Viewpoint: LCFS market hunts for fundamentals

OREANDA-NEWS. December 24, 2015.  California Low-Carbon Fuel Standard (LCFS) credit prices in the third quarter nearly doubled as part of a ongoing rally that has raised their value significantly this year.

LCFS credit prices have gained ven as their supply grew. Twice as many LCFS credits were generated in the third quarter as were needed for compliance, while the spot credit market behaved like it was short. LCFS credit prices have pushed up against \\$120/metric tonne in recent weeks and were assessed at \\$112/t yesterday as activity quieted ahead of Christmas.

Some of the disconnect between prices and credit supplies is due to timing: credits are only generated about two months after the fuels are blended and used in California. But other factors are at play and traders have said that LCFS credits trade more on sentiment than anything else.

The spot market appears shorter due to entities that are holding onto their excess credits rather than making a profit on them. Compliance entities perceive a difficulty with meeting the program's more aggressive targets on its way to the 10pc cut in fuels' carbon intensity mandated for 2020. The bid-offer spread in the LCFS market is always measured in dollars and not cents, and can easily be in the \\$5-\\$10 range.

The wide spreads, along with the market's uneven activity and relative paucity of sellers, have pushed prices higher. Sellers have gotten used to a pattern in which they can hold on at several dollars above the last traded price for a buyer to raise an offer after several days of quiet. The fuel distributors who are the main buyers have become less sensitive to LCFS credit prices as they increasingly pass on LCFS costs to retail gasoline and diesel buyers.

Policymakers intended for regulations such as the LCFS to force adoption of preferred technologies. The regulations are aggressive enough to accelerate the use of ways of doing business that are perceived as more environmentally friendly, similar to the way the US acid rain program forced the swapping of high-sulfur coals for lower-sulfur specifications and then the installation of power plant scrubbers.

The state Air Resources Board is attempting to cap LCFS credit prices at \\$200/t as a consumer protection measure. While the \\$200 price is meant as the program's upper limit, market participants appear to increasingly view it as a target level for prices to reach next year, helping fuel the 2015 rally.

Soft price caps have proved hard for environmental regulators to tackle this year, with the Regional Greenhouse Gas Initiative's New England carbon allowance market coming under speculative attack. LCFS credit prices were fairly low — in the \\$20s/t — when regulators were setting their cap. But the market quickly moved to take up the slack as the rules were proposed and finalized this year.

If prices keep rising next year, some market participants will test regulators' willingness to defend the ceiling price. California regulators have said they would open a fuller program review if the prices remain high and credit shortfalls appear.

The market trend this year, with prices remaining buoyant despite the rising credit supply, implies that credit prices could reach and stay close to the \\$200 price cap for years despite a steady supply of credits.

The breadth of the LCFS program presents a major challenge to regulated entities. The program regulates all fuels, and it is rare to find companies or traders with in-depth knowledge of liquid fuel supplies and natural gas vehicle sales. The LCFS credit price is meant to help sort through that clutter. But the program's number of moving pieces and its ban on purely speculative trade appear to have left much of the market playing it safe by holding onto credits. The recalculation of carbon intensity scores over the next year is contributing to near-term uncertainty and complicating efforts to estimate 2016 supply and demand.

The physical market is starting to make longer-term plans, with interest for Brazilian sugarcane ethanol with a carbon-intensity score under 58.4gCO2e/MJ to be delivered in the third quarter of 2016 heard earlier this week. For gasoline distributors to blend to compliance with E10 gasoline, they need an ethanol that scores 53gCO2e/MJ or below.

Increasing interest in very-low-carbon ethanols is one of the few ways that gasoline distributors can try to opt out of dealing in the LCFS market. Diesel distributors have an easier time of it since the 2010 baseline for the program had no blending of biodiesel and renewable diesel, both of which made up 9.25pc of the third quarter diesel pool.

The ramping up of the LCFS targets for 2016 is a key test for the program and its aim to commercialize the new fuels the state needs to transform its transport sector. But it will also test if the disconnect between LCFS market trades and actual supply and demand can be bridged.

If the price hikes this year and the higher target next year cannot push the market participants towards understanding and trading its fundamentals next year, it is unclear what will.