Optimism amid unknowns of Ontario’s first carbon auction

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Analysts are expecting Ontario’s inaugural cap-and-trade auction to be well subscribed, with participants eager to snap up allowances before the coming decade of constrained supply.

Some 25.3 million vintage 2017 spot Ontario Carbon Allowances (OCAs) were offered on Wednesday, March 21st, with a further 3.1 million vintage 2020 allowances for sale. The bidding window is open from 1300-1600 EST (1700-2000 GMT).

More than 230 entities are currently registered to participate in the scheme, according to the latest government list, and analysts and traders are optimistic about the appetite from participants, expecting most or all available OCAs to be sold.

One trader who asked not to be named told Carbon Pulse that they expected the auction to sell out, with around 75% of big emitters taking part.

“The likely scenario is somewhere close to but not fully subscribed,” said another.

And the novelty of the market could play to its advantage, with experts pointing to a high level of interest among participants in embarking in the new scheme straight away.

“It seems a lot of compliance people have been talking about it for a longer amount of time. My guess is they want to get out there and cut their teeth and participate,” added the first trader.

Jackie Cooley, a carbon market analyst at ICIS, agreed.

“There’s been a lot of engagement recently among market participants and financial companies as well, and I would expect that you have an auction that is fully subscribed,” she told Carbon Pulse.

“In a lot of new markets, you tend to see a lot of interest at the beginning. No one knows the true size of demand, so you tend to see higher demand in the first few auctions than you do once markets settle into a norm.”

FLOOR PRICE

Meanwhile, analysts are uniformly expecting the OCA auction to settle either at or close to the US$13.57 floor price, which at Tuesday’s CADUSD exchange rate equated to around C$18.07.

“At the beginning of the compliance period, I would expect that participants are unlikely to bid aggressively, so the settlement will likely end up very close to the reserve price,” said Alexandra Sadvari, a Toronto-based associate at the law firm Gowling WLG.

Nicolas Girod, an analyst with trading firm ClearBlue Markets, added: “If you look at the secondary market, it is trading close to the floor price and there’s not that much liquidity in the market, so I don’t expect [the auction] to be much higher.”

California allowances – the most liquid WCI contracts – were trading at $13.57 this week on the March-delivery futures on ICE, while vintage 2017 OCA Dec-17 futures for delivery in December have been stuck at C$18.41 for more than two weeks.

FUTURE CONSTRAINTS

ICIS’s Cooley added that stringent carbon targets in Ontario over the next decade could give entities an incentive to buy allowances earlier rather than later.

The scheme’s emission cap will initially be set at 142.3 million tonnes in 2017, declining to 124.7 million by 2020 as the province attempts to hit its goal to cut GHGs by 15% below 1990 levels by the end of this decade.

“And if you extrapolate the programme based on their 2030 targets [of 37% below 1990], suppliers will be pretty heavily constrained in Ontario, and they’ve done a lot of their heavy lifting in terms of reducing emissions. There’s no coal power plants in Ontario anymore,” Cooley said.

“Anyone that’s looking long term, looking at the fundamental factors, could be more encouraged to participate in the near future.”

A report released Monday by ClearBlue Markets predicted that, after an initially oversupplied market in 2017, the demand for allowances would outstrip supply by 29.4 million over the first four-year compliance period (2017-2020) as the cap shrinks.

While linking with an oversupplied California-Quebec market next year could ease this shortage, it may be unable to alleviate the near-term bearish sentiment.

“With linkage, Ontario/the broader WCI system would remain oversupplied until the medium term, which means Ontario players would not be incentivised to bid up prices in the early auctions,” said Rachel Jiang, an analyst at Bloomberg New Energy Finance.

The number of free OCAs given to most industrial facilities will also decline at an annual rate of 4.57% from 2018 and will be reviewed at the end of the first phase, while none are being given to fuel supplier/distributors, electricity importers and some electricity generators.

UNCERTAINTY AND THREATS

However, it is the behaviour of fuel distributors – which have held back in recent poorly-subscribed California-Quebec auctions – that is one of the big uncertainties in the forthcoming Ontario sale.

“Are they really ready for trading? Do they have a strategy in place? That’s the first thing,” said Girod.

Participants may not feel spurred to rush into the first auction and many could sit on the sidelines for now as they face a Nov. 2021 deadline for full compliance.

“They have a lot of time. They have four years to buy their missing allowances, so my guess is we will see around 50 compliance entities in this first auction,” added Girod.

Uncertainty over California’s market is also looming large. While Ontario’s WCI linkage has yet to be officially enshrined, many participants are keeping an eye on developments to the south.

Three of the last four WCI auctions have seen fewer than a third of the allowances on offer sold, while an ongoing court case is hanging over the future of the California market, putting its right to conduct auctions in peril.

An outcome is expected within the coming weeks, with some observers saying that a victory for the challengers would likely knock California allowances below the price floor and into the mid single digits, and with them Canadian carbon prices.

“If you expect that the linkage will happen, do you really want to buy a lot of [OCAs] near the auction floor level? Maybe [emitters] will be willing to wait to the second auction to have more clarity,” said Girod.

While the two markets remain officially separate for now, concern over California-Quebec is likely to remain a “smaller factor” in dissuading participation, another observer suggested.

But one of the largest threats to Ontario’s auction participation and the entire carbon market could be the province’s official opposition.

Progressive Conservative leader Patrick Brown on Tuesday vowed to scrap the cap-and-trade scheme and withdraw the province from the WCI programme should his party win in June 2018’s provincial elections.

That could keep bidders at bay, fearing that they could shell out for allowances for a compliance deadline that may never arrive.

According to the Toronto Star, Brown said his party’s policy advisory committee is examining the legal implications of shutting Ontario’s market and leaving WCI.

He has previously pledged to replace the cap-and-trade scheme with a carbon tax, which the ruling Liberal government claims would be a more expensive option.

By Sophie Yeo – sophie@carbon-pulse.com

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