Contributed by Robert Lyman © 2017

Cropped photo of Robert Lyman

Robert Lyman

Robert Lyman is an Ottawa energy policy consultant with 27 years experience as a public servant and 10 years experience as a diplomat. 

Introduction

Ontario and Quebec have adopted “Cap and Trade” as an important element of their approach to reducing greenhouse gas emissions (GHGs). Cap and Trade is one way to implement carbon pricing, which refers to the application of taxes or permit charges on activities that produce GHGs. The taxes or charges are as measured in terms of tonnes of carbon dioxide equivalent (C02e). In theory, the addition of these taxes or permit charges will discourage use of fuels that emit GHGs and facilitate the development and use of alternative energy sources.

Under the new system, a cap, or volumetric limit, is placed on the emissions that the government will permit designated companies, referred to as the “covered emitters”, to produce during a specified period. Covered emitters must obtain, and subsequently remit to the government, an amount of allowances equal to their emissions over the term of the compliance period. Emitters can obtain allowances from government for free or at auction, or by trading them with other companies (the trade).

Allowances are effectively permits to emit GHGs. The government limits, and gradually cuts, the total number of allowances available, thereby driving down the amount of emissions that covered emitters can lawfully release each year. As allowances become scarcer, their price should rise, due to the rising cost of the emissions reductions and the results of many companies bidding for the allowances available.

There are important similarities and differences between the use of carbon taxes and cap-and-trade systems to implement carbon pricing. The purpose of this note is to offer a primer, or introductory explanation, of the cap-and-trade system being employed in Ontario. Further notes will describe some of the problems and controversies concerning this system and the consequences of the interaction of the Ontario and Quebec systems with that of the state of California.

Why Have Governments Adopted Cap and Trade?

The most important reason that Ontario and Quebec have adopted cap-and-trade is that it will make the use of fossil fuels – oil, natural gas and coal, – more expensive. For consumers who rely on these fuels to heat their homes, fuel their cars, and generate electricity, this might seem a perverse objective. However, these governments are persuaded that reducing GHGs in Canada will somehow help to solve a global problem, the possible catastrophic warming of the earth many years from now as a result of human emissions. In essence, Ontario and Quebec have officially accepted the theory that this is happening and that what we do in Canada will somehow alter the global trends. This is not the place to contest those theses.

As fuels become more expensive, people will have an incentive to use less, everything else equal.

Carbon prices and cap-and-trade systems have advantages and disadvantages from the governments’ perspectives. A carbon tax system sets a specific tax per tonne of emissions and a specific, predictable schedule of tax increases, so that consumers and industry know with (some) certainty what energy will cost now and in the near future. It is relatively straightforward to implement, assuming that the tax is universally applied (i.e. there are not a large number of politically inspired exemptions) and the revenues received by governments from the tax are returned (“recycled”) back into the economy through reducing other broadly applied taxes, like income taxes or the HST. The effects are relatively easy to monitor. Carbon taxes, however, have two disadvantages, even from the perspective of those who support them in principle. First, one cannot predict with certainty what their effect will be in reducing fuel use and emissions. Second, taxes are more direct and visible, and therefore more likely to provoke political opposition.

A cap-and-trade system, by contrast, offers more certainty about the amount of emissions that will be reduced, as the entire system is designed to achieve this goal. It also offers the opportunity for governments to amalgamate their efforts with those of other jurisdictions, and thus to allow emitters in one’s own jurisdiction to trade emissions reduction opportunities with those elsewhere, thus potentially reducing the cost of emissions reduction. The problem, however, is that one cannot know in advance exactly how high (or low) the price of permits will go; this is often largely the result of the supply of and demand for emissions permits.

There are many other problems with both carbon taxes and cap-and-trade systems that I will deal with later in this series.

How will the Ontario Cap and Trade System Work?

Ontario and Quebec are both members of the Western Climate Initiative (WCI), which includes British Columbia, Manitoba, Quebec, Ontario and California.  Only California, Quebec and Ontario have agreed to link their respective cap-and-trade systems into a unified market. Ontario established a cap-and-trade program in 2017 and it will link to the larger market by 2018.

Ontario’s cap and trade program includes a number of components that I will describe in the following sections.

The Cap

The cap is the maximum number of GHG allowances that the government will create each year. In Ontario, the Minister of the Environment and Climate Change sets this figure. The Minister has already announced that he will create:

  • 142,332,000 emission allowances for 2017
  • 136,440.000 for 2018
  • 130,556,000 for 2019
  • 124,668,000 for 2020

The 2017-2020 timeframe is the first compliance period, and the above schedule represents a ratcheting down of the allowances available by 4% per year. The overall cap is intended to reduce emissions by 17.7 million tonnes (Mt) by 2020.

Coverage

Ontario’s cap and trade program will include about 82% of the province’s emissions.

The program will include Ontario’s major industrial GHG emitters (“Large Final Emitters”), businesses that distribute an amount of natural gas that when consumed would emit at least 25,000 tonnes of CO2e per year, fuel suppliers that sell more than 200 litres of fuel a year, and electricity importers. These are collectively referred to as the Mandatory Participants.

Additional businesses that emit between 10,000 and 25,000 tonnes of CO2e per year and that are engaged in “specified GHG activities” can choose to participate in the Program as Voluntary Participants.

Others can choose to anticipate voluntarily as Market Participants.

Only the Mandatory and Voluntary Participants need to participate in the “true up”, or compliance check, at the end of each compliance period.

As virtually all the large fuel suppliers in the province are included as Mandatory Participants, the costs that these incur in obtaining allowances needed will be passed on to their customers, the end users of energy products. Consumers will not see the specific effects on the prices they pay resulting from the increased costs imposed on fuel suppliers by the cap-and-trade system.

Compliance Instruments

Capped participants must obtain and surrender to government one allowance or credit for each tonne of CO2e they emit in each four-year compliance period. For 2017 to 2020, this “true-up” will occur in 2021.

By “compliance instruments”, I mean the variety of ways in which participants can obtain allowances or credits.  Much of the complexity and special consequences of the cap-and-trade system arise from the number of compliance instruments and the special rules governing each of them.

The first way is through the government issuing allowances for free. Free issuance of allowances essentially exempts certain organizations and sectors from the costs and burdens of compliance with the cap-and-trade program. The Ontario Minister will decide each year how many free allowances will be issued and to whom. In principle, he is supposed to do this in accordance with the government’s Distribution of Allowances Free of Charge methodology that is incorporated by reference in the Cap and Trade Program Regulation. During the first compliance period, many industrial facilities that apply will receive free allowances. Energy suppliers will not.

The second way is by purchase of allowances from government at the quarterly auctions and sales. For each auction, the government establishes a minimum allowance price. The minimum allowance price will be raised by five per cent annually plus an amount to reflect inflation. The Minister must distribute the allowances to the participant that made the highest price bid and then to the other participants in descending value of bids. In addition to auctions, the Minister may sell allowances at fixed higher prices (i.e. higher than they would receive at auction) to participants in Ontario that do not have sufficient allowances to meet their compliance obligations.

Allowances are associated with a given year, known as their vintage. However, under the current Ontario rules, there are no limits on how long Participants can “bank” their allowances. Thus a 2017 vintage allowance can be used both within the current 2017-2020 compliance period and the subsequent ones. Each auction will sell the current vintage year and may offer a select number of future vintage year allowances. This will allow Participants to speculate and hedge.

Emission allowances can be traded between Market and Capped Participants from any partner jurisdiction. Thus, the third way Participants may obtain allowances is by purchasing them on the secondary, or commercial, market. Transactions in the secondary market are at prices freely determined by the parties. It also is expected that a market for futures contracts will evolve.

The fourth way is through “early reduction credits” issued by the Minister. These credits are ones that are supposed to be based upon the submission by a Participant of evidence that it has reduced emissions before the implementation of the cap-and-trade program in a way that is “real, permanent, irreversible, additional and verifiable”.

Finally, participants may purchase what are known as “offset credits”. The Minister may issue offset credits to a Participant that carries out a project to reduce, capture, store or eliminate emissions not covered by the cap-and-trade program. The definition of offsets will be a key feature, including such issues as where the offsets occur and whether they are “real, permanent, irreversible, additional and verifiable and carried out in accordance with prescribed protocols”.

Once Ontario is fully integrated with the cap-and-trade systems of Quebec and California, Participants in Ontario can also obtain allowances or credits issued by the partner governments.

Where Does the Money Received by the Government Go?

The proceeds from the auctions and sales (expected to be about $1.85 billion a year to 2020 in Ontario) will be “recorded” in the Greenhouse Gas Reduction Account, or GGRA (it is not clear whether Ontario will establish a clearly separate fund, or simply treat the revenues as part of the provincial Consolidated Revenue Fund). The revenues can be “reinvested” in climate change mitigation measures.

The Ontario Climate Act is very general in its provisions as to how the funds recorded in the GGRA may be used. It states that the funds may be used for any initiative that is reasonably likely to reduce or support the reduction of greenhouse gases, or for related government expenditures. Schedule 1 of the Act contains a virtual laundry list of types of emission reduction initiatives that may be funded, including: research, development and technology; education and training; public information; innovation; and “other”. The Government, in essence, can spend the funds any way it wishes so long as there is some vague link to emissions.

The next paper in this series will discuss the problems and controversies surrounding the current design of the Ontario cap-and-trade system.

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