November 04, 2024
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Carbon Watch
August 31, 2024
Carbon Markets – The Inefficient Frontier
Environmental commodity markets are often characterized by inefficiencies resulting from a patchwork of varying regulatory systems, end users that are mainly focused on compliance as opposed to price, and limited investor familiarity with environmental commodities. As such, they have exhibited low correlations to financial markets over time. Environmental commodity market inefficiencies are largely driven by regulated entities whose market behavior typically focuses on achieving annual compliance and as a consequence a ratable buying approach of environmental commodities vs. speculating on future pricing.
Additional inefficiencies include a) the limited (but growing) number of institutional investors who tend to focus on several of the larger environmental commodity markets while leaving the lesser-known markets to specialists, and b) the relatively high barriers for entry to access the primary vs. secondary market. These inefficiencies must be well understood to navigate these markets successfully as they often explain the dissonance between fundamentals and price action.
The recent activity around California’s Cap & Trade Program (“CCA” or the “Program”) was reminiscent of this point. In July 2024, the Program’s regulator, California Air Resources Board (“CARB”), held a workshop to discuss pending regulatory amendments so the Program remains on track to meet its Greenhouse Gas (“GHG”) emissions reduction target. CARB has been discussing these amendments since November 2022, holding 8 workshops & community meetings since, with this latest being the most detailed as to when and how exactly CARB plans to implement these amendments. The proposed details were fundamentally constructive; however, it was also announced that the implementation of the changes would likely be delayed from 2025 to 2026 to meet the technical requirements for their policymaking timeline. While delays are not favorable, they are not unusual in policy development. In fact, this happened at the start of the Program with a one-year delay to implement CCAs from 2012 to 2013.
The announced and likely delay surprised the market and led to a sharp decline in price Short-term traders turned bearish over the delay, despite the rest of the news in the same workshop that the fundamentals will become significantly tighter by decreasing supply dramatically over the next 5 years beginning in January 2026 (if not earlier).
Given that the timing slip does not impact overall program goals or fundamentals over the medium and long-term, in our view there has never been a stronger case for increased demand, reduced supply, and therefore likely higher prices in the CCA market. Consequently, one short-term trader’s bearish view is another investor’s bullish view. Market participants with a medium to longer-term horizon are likely viewing current prices as an attractive entry point given the bullish outlook on supply/demand balances.
In summary, inefficiency in environmental markets stems from the diversity of participants and their differing incentives ECP’s fundamental and regulatory analysis gives us conviction that CCAs are an attractive investment opportunity in the medium-to-long term despite any short-term market trends and volatility.
