The California legislature recently passed a series of bills, signed into law by Governor Gavin Newsom on 16 September, that should have meaningful effects on environmental policies and the green energy transition. The highlight of the bills is a goal of carbon neutrality by 2045.
While this legislative package is meaningful for many industries, we focus this note on the impact to the state’s carbon cap-and-trade program. Although the bills have positives and negatives for the value of California carbon allowances (CCAs), we view the likely alignment of the cap-and-trade program with the 2045 goal to be positive for carbon prices.
The bills follow on the heels of the Inflation Reduction Act (IRA), passed by the U.S. Congress and signed into law by President Biden, which included many components supportive of renewable energy, carbon sequestration, and other climate-friendly policies. Much like the IRA, the California bills together aim to reduce emissions and encourage growth in non-hydrocarbon energy sources, while encouraging carbon capture usage and sequestration (CCUS) to facilitate the ultimate goal of carbon neutrality.
In his August letter to the California legislature, Governor Newsom outlined five priorities:
- A legally binding goal to achieve statewide carbon neutrality by no later than 2045
- An acceleration of the pace of greenhouse gas cuts
- Interim targets for alternative sources of energy
- Setbacks for new oil and gas production wells
- A regulatory framework for carbon removal technologies
In addition, the governor’s office prioritized legislation to extend the operation of the Diablo Canyon nuclear plant to 2030 from the current scheduled closure by 2025. This closely followed on rulemaking that will prohibit the sale of new vehicles powered by internal combustion engines in the state by 2035.
The irony of the timing of passage of this rule – while at the same time California was asking consumers to conserve energy and not charge their electric cars – was not lost on many and, if anything, demonstrates the long-term challenges the state faces in meeting its varied goals.
State steps support cap-and-trade valuations
By the end of California’s 2022 legislative session on 31 August, all of the governor’s proposals passed but one – California Assembly Bill 2133, which fell short by four votes in the state assembly after passing through the senate. The bill would have strengthened California’s 2030 target to reduce emissions from 40% to 55% below 1990 levels, much like the European Union is intending to do with its own carbon emissions from power and large stationary industrial sources.
While the 55% reduction target could have been an immediate catalyst for higher carbon prices, the California Air Resources Board (CARB) is likely to align policies in the state’s cap-and-trade program to reflect the newly legislated goal of carbon neutrality by 2045 (California Assembly Bill 1279). Modifications to align the program – which is currently slated to expire in 2030 – with broader, more ambitious climate goals and an extension to 2045 would provide welcome clarity and could support higher valuations for CCAs, in our view.
CARB sells CCAs at auction, generating revenue that’s invested in projects such as renewable energy, public transportation, recycling, and affordable housing. By buying CCAs, investors can help fund efforts to decarbonize California’s economy while also providing companies incentives to reduce their emissions. CCAs may have a natural fit in environmental, social, and governance (ESG) portfolio allocations.
By extending the cap-and-trade program alone, the present value of the future price floor for auctions of CCAs (see Figure 1), which rises at a rate equal to the consumer price index (CPI) plus five percentage points, could increase by at least 50%.
In addition, other jurisdictions in the U.S. and globally continue to move to reduce carbon emissions as well, which may enable CARB to continue to tighten the cap-and-trade program due to reduced potential leakage of economic activity to other more carbon-friendly areas.
Less than a year ago, the U.S. reentered the Paris Agreement but brought very little in the way of proposals to the U.N. Climate Change Conference (COP26) in Glasgow, Scotland. The White House’s attempts at climate change legislation appeared to be floundering, and few initiatives were progressing on the state level. Fast-forward one year and much has changed.
Yet recent events in Europe demonstrate that it’s necessary to consider expanding energy supplies while also ensuring the security of those supplies. At the same time, growing clean energy supplies and reducing carbon emissions to limit global warming and its adverse effects should be imperatives. To that end, we believe the steps taken by the U.S. and California – while not perfect or beyond criticism – are pointed in the right direction and are strongly supportive of carbon prices.
Visit PIMCO’s ESG page to learn more about our ESG capabilities and investment approach.
Greg E. Sharenow is a portfolio manager focusing on commodities and real assets. Lewis Hagedorn is a commodities portfolio manager. Andrew DeWitt is a portfolio manager focusing on commodity and multi-real-asset strategies.