Contributed by Robert Lyman © 2017
The third of a three-part post.
In January 2017 Ontario initiated a Cap and Trade program as one way to reduce greenhouse gas (GHG) emissions. Under this program, the provincial government will impose limits on, and over time reduce, the economy’s allowable emissions. It will also issue permits, or allowances, that firms must have to demonstrate that they have complied with the program. Finally, it will allow firms to trade these allowances with one another.
This is the third article in a series on the Ontario Cap and Trade system. The first article contained a short primer on how the Cap and Trade system will work. The second offered a critique of the program’s rationale and operation. This article will explain and critique the relationship between the Ontario Cap and Trade program and that of California with which Ontario will form an integrated market for trading of allowances.
The Western Climate Initiative
Ontario first committed to emissions trading as its choice of carbon pricing in 2008 when it joined the Western Climate Initiative (WCI). Thirteen governments (nine U.S. states and four Canadian provinces) formed the WCI, five of which remain (British Columbia, Manitoba, Quebec, Ontario and California). California and Quebec have already implemented a Cap and Trade program and unified emissions trading market. Ontario intends to link its Cap and Trade program to this larger market by 2018.
The Environmental Commissioner of Ontario explained the intention behind establishing a multi-jurisdictional enlarged market as being to:
- Enable access to a bigger pool of low-cost emissions reductions;
- Level the international playing field by harmonizing carbon prices across jurisdictions;
- Leverage common infrastructure, reducing implementation costs; and
- Simplify administration for industries operating in multiple jurisdictions.
In effect, the participating governments believe that compliance costs for industry would be much higher in an unlinked, one-jurisdiction-only, Cap and Trade program. Once Ontario links to the larger emissions trading market, firms in Ontario will have the choice of incurring the cost to reduce emissions themselves or buying emission allowances from firms in either Quebec of California. Ontario emitters probably will find it less expensive to buy allowances from California firms than to reduce emissions in Ontario. The Environmental Commissioner for Ontario also explained the reasons for this:
- California’s economy is four times larger than Ontario’s so its allowances will greatly outnumber those to be issued in Ontario.
- California has lower GHG emissions in relation to its GDP, largely because it has a warmer climate and a different industrial base than Ontario.
- California has more low-cost emission reduction opportunities than Ontario because of its more varied economy.
- California’s cap is reducing more slowly than Ontario’s, at least in the period to 2020. California’s cap is reducing at the rate of about 3.1 to 3.5% annually from 2015 to 2020, compared to Ontario’s decline rate of 4%.
- California’s allowances are selling near the legal floor price, which is now U.S. $12.73 (CDN $15.95 at current exchange rates). In 2016, none of the quarterly auctions sold out, because of a surplus of allowances already on the market. Under California law, unsold allowances create an overhang in the market that dampens future prices. California had almost 117 megatonnes (Mt) of unsold allowances in the May and August 2016 auctions alone. Unsold utility allowances are offered for sale at the next auction. Unsold state allowances are placed in a holding account and will gradually be offered for sale again once two sold-out auctions have occurred with prices above the floor price.
- California may have more allowances than it needs until after 2020. Some analysts of the market believe that California’s cumulative surplus of unneeded allowances in its holding account will not disappear until well into the next decade, thus keeping allowance prices lower.
Recent California Developments
There have been some important legislative developments in California that will affect the California Cap and Trade program in the future. On July 17 2017, California’s legislature passed legislation (Bill AB 398) to extend the Cap and Trade program to 2030. The bill received broad bipartisan support and was passed with a two-thirds vote, which is the minimum threshold necessary to pass tax laws in California (the allowances system is viewed as a tax, interestingly enough). At the same time, the legislature passed Bill ACA 1, which establishes the Greenhouse Gas Reduction Fund (GGRF), into which all revenue from the auction or sale of allowances will be deposited (a two-thirds vote of each house will be required to appropriate the funds).
The legislation will likely affect the Cap and Trade programs in Ontario and Quebec. It established a price ceiling for emission allowances, the level of which will likely be determined by the California Air Resources Board (CARB). The legislation also authorized the establishment of price steps, or “speed bumps”, at various points between the price floor and ceiling price. Once the allowance price hits any of these speed bumps, an additional supply of allowances (taken from a reserve), will be released to soften price increases.
The price ceiling under AB 398 may help to restrain the rate at which compliance costs rise in Quebec and Ontario.
While these changes are intended to moderate compliance costs, other changes will increase them. Capped emitters were previously allowed to purchase offsets to meet up to 8% of their compliance obligations; AB 398 reduces this to 4% until after 2025, when the offset ceiling will go up to 6%. The bill also requires an increase in offset projects with “direct environmental benefits” in the state. These are defined as the reduction or avoidance of any pollutant that could have an adverse impact on the waters of California. A new Compliance Offsets Protocol Task Force will provide guidance on new offset protocols; the priority will be that those projects must increase benefits for “disadvantaged communities, Native American or tribal lands, and rural and agricultural regions”. It is expected that California’s offset supply will be well short of future demand, potentially placing upward pressure on offset prices. That means Canadian suppliers of “offsets” could get higher prices from California buyers.
The legislation was welcomed by supporters of Cap and Trade because it offers more certainty that the program will continue at least until 2030 and it increases the likelihood that allowance auctions from now to 2020 will sell out as companies buy now to avoid the inevitably higher costs in future. Energy Innovation, an energy and environment policy firm based in San Francisco, estimates that AB 398 will generate over $26 billion in new revenue for the GGRF from 2020 to 2030, while earmarking at least 35% of these funds for disadvantaged and low-income communities.
The Dynamics of the Relationship
Integration with the California emissions trading market will have a variety of effects on Ontario firms, some of which have already been noted. California is a larger and more diverse jurisdiction, and decisions about the design and operation of the system that affect allowance prices will probably be driven by the policy and legal considerations there. By linking with California, Ontario gives up a substantial amount of policy flexibility and control. It allows emitters in Ontario to benefit from access to lower emissions allowance prices, but that may mean that billions of dollars will flow out of Ontario over time to achieve emission reductions elsewhere. While this may be an inconsequential result if one considers climate change as a global problem, the Ontario government may find it difficult politically to sell this to Ontario residents.
Further, if Ontario emitters take full advantage of the opportunity (to 2020 at least) to purchase cheaper allowances from California, this will reduce the funds Ontario receives from its own allowance auctions, and thus the buildup of funds in the provincial Greenhouse Gas Reduction Account (GGRA). Ontario is counting on these funds to pay for all sorts of new programs and subsidies and would either have to find a new source of funds or not proceed.
There is also an important federal-provincial aspect to the interaction of carbon pricing systems in Canada. In October 2016, when Prime Minister Trudeau announced a new national carbon tax, he stated that the federal objective was to establish a pan-Canadian approach to carbon pricing. Carbon taxes will rise from $10 per tonne of carbon dioxide equivalent (CO2e) in 2017 to $50 per tonne by 2022, with the clear implication that they would continue to rise indefinitely thereafter.
Provinces that are already pricing carbon at an equivalent rate will be exempt from the federal tax as long as they meet or exceed the federal tax rate. The provinces that operate a Cap and Trade program will also be exempt, provided certain conditions are met. The province must have a 2030 emissions reduction target that is in line with the federal objective of a 30% reduction from a 2005 base period. It also must have an annual emissions target for 2022 that “corresponds, at a minimum, to the projected emissions reductions resulting from the carbon price in that year in price-based systems.” This implies that permit prices and carbon taxes must be at the same levels, but the policy is vague.
Canadian politics and policy concerns will determine how fast carbon taxes rise in most Canadian provinces. The prices of emissions allowances in Ontario and Quebec, however, will be determined by developments within the California market where California politics and policy concerns dominate. It therefore seems likely that a disparity will emerge between the carbon prices in Ontario and Quebec and those in other provinces. The California legislature’s broadening of the objectives of the state’s Cap and Trade legislation to include improving water quality and achieving social objectives illustrates how politics can complicate the straightforward pursuit of a GHG emissions reduction objective.
Actually, it is not clear which will be higher, the taxes or the permit prices, as both will be rising. If the disparity is large and persistent, this could be an extremely contentious issue in federal-provincial relations. In addition, energy prices in most of the United States will be much lower, free from carbon pricing, placing firms in Canada and California at a competitive disadvantage. Canada, Mexico and the United States will soon renegotiate the North American Free Trade Agreement (NAFTA) with the hope of reducing trade barriers and ensuring fair market access within the continent. It seems a strange time to implement a carbon pricing system that will make it more difficult for firms within the WCI jurisdictions to compete.
More reading on carbon trading: