By Michael Newman, Chief Operating Officer, Parhelion Underwriting Inc.
Special to The Digest
Trading in the climate finance market – the systems designed to reduce greenhouse gas emissions – sometimes create areas of uncertainty. The risk of invalidation of credits worry market participants – but insurance risk capital can be used to mitigate these concerns and in fact already works successfully in several markets. One example of this is in the California Cap-and-Trade program where “buyer liability” has created a price differential between carbon offsets depending on the level of risk associated with them. By removing this risk from both offset buyers (typically refineries and utilities) and sellers (project developers), insurance adds certainty and therefore liquidity to the market because it’s a guarantee with investment-grade A+ security.
Several years ago, Parhelion introduced the Platinum Carbon Credit invalidation insurance product to the California Cap & Trade market and followed up with the Platinum RINs invalidation insurance policy for the U.S. Renewable Fuels Standard (RFS) earlier this year. We have now entered another environmental commodity market, California’s Low Carbon Fuel Standard (LCFS) – and we thought you might be interested in our underwriting process: the information we used to analyze and rate the invalidation risk in the LCFS market.
Our background research was that petroleum importers, refiners, and wholesalers are Regulated Parties (RPs) under the LCFS. CARB approved alternative fuels producers can opt-in to the program; these participants are also referred to as RPs. RPs (of whom there were 317 actively reporting in 2018) must meet the established declining targets for greenhouse gas emissions each year. The criteria by which regulated party status is determined is detailed in s.95481 and s.95483 of the Low Carbon Fuel Standard Regulations.
The LCFS is performance-based and fuel-neutral, allowing the market to determine how the CI of California’s transportation fuel pool will be reduced. Oil refiners and producers can choose to innovate to reduce the CI of their fuels, buy lower-CI fuels from other producers or trade credits. Only the RPs are permitted to hold credits and transactions cannot be conducted with an entity which is not an RP. A fuel producer with deficits must have enough credits through generation and acquisition to be in annual compliance with the standard. LCFS credits do not have a vintage and do not expire. LCFS credits are generated and issued by the California Air Resources Board (CARB).
The market Volumes of credits traded have increased markedly over the past two years, with volumes exceeding 1million for the first time in Dec 2017. Since then there have been 12 months in which volumes have ranged between 1m & 2m with the 2m barrier being breached for the first time in 2019.
Similar to volumes, LCFS credit prices have been rising steadily in the last two years, with the average price during 2017 being $89. This rose to $160 for 2018, and in Q1 2019 it rose again to $188, as demonstrated by the following graph:
The chart below shows the total credits and deficits generated in the LCFS for the four quarters of calendar years 2011 to 2018:
Focusing on the risk of invalidation, we reviewed the enabling legislation: Assembly Bill 32 was adopted in 2006 and LCFS Regulations adopted in 2010.
We noticed that there has been is a recent change. In early-2019, CARB set out a regulatory process for making the market whole, with a hierarchy to be used to determine responsibility in cases of invalidation ( § 95495.Authority to Suspend, Revoke, Modify, or Invalidate- (5) Adjustment of Invalidated Credits or Miscalculated Deficits) that states:.
The Executive Officer will seek the following options to address any invalid credits or miscalculated deficits in the program: (A) First, the Executive Officer may remove the invalid credits from, or add miscalculated deficits to, the account of the credit or deficit generator, or other entity deemed responsible for the invalidation or miscalculation in the final determination pursuant to section 95486. The entity is responsible for returning its account to compliance. (B) Next, the Executive Officer may choose to retire credits from the Buffer Account to address invalidated credits or uncovered deficits. (C) After exercising options in subsection (A) and (B) above, the Executive Officer may remove remaining invalid credits from an entity’s account that holds or previously held invalid credits. The entity is responsible for returning its account to compliance.
Next, we reviewed Loss Experience
For underwriting purposes, the ‘loss ratio’ is the raw statistic of historic losses as a proportion of the total exposure. In our case, how many credits have been removed from the system and how many credits have been created over the 9 years the program has been in existence or:
The number of credits that have been removed (= Settlements + Account Balance Adjustments)
The number of credits created
So, we looked at the Settlements and Account Balance Adjustments in the LCFS system that would enable us to quantify the ‘losses’.
Account Balance Adjustments
Full details of administrative adjustments to participants’ accounts in the LCFS Reporting Tool and Credit Banking and Transfer System are listed ion CARB’s website. The adjustments reflect corrections to inaccurately reported data discovered through audits or self-reported to ARB. In some instances, the data correction would retroactively improve a company’s credit balance; because the LCFS regulation prohibits such retroactive claim or generation of credits, in such instances credit account balances are administratively returned to pre-correction status.
Risks often act as barriers to investment in innovative changes in commerce and it takes the huge pool of global insurance and reinsurance capital that has traditionally taken the risks that other forms of capital (debt and equity) can’t or won’t take, to ensure liquidity in new markets.
Based on this research of the market, legal considerations and recent regulation changes, calculation of the ‘loss ratio’ and our projections of future trends, we determined that we could underwrite the risk of invalidation and now have designed an insurance policy that is the only one of its kind that:
- will replace invalidated credits at the prices prevailing at the date of invalidation, plus
- penalties and injunctive relief (per S. 95494 of the Regulations).
- policy trigger is CARB declaring LCFS credits to be invalid (as detailed in S.95495); and
- is underwritten with Investment-grade security (Lloyd’s, London is rated A+ by S&P).
For more on this contact: Mike Newman at [email protected] and +1 (323) 459-5346.