In March 2008 the Harper government announced the final details of its regulatory framework for reducing industrial greenhouse gas (GHG) emissions. The regulation outlines a baseline-and-credit system where firms would be required to meet intensity targets beginning in 2010 designed to reduce Canada’s total GHG emissions by 20 percent below 2006 levels by 2020, and by 60 percent to 70 percent below 2006 levels by 2050. The government has indicated its intention to move from emission intensity targets to fixed emission caps in the 2020-25 period.

Intensity targets are relative targets that specify GHG emissions per unit of production of a good relative to a base year, as opposed to absolute targets that specify reductions in total GHG emissions. Regulated companies will have several options to meet their intensity targets. One alternative is domestic emissions trading, where companies whose emissions are below their target will receive credits that can be sold to other companies. If the federal government’s proposal passes into legislation, Canada would see the emergence of a new asset class that would have important effects on the behaviour of firms. In particular, firms would need to pay attention to this market when making investment decisions.

This article begins with an overview of the global carbon market and the role of emissions trading. Emissions trading can be important for encouraging the reduction of emissions in a cost-effective manner. The article summarizes some of the lessons from the European Union Emission Trading Scheme (EU ETS), which has been running since 2005. By learning from the European experience, Canada can avoid the uncertainty and volatility witnessed in the EU carbon markets, while benefiting from an efficient trading mechanism that contributes to Canada’s economic welfare. Finally, it highlights five potential issues raised by the design of Canada’s system:

• the potential uncertainty and volatility of carbon prices

• the impact of the Canadian technology fund on carbon price dynamics

• the risk of illiquidity and the absence of hedging instruments

• the need for an emissions registry with third-party verification, and

• the obstacles to linking with a future US cap-and-trade system.

Following the signing of the 1997 Kyoto Protocol, a new global market for trading allowances to emit carbon dioxide (CO2), known as the “carbon market,” has emerged. From a market value of US$10.9 billion in 2005, the annual value of global trading in carbon markets grew to US$64 billion in 2007 (see table 1), an increase of close to 500 percent. This market consists of two types of assets: emissions allowances from national cap-and-trade schemes, and project-based emissions credits (or offsets) created under the two Kyoto Protocol mechanisms. An emissions allowance represents a permit to emit one tonne of CO2 or its equivalent in other greenhouse gases. Emissions allowances are created under national cap-and-trade schemes, where the supply of carbon allowances for a given period is set by a national regulator to achieve a targeted reduction in overall GHG emissions over a given time horizon. Individual firms then decide how best to meet their individual targets— either by improving their production processes or by purchasing allowances from other firms (known as emissions trading). Emissions trading has taken off since 2005, with trading in this new asset class representing 78 percent of the carbon market by value traded in 2007, with almost all the volume in the EU ETS.

Emissions trading is seen as a costeffective and flexible way to reduce carbon emissions. By creating an allowance that can be traded, emissions trading transforms a constraint (the obligation to cut emissions) into an asset (a new commodity to be traded alongside other commodities such as oil, natural gas and electricity).

This approach provides flexibility for firms that can choose the most cost-effective strategy to meet their individual emissions targets. Firms with low-cost opportunities to reduce emissions can invest to reduce their emissions and finance part of this investment by selling their surplus allowances to firms that have uneconomic abatement opportunities. An important benefit is that emissions trading becomes a source of information for firms on the costs involved in reducing CO2 emissions, and for policy-makers on the appropriate level and the pace to achieve national targets.

The most active cap-and-trade market for carbon is the European Union Emission Trading Scheme (EU ETS), launched in 2005. Table 1 shows that the allowances created under the EU-ETS represented 78 percent of the global carbon market by value traded in 2007. Emissions trading in CO2 under the EU ETS has followed the practices pioneered by the United States Acid Rain Program, where a cap-and-trade system in emissions of sulphur dioxide (SO2) and nitrogen oxides (NO2) developed following the passage of the 1990 US Clean Air Act. The US and European experiences suggest five steps in the creation of a cap-and-trade scheme.

The first step is to pass regulation that sets mandatory limits (or caps) on CO2 emissions over a specific time period. The national cap determines the supply of allowances over a given period, which will affect the price signal. The cap is set to achieve a reduction in emissions to a desired level over the target horizon.

The second step is to pass national regulations that specify which individual firms are covered by the cap— whether private companies, public sector installations or both. Each firm is given its own cap consistent with an aggregate reduction in CO2 emissions. The firms are then allocated the appropriate number of carbon allowances. At the end of the period covered by the regulations, each firm must either reduce its CO2 emissions to a level at or below its individual cap, or deliver allowances equal to the excess amount of emissions. Firms that fail to meet their targets are fined.

Once allowances are allocated, the third step is for trading to begin. Each firm must determine the most cost-effective means to reduce (or abate) its carbon emissions. The firm may invest to improve its production processes. Or it may judge that it is cheaper to buy allowances in the carbon market sufficient to cover its excess emissions.

Physical trading in carbon instruments takes place either on an organized exchange or over the counter, similarly to the trading of other commodities. A number of carbon exchanges have emerged in Europe and North America that trade spot, forward and option contracts in carbon. In Canada, for example, the Montreal Exchange launched the Montreal Climate Exchange in 2006 to provide a location for Canadian firms to trade in CO2 allowances.

The fourth step is to put in place the necessary infrastructure. Experience suggests that a successful cap-and-trade system relies on the following elements:

• registration of the ultimate owner of credits

• independent monitoring of emissions from a facility

• reporting of emissions to a central authority over a given period, and

• verification of the level of emissions and confirmation of reductions.

These components are critical for promoting both public and business confidence in the system, allowing the market to function properly and minimizing uncertainty.

The fifth step is to ensure compliance. At the end of the period covered by the scheme, regulators must reconcile a firm’s emissions against its holdings of allowances to ensure compliance. The firm must either deliver the equivalent number of allowances for its excess emissions or pay some predetermined fine if it is short. This fine effectively sets an upper limit on prices for emissions.

In the case of the US Acid Rain Program, compliance has been very high, with over 99 percent of firms meeting their targets, thanks to rigorous monitoring, reporting requirements and stringent penalties. By 2007, the Environmental Protection Agency reported that sulphur dioxide emissions were 41 percent below their 1980 levels, while emissions of nitrogen oxides were 57 percent below their 2000 levels.

Since 2002, a number of countries have experimented with voluntary cap-and-trade schemes, but only New South Wales in Australia and the European Union have passed regulations establishing legal caps on CO2 emissions.

The EU ETS, launched in 2005, sets mandatory caps on CO2 emissions for the 27 member countries of the European Union. The EU-ETS has consecutive trading phases, with the first phase running from 2005 to 2007 and a second phase from 2008 to 2012. A review of the third trading phase of the ETS, starting in 2013, is in preparation. In phase I, the scheme is mandatory for 11,500 energy-intensive installations across the EU that account for almost half of Europe’s CO2 emissions. The number of allowances given to installations covered by the scheme is based on national emissions caps set by EU member states in their National Allocation Plans (NAPs).

Uncertainty over supply and demand in the EU-ETS has led to very volatile prices for EU allowances (see figure 1), which is a typical feature of any new trading system where market players have insufficient information about supply and demand dynamics. Over the past two years, the average price of spot EU allowances for delivery in phase I was €14.91 per tonne of CO2, with a high of €29.60 and a low of €0.09. Prices dropped sharply in April 2006, after the release of the EU verified-emissions report that showed emissions were around 7 percent lower than expected. Prices fell again in September 2006 following the collapse of spot natural gas prices.

Member states did not allow installations to bank excess allowances from phase I for use in phase II, so by mid-2006 there was no longer any demand for phase I allowances, since companies had purchased all the necessary allowances. As a result, the price of spot allowances fell close to zero and remained there as the first phase expired at the end of 2007. By contrast, the forward price of EU allowances for delivery in 2008 averaged €20.06. Forward allowances have exhibited lower volatility than spot EU allowances as market participants anticipate improvements in the allocation and design features of the EU ETS.

There are a number of lessons to be learned from the operation of phase I of the EU-ETS. These lessons point to design features and operational issues that other countries should consider when developing their own emissions trading systems.

A difficult issue in a cap-and-trade system is setting the level of the overall cap on CO2 emissions. The cap effectively sets the number of allowances that will be created under the scheme and thereby affects the price at which they trade. Setting the right cap requires, foremost, reliable data about historic emissions for each installation. The lack of reliable data is seen as the main cause of the collapse in the allowance price in the EU ETS.

To ensure that trading takes place, a cap-and-trade system must include a diversity of players with different abatement costs. If all firms covered by the scheme face similar costs to reduce emissions, there is no incentive to trade. For example, the EU ETS covers 11,500 energy-intensive installations across the European Union, over a range of sectors. From the perspective of diversity, the entry of financial actors that trade for speculative rather than compliance purposes is a welcome development in the carbon markets. Brokers, dealers and investors such as hedge funds have the potential to increase market efficiency by providing liquidity and facilitating price discovery.

Under phase I, European companies were able to meet their emissions targets either by buying the necessary EU allowances or by importing credits from the Kyoto Protocol’s Clean Development Mechanism (CDM) projects through a “linking” mechanism. The design flaw with this initiative is that there were insufficient limits on the number of credits that could be imported.

The EU experience with emissions trading suggests that rules for a capand-trade scheme should be clear and easily enforced. Markets function better and transaction costs are lower when rules are simple and easily understood by all participants.

A key complaint about phase I has been that the allocation of national allowances was too complex and not transparent enough. Complexity contributes to uncertainty. A lack of transparency also makes it difficult for firms to understand and form a view on investment plans.

On March 10, 2008, the federal government released Turning the Corner: Regulatory Framework for Industrial Greenhouse Gas Emissions. This document elaborates and strengthens the April 2007 Regulatory Framework for Air Emissions that laid out the broad design of regulations for industrial emissions of both GHGs and air pollutants. Turning the Corner targets reductions in Canada’s total GHG emissions by 20 percent below 2006 levels by 2020, and by 60 percent to 70 percent below 2006 levels by 2050. These targets are seen as realistic and achievable through a combination of federal and provincial policies. Turning the Corner suggests that linkages to North American emissions trading systems— such as the Western Regional Climate Action Initiative and the Regional Greenhouse Gas Initiative— will be actively pursued.

Environment Canada estimates that industrial sectors contribute 50 percent of Canada’s total GHG emissions. Industrial sectors include, among others, electricity produced by combustion, oil and gas, base metal smelters, iron and steel, some mining sectors, cement, pulp and paper, aluminum and chemical production. Firms in these sectors will be required to reduce their emissions intensity from 2006 levels by 18 percent by 2010, with 2 percent continuous improvement every year after that, for a cumulative reduction of 26 percent by 2015.

The Canadian proposal targets relative intensities of GHG emissions, with credits issued with reference to a base year (known as a baseline-and-credit system). Intensity targeting contrasts with the absolute (or hard) targets in the EU cap-andtrade system and the bipartisan proposal outlined in America’s Climate Security Act. According to the World Resources Institute, the only precedents for Canada’s intensity targeting framework are the United Kingdom’s voluntary Climate Change Levy Agreements (CCLAs), which ran from April 2002 to December 2006, and Argentina’s voluntary system, which began in 1999. Intensity targeting is seen as more compatible with economic growth. Whether it produces more or less reductions than absolute caps depends on the stringency of the intensity targets. Given the limited precedents for intensity targeting, Canada’s experiment will be watched closely by other jurisdictions.

Operationally, an emissions intensity target would be set for a given product with reference to a base year. Facilities that reduce emissions below their target would be allocated tradable credits that they could either bank for a future compliance obligation or sell to another facility. Facilities that emit above their target would have to buy credits from other facilities or use their own banked credits to meet their regulatory obligation.

For example, suppose the emissions intensity target is 5.0 kilotonnes (kt) CO2 equivalent for every tonne of widgets produced. Suppose Facility A has an emissions intensity of 4.5 kt per tonne and produces 1,000 tonnes of widgets during the year. It would then receive tradable credits from the government equal to the difference between the target (5.0 kt) and its actual emissions intensity (4.5 kt), times its production in that year (1,000 tonnes), or (5.0-4.5) x 1,000 = 500 credits received.

Suppose Facility B has an emissions intensity of 5.3 kt per tonne and produces 1,00 tonnes of widgets. It would be required to remit to the government credits equal to the difference between its actual emissions intensity (5.3 kt) and the target, times its production (1,200 tonnes), or (5.3-5.0) x 1,200 = 360 credits owed. It could buy these credits from another facility or use credits that it has banked from a previous compliance period.

While in-house reductions are one way to comply with a firm’s targets, the Canadian design provides regulated firms with the following alternatives:

• buy excess credits through domestic emissions trading

• invest in the federal government’s Climate Change Technology Fund (CCTF)

• invest in projects outside the regulated industries that generate domestic offsets, or

• import credits under the Kyoto Protocol’s CDM up to 10 percent of a firm’s annual obligations.

There will also be some credit available for firms that take early action to reduce their emissions.

The design of Canada’s system for domestic emissions trading raises a number of issues that policy-makers and market participants should consider carefully.

First, intensity targeting introduces greater uncertainty as firms and other market participants may find it difficult to forecast the supply and demand in this market, leading to price swings similar to those that occured in the EU ETS. Unlike a carbon tax or levy that sets a price for carbon directly, intensity targeting will set the price indirectly, leading to greater volatility in the price. While volatility is a feature of many asset prices that are subject to market forces, the World Resources Institute suggests that the uncertainty and, by implication, the volatility in carbon allowances may be greater under a baseline-and-credit system than under an absolute cap-andtrade system.

Participants in existing asset markets where supply and demand are uncertain— such as the foreign exchange markets— have found ways to manage this uncertainty. Fluctuations in the Canadian dollar, for example, can be hedged due to the availability of derivative instruments such as currency forwards, futures and options. These financial instruments develop when markets are deep and liquid, and feature a diversity of players with different risk preferences.

In the case of the EU ETS, forwards on EU allowances have been available for some time, although the World Bank reports that these hedging instruments became liquid and widely available only in 2007. London’s European Climate Exchange (ECX), which dominates trading on the EU ETS, estimates that approximately 95 percent of the total volume in the European carbon market is seen in derivative trades (forwards, futures and options), with the balance in spot trades. Hedging instruments are therefore crucial tools in a new and volatile market.

Second, the option to meet 70 percent of intensity targets in 2010 by purchasing CCTF credits at $15 per tonne will have an impact on carbon price dynamics. By providing a cheap alternative to in-house reductions or emissions trading, CCTF credits will effectively place a price cap on carbon credits. The price of CCTF credits is set to rise slowly over subsequent years, while the maximum allowable contribution will decline to 10 percent by 2017. Environment Canada’s economic assessment forecasts that CCTF credits will represent the cheapest compliance option in the early years. By 2018, once access to CCTF credits is reduced, Environment Canada estimates that firms may face carbon prices around $65 per tonne, at which point abatement, domestic offsets and emission trading should become more cost competitive. The CCTF will therefore reduce the liquidity of Canada’s carbon market in the early years.

Third, Canada’s market for trading carbon allowances may suffer from a lack of hedging instruments due to the availability of cheaper CCTF credits, the limited number of regulated players and the uncertainty about supply and demand. Trading volumes may be limited if there is an insufficient surplus from regulated firms. In the EUETS, companies are allocated allowances equal to their total cap, not just the surplus to their cap. While the EU ETS features over 11,000 regulated entities, estimates suggest that only 700 Canadian firms will be covered by industrial caps. Without a large diversity of players, it is not clear which companies will provide liquidity by selling surplus allowances. It remains to be seen whether firms in unregulated industries will have an incentive to supply domestic offsets to regulated firms. If the carbon price is too low, the incentives will not be great.

The concern about supply and illiquidity may limit the availability of hedging instruments. Limited turnover in the underlying carbon credits will make hedging difficult, limiting the development of derivatives. In this situation, the ability of the market to discover the fundamental price becomes impaired, and transaction costs will likely be higher.

Fourth, Canada needs to put in place an emissions registry and a system for verifying emissions from regulated companies. A UN compliance committee recently noted that Canada had not yet established a national registry to keep track of its GHG emissions, putting it in violation of the Kyoto Protocol and jeopardizing access to CDM offsets. A registry is crucial for ensuring the success of emissions trading, as it provides credibility for counterparties on ownership. The World Resources Institute argues that intensity targeting systems require a higher level of public assurance regarding data quality in order to be credible and effective. The federal government therefore needs to collect and publish data on energy intensity and output, as intensity targets are a function of both inputs.

While emissions for relatively homogeneous products such as cement, steel, aluminum or electricity are easier to monitor, more complex products with multiple energy inputs such as chemicals or pulp and paper are more problematic. The EU has addressed this issue by providing third-party verification, which ensures compliance and avoids the risk of firms gaming the system. Canadian policy-makers should consider this option carefully. Section 1104 of America’s Climate Security Act provides a template for this function.

Finally, the design of Canada’s intensity targeting system may prevent linkages with a national cap-andtrade system in the United States. Section 2502 of America’s Climate Security Act states that US firms would be allowed to purchase allowances only from foreign systems that impose mandatory absolute tonnage limits on GHG emissions. The American system is expected to emerge around 2012. As a result, Canada’s intensity targeting system may need to be amended in its early years in order to allow linkages with the US carbon markets, which will rival the EU ETS in size and diversity of players.

A related issue is that the different supply and demand dynamics and greater complexity of the Canadian system will likely lead to price differences between markets. As a result, a carbon allowance in Canada will have a different cost than an allowance in the United States. Linking trading systems with the US (and the EU) would facilitate arbitrage, increase liquidity, reduce transaction costs and allow Canadian firms to face a global price for carbon emissions, maintaining Canadian competitiveness.

In summary, the carbon market is here to stay. Emissions trading is a cost-effective and flexible mechanism to reduce carbon emissions. An effective system has these features: a regulated cap to set a clear goal; an allocation of carbon credits (or allowances) that assigns responsibility to firms; a trading facility to allow cost-effective reductions; a monitoring and reporting system to ensure accountability; and a reconciliation with effective enforcement to ensure compliance. The Canadian intensity targeting framework meets some of these criteria, but falls short on others. In particular, the greater complexity, potential illiquidity and existence of cheap alternatives may hamper development, increase volatility, raise transactions costs, limit the availability of hedging instruments and restrict the ability to link with the US and EU systems. Canadian policy-makers should consider whether it is better to proceed with a system that may be illiquid in its early years, or whether it is worth amending it to address these issues. Whatever choices are made, simplicity and transparency will ensure the most effective outcome.