Canada’s Kyoto plan

Although far less ambitious than the emissions trading practices of the U.K. and Europe, the federal government’s plans for addressing Canada’s Kyoto commitment promise change

By John Banigan

Most experts agree that the global economy will be restructured to reduce its carbon intensity for a host of economic, energy, environmental and health reasons. A wide range of approaches to this are being launched internationally as each signatory nation to the Kyoto Protocol consults its stakeholders and devises implementation plans that match national circumstances. However, early adopters to the new paradigm will reap environmental and economic benefits, and will gain an initial competitive advantage over their rivals. The adjustment to a less carbon intensive economy involves transition costs, but once these costs are borne, competitive advantages will be gained.

Although Canada is one of some 130 nations to ratify the Kyoto Protocol, it is the only NAFTA member to do so. This constrains policy makers in Ottawa, as legitimate competitiveness issues must be addressed. The minority Liberal government was mindful of these constraints in its implementation plan announced on April 13, 2005, entitled Moving Forward on Climate Change: A Plan for Honouring our Kyoto Commitment.

Business executives worldwide are monitoring and assessing the regulatory regimes being implemented by Kyoto signatory nations to prepare their compliance plans. Leading U.S. companies are also active participants, responding to state-level climate change measures (some 37 states have introduced climate change policies) but also marketing greenhouse gas emission mitigation and measurement technologies to international markets.  

Minority politics: not a hindrance

Canadian executives must also factor into their assessments the implications of a minority Parliament. While the government narrowly avoided defeat on a non-confidence motion in the House of Commons in May, the Prime Minister has promised he will call an election within 30 days of the Gomery Commission report, which is expected in December. 

Notwithstanding the rhetoric, it’s reasonable to expect more similarities than differences in climate change policies amongst the political parties. Due to their efficiency compared with other policy instruments, market-based mechanisms like emissions trading and offsets will likely be essential features of any climate change policy framework, compared to “command and control” alternatives. Emissions trading allows the owners of regulated sources of emissions to choose between introducing new capital spending on more efficient technology or purchasing the emission rights from others. Creating offsets allows unregulated companies to voluntarily opt in to the trading regime, broadening the market.

The New Democrats and the Bloc Quebecois are pro-Kyoto, so their support could be sufficient to support a Liberal government if they hold the balance of power. The Conservative party is officially anti-Kyoto, although it supports a clean air agenda and has already indicated support for examining an emissions trading regime. Regardless of the outcome of the next election, now expected in spring 2006, an emissions trading regime will likely be instituted in Canada.

Emissions trading works

Emission trading and offsets are not new concepts, having been introduced in the U.S. Clean Air Act almost 30 years ago. But the scope in the early years was limited to a small number of power plants (110 in total) and their sulfur dioxide emissions. Trading emissions techniques were further developed with the regulatory regimes in the U.S. for the restricted production rights for leaded gasoline and chlorofluorocarbons, to facilitate the phasing out of these substances. Some voluntary emissions trading pilots were also introduced on a limited scale for greenhouse gas emissions in sectors like aluminum smelting. Studies by the Environmental Protection Agency conclude that emissions trading schemes have been cost effective compared with command and control approaches, especially when there are banking and opting in provisions.

Measuring and monitoring the six greenhouse gas emissions sources from a much larger number of diverse sources and trading in these rights will be considerably more complex than the early sulfur emissions market. Low cost and reliable systems to measure direct emissions of carbon dioxide and methane presently exist for some emission sources but are less reliable for other sources, such as coal mines and landfill projects. In addition, measurement and monitoring of the capture and sequestration of carbon dioxide in forests and agricultural soil is more complex.

While some 110 U.S. power plants —  regulated monopolies selling electricity, a product with considerable price elasticity — can trade sulfur emission permits with relative ease, a broader and more diverse universe of emission rights traders will require more rigorous legal and institutional frameworks to become an efficient and effective trading regime.          

Many interested stakeholders have banded together to share best practices in emissions trading and to identify success factors based on early experience. One such group is the International Emissions Trading Association based in Geneva, which includes as members leading Canadian companies like Alcan. 

Capping emissions

Economists, regulators and diplomats of the Kyoto signatory nations have developed their own lexicon for the process, which can be confusing. Emissions trading or a “cap and trade” system is often described in these circles as “the carbon market.” But before there is trading in carbon emissions permits, there must be restrictions on emissions permitted by major sources, with penalties for non-compliance. Trading in emissions permits is clearly a flexible and efficient method of allocating scarce resources. But establishing global limits to the permits in each country and allocating them to firms or establishments is highly complex and controversial. Equally difficult is establishing the price of the initial allocation of permits and the extent to which future permit prices will be determined by the market alone.

The competitiveness impacts on firms subject to a cap and trade system for emissions permits will vary widely depending upon the impact on production costs — i.e. its energy intensity, and the capacity of the establishment to pass on its additional production costs to its customers in the form of higher prices. The degree to which the output of the establishment is traded internationally is a major factor, particularly when producers in countries that have ratified Kyoto compete with producers in nations that haven’t. Iron and steel and pulp and paper are generally internationally traded commodities while cement and electricity are less commonly so. Aluminum costs are highly sensitive to electricity costs but much of these input costs are self-generated or subject to long term supply contracts.

The most ambitious emissions trading regime implemented to date is in the European Union, which approved its implementing directive in 2003. Emissions trading is one of the principal policy tools deployed in the E.U. to meet its Kyoto commitments (member states have their own Kyoto commitments as well, and some latitude in implementing the E.U. directive). The 25 E.U. member states enacted trading regimes across all of the largest sources of greenhouse gas emissions including power stations, cement, pulp and paper, glass and ceramics, oil refining, iron and steel and all other manufacturing facilities greater than 20 MW thermal capacity. This represents 46% of E.U. emissions. However, the approach to capping emissions by industrial establishment (allocations, pricing policies and planned enforcement regimes) was different in each member state.

Canada’s plan: addressing LFEs

While Canada initially contemplated an emissions trading regime that would include a broad coverage of firms and industries, the final target group, called the “Large Final Emitters” (LFE) covers about 700 companies representing about 50% of emissions. This is a relatively small target population, compared with the U.K.’s, for example, which has negotiated emissions reduction agreements with about 5,000 firms. Extensive consultations with industry stakeholders caused the Canadian government, to its credit, to modify its approach for the Climate Change Action Plan announced in 2002. The planned approach of sectoral covenants with a regulatory or financial backstop was abandoned as too complex, imposing undue competitive burdens on certain sectors.

The target emissions reductions for the LFE sector has been reduced from 55 mega tonnes to 45 mega tonnes. The targets also now recognize the distinction between fixed process emissions and other types of emissions: fixed emissions are those arising from fundamental chemical reactions, not fuel consumption (something beyond the control of industry). Fixed emissions are assigned a zero emissions reduction target, the burden falling upon other types of emissions where technological changes permit emissions reductions.

Emissions targets for new facilities or those undergoing major transformation will be based on a technology benchmark called Best Available Technology Economically Achievable (BATEA). This approach promotes deploying technologically advanced solutions but recognizes that this standard evolves over time. BATEA is also a concept used in determining eligibility for financial assistance under the Climate Fund, discussed below.

One of the key design features of the Canadian LFE plan is a commitment by the federal government to cap the cost of compliance at $15 per tonne of carbon dioxide equivalent. This commitment was initially made in a letter to industry stakeholders by the Prime Minister but for greater certainty, the government also committed to enshrining this commitment in legislation. This creative initiative has gone a long way to secure the buy-in of the private sector by eliminating the upside risk associated with the carbon market.

Compliance

LFE companies have a number of options for compliance:

• Investment in in-house reductions through capital investment to improve production efficiency and deploy advanced technologies;
• Purchase of emission reduction permits from other LFE companies in Canada;
• Investment in domestic offset credits outside the LFE system (offsets); and
• Purchase of international credits verified by the United Nations-sanctioned Kyoto mechanisms called “Joint Implementation and the Clean Development Mechanism” arising from the export of Canadian technology and expertise for new climate change investments abroad.

Once their obligations under the LFE system are discharged, Canadian companies can also sell greenhouse gas emission credits to the proposed Climate Fund, which will be established to develop the domestic and international emissions trading arrangements. A companion entity, the Partnership Fund will develop greenhouse gas emissions projects in collaboration with the provinces and private sector stakeholders. The 2005 budget provided for $1.25 billion in initial funding for these two new entities, which will be implemented by new legislation. Public consultations will be conducted on the details of implementation for these new entities next autumn.

Offsets

For entities outside the LFE system, a regime of greenhouse gas emissions offset will also be established. Offset credits can be purchased by LFE companies or the Climate Fund and are devised as a means of rewarding investment in emissions reductions projects. Examples of activities eligible for offsets include:

• farmers who adopt low-till or zero-till soil practices;
• forestry companies that engage in state-of-the-art forestry management projects (called sinks);
• property developers that include district heating and renewable energy elements in new real estate projects;
• businesses that develop innovative recycling and energy efficiency practices;
• companies that invest in alternate transportation modes and telecommuting; and
• municipalities that generate electricity through landfill gas and renewable energy projects.

Implementation

An offset verification and certification process will need to be established to turn these offset projects into bankable exchange instruments, tradable with confidence by arms length participants. Considerably more research and consultations will be required to bring this concept to fruition. For example, institutional measures to back stop the residual risk of trading emission permits will be needed to build confidence in emissions trading.

While Canada and the other Kyoto signatories have come a long way in developing practical implementation plans, much remains to be done. Regulatory systems tend to evolve over time and refine their operations through real time experience. Yet the legal and administrative systems required to implement the Kyoto Protocol are still on the drawing boards and far from an orderly introduction.

The government has indicated its preference to amending the Canadian Environment Protection Act (CEPA) as the enforcement system for emissions trading. This legislation is well known to the LFE community as it is used to regulate other substances. In addition, CEPA provides for equivalency agreements with the provinces and territories and aboriginal governments, bringing additional flexibility.

Future articles in CMA Management will explore some of the emerging risk assessment and accounting issues and opportunities in the new world of the carbon market, and the professional implications for CMAs. 

John M. Banigan is vice-president of Tactix Government Consulting Inc. He recently left the federal government after a 30-year career, latterly as ADM Industry at Industry Canada.           

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