Casino Royale: California’s Fuels Under the Cap Program
August 19, 2014
Market participants are starting to speculate about the next phase of Cap & Trade under California’s AB32 the Global Warming Solutions Act. That phase, Fuels Under the Cap, is designed to control Greenhouse Gas (GHG) emissions from transportation fuel, including gasoline, diesel, propane and natural gas. The first phase of Cap & Trade includes industrial sources like power plants, oil refineries, cement plants and other GHG sources. The next phase will have a direct impact on consumers as “Covered Entities” (CE) pass along the cost of the program to consumers. This phase begins January 1, 2015 and will impact some 950 thousand barrels per day (kbd) of gasoline and 350 kbd of diesel.
A firm is a CE and subject to Cap & Trade if the GHG emissions from the combustion of the transportation fuel they are responsible for is greater than 25,000 metric tons per year. This is equivalent to about 2,700,000 gallons of gasoline, or the volume sold through a good-sized gas station. Most CEs are refiners but some petroleum marketers who operate “above the rack” with volume greater than 2.7 million gallons will be considered CEs under the regulation.
Free allowances are provided to many of the industrial entities that were covered in the first phase of Cap & Trade. In the upcoming phase when transportation fuels are included, CEs will have to purchase allowances from CARB or the secondary market to satisfy their obligation to offset the emissions from the fuel. At current carbon price of about $11 per ton of GHG, the cost of credits would be about 9 cents per gallon (cpg) of gasoline. California retail gasoline prices have averaged over 36 cpg over prices in the rest of the country. Retail prices in California are about $3.92 per gallon.
Nobody knows what the cost to consumers will be because the prices of allocations are set at quarterly auctions held by CARB. Oil companies will pass along those costs, but they don’t know what they will be until they find out how the auction turned out. The range of estimates varies from 10 to 70 cpg.
The University of California estimates that allocations will trade near the floor that CARB has set. Indeed, for the first two years of the program, that has been the case. However, the concern is that CARB does not have enough allocations to meet demand, causing a spike in allocation prices, up to or beyond a ceiling that is currently about 40 cpg.
During the transition to this program, an issue for CEs is deciding where to set the cost pass-through. If they set it near the floor price, and allocation prices spike later, then they won’t be able to recover their costs. They are placed at risk because they have an obligation to buy allowances but don’t have a way to manage the price.
Petroleum marketers are CEs for about 10% of the state’s gasoline and more than 50% of its diesel. They may well consider the gamble of participating “above the rack” as complicated and risky, reducing competition in this segment of the business. The California Independent Oil Marketers Association (CIOMA) has warned, “California consumers and businesses will pay incrementally higher fuel prices as compared to a normally functioning wholesale market.”