California and Quebec: A Partnership Par Excellence

rp_erica-morehouse-287x377-228x300.jpgOn Tuesday, the Canadian province of Quebec held its second cap-and-trade allowance auction.

Today, the results are in – and they’re encouraging.

99% of the current vintage year allowances and 84% of the future vintage year allowances offered for sale in this auction were purchased at the floor price of $11.39 CAD.  This is a significant increase from Quebec’s first action, which saw the sale of only 34% and 27% of current and future allowances, respectively.

These results reflect growing interest and demand in this burgeoning carbon market after it officially linked with California’s program at the beginning of 2014.

However, the results of Quebec’s auction are a bit different from the results we saw in California’s sixth auction last month. Most notably, California’s auction saw higher demand for allowances, driving the settlement prices for both current and future allowances above those seen in Quebec’s auction.

So, why do these differences exist?  And what do the Quebec auctions actually tell us? 

The answers to these questions center on how much smaller Quebec’s economy is than California’s, about a sixth of the size. This is in large part due to the sheer magnitude of California’s population – nearly 38 million compared to Quebec’s 8 million. Because the Golden State is a much larger market than Quebec, we can expect the California market to be a much stronger driver of prices and have heavier trading activity.

California and Quebec are planning to hold joint auctions this year, and at that time the two markets will completely align with a uniform price for both sets of allowances. Until then, given that Quebec’s program is much smaller and has had less time to develop, the California auction prices and market conditions are more predictive of what the linked program will look like once joint auctions begin.

There are a few reasons for the lower prices and demand we are seeing in Quebec. First, entities can only participate in Quebec’s market if they are located in Canada. This means a company regulated by California’s cap-and-trade program, with no presence in Canada, will have to wait until joint auctions to buy Quebec allowances directly at public auction. Because Quebec’s economy is so much smaller, this drastically limits the pool of participants. There were just 16 participants in the Quebec auction compared to 71 participants in the last California auction.

Second, unlike California entities that must turn in allowances to cover a portion of their compliance obligations at the end of this year, covered entities in Quebec do not have to turn in their first batch of allowances until 2015. (This is one of the few small differences between California and Quebec regulations.) These entities aren’t feeling the same sense of urgency to acquire allowances as California entities. Furthermore, Quebec’s program, just as California’s, was designed to allow companies time to smoothly transition to a capped economy. As Quebec’s program is still at an early stage, prices were expected to be slightly lower.

In fact, the results of this last Quebec auction show exactly why linkage is so useful.

Linkage can allow a smaller market like Quebec’s with less trading to link with a larger, more active one like California’s. This will in turn increase the trade activity of both markets, which translates into less price volatility and a healthier joint market. In addition, linkage can create cost savings by broadening opportunities for lower cost reductions and giving businesses greater investment flexibility.

The linkage of Quebec and California will be a model for other jurisdictional linkages, showing that greater emissions reductions can be achieved together than either market could achieve alone. As the saying goes, two heads are better than one. California has a strong partner in Quebec and we can expect to see that partnership reach its full potential when joint auctions begin later this year.

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