power plants by June 1, 2014, with final rules due a year later.

RGGI officials have been working behind the scenes over the past several months talking about the economics of their market-based program and why the EPA should recognize the RGGI model as an effective system of GHG emission reductions for the power sector.

Many experts believe that RGGI will be accepted as a compliance mechanism by the EPA and that would likely have a positive impact on the program. That expectation could have been a factor in boosting demand for RGGI allowances in the latest auction, but it’s difficult to know for certain.

“I think there is a bet on the future of RGGI under the EPA rules,” Shattuck said. “I would be surprised if (the EPA) didn’t leave enough room for RGGI.”

“There might be some gambling going on that RGGI allowances could be a more valuable commodity under heightened federal rules on climate change,” Shobe observed. “But the risk works the other way as well. We don’t really know what EPA is going to do. There’s some risk that RGGI cap-and-trade program wouldn’t satisfy the requirements of EPA rules. I just don’t see that as a huge driver of current prices under RGGI. It could be happening, but that’s a very speculative bet right now.”

Expectations that RGGI would comply with the EPA’s program have driven an increasing awareness among non-RGGI states of its cost-effective, market-based approach, O’Mara said. While no state has said it wants to join RGGI tomorrow, several have been carefully studying the RGGI approach, he said. A benefit for other states is that RGGI has already worked through all of the potential kinks of a market, including ensuring a smooth auction and monitoring for potential manipulation. As more states focus on planning for compliance with the upcoming EPA rules, O’Mara expects an even greater focus on RGGI and potentially a decision by some states to join the program.

“It’s going to be an exciting next 12 months,” he said.

The Backstory

The Regional Greenhouse Gas Initiative (RGGI) is the first cap-and-trade program implemented in the United States to reduce greenhouse gas (GHG) emissions in the power sector. It was established in 2005 by 10 states in the US Northeast – although the state of New Jersey dropped out of the program in December 2011— and held its first auction of carbon dioxide (CO2) allowances in September 2008. Under the cap, the RGGI states will achieve an almost 50% reduction in CO2 emissions in the power sector from 2005 levels by 2020.

RGGI officials engaged in an extensive revamp of the program in 2012, with the changes taking effect in January 2014. Those changes included:

• Reducing the 2014 cap by 45% from 165 million tons to 91 million tons of carbon dioxide, with additional decreases of 2.5% per year from 2015-20.
• Adding a new cost containment reserve that releases allowances if auction prices reach a certain pre-determined pricing points: $4/t in 2014, $6/t in 2015, $8/t in 2016, and $10/t in 2017, rising by 2.5% in each of the following years.
• Adding a new forestry protocol that covers improved forest management, avoided conversion and reforestation activities, bringing RGGI’s protocol more in line with California’s forest protocol, which has spurred development of forestry projects across the US.