Canada's Cap and Trade - Lessons from Europe

Canada’s National Round Table on the Environment and the Economy has proposed that Canada adopt a national climate change strategy and that it uses a national cap and trade as the cornerstone of this strategy, doing away with a patchwork quilt of Provincial regulations and law.

In the cap-and-trade system, all businesses would have to buy credits to cover the emissions they produce. If a company's emissions exceed the cap set by government, they would have to buy more credits from companies that came in under the cap. Such a system creates financial incentives for companies to reduce their emissions because they can then avoid having to buy more credits and also be in a position to sell their unused emission credits, creating a new revenue stream. Doing this the Canadian government simply oversees the activities and the companies pass on the net costs of this buying and selling of credits to consumers. No new taxes.

The underlying intention is to lower greenhouse gas emissions, which some believe cause climate change. The current Canadian government has committed to:

• Impose mandatory targets on industry to achieve a goal of an absolute reduction of 150 megatonnes in greenhouse gas emissions by 2020. This despite the fact that Canada signed up to Kyoto and is expected to reduce emissions by 20% - much more than the target of
• Impose targets on industry so that air pollution from industry is cut in half by 2015.
• Regulate the fuel efficiency of cars and light duty trucks, beginning with the 2011 model year.
• Strengthen energy efficiency standards for a number of energy-using products, including light bulbs.

Cap and Trade would go beyond these targets, according to the panel, and seek to take us nearer to a 20% reduction in emissions by 2020, achieved in part through the trading mechanism but also through a deliberate slowing of economic growth. This proposal may also align Canada with the US, where Barrack Obama would like to see emissions reductions back to 1990 levels by 2020 – an 11% reduction on current emissions (1.5% per year). Obama set aside $80 billion in his economic stimulus package for green energy, promised $150 billion for research over 10 years, and has started to tighten regulations on auto emissions. However, the Senate recently voted to exclude cap and trade from the budget reconciliation talks now taking place in congress.

The problem is that cap and trade will increase energy costs. One estimate is that, to achieve any more aggressive targets than the modest goals set by Harper and Obama, it is likely that carbon will need to trade at app., $100 - $125 per tonne - having a major impact on oil supply, food supplies and social infrastructure. The low carbon economy will be very damaging to communities. When carbon starts to trade about $40 a tone, then real change in the nature of the economy will begin to take place.

What is key to all of this is to get the cap and trade system right the first time. The European Union introduced cap and trade scheme in 2005. In the first phase, 10,000 large emitters were allocated credits representing some 40% of CO2 emissions. If CO2 permitted emissions were exceeded, the EU imposed a fine of €100 per tonne unless a carbon certificate could be produced (1 tonne = 1 certificate). These certificates could be bought on the trading market for between €8-€30 a tonne.

Companies will only invest in new technology aimed at reducing emissions if they are confident that carbon prices will be high enough to justify the cost. At their late-March 2009 level of €12 per tonne, prices for carbon certificates within the EU are too low to make such investment worthwhile. Indeed, the current state of the carbon market poses a bigger risk to the future of the cap and trade scheme in Europe than the previous collapse of carbon prices. Prices fell to around €1 in 2007 because too many allowances were distributed for the first phase of the scheme (from 2005 to 2007) and companies were not permitted to hold on to surplus permits for use in the subsequent phases (2008-12 and 2013- 20). However, the price of carbon for use in phase two remained above €18 per tonne during 2007 (and hence well above current levels), because investors were confident that emissions caps in the latter phases would be tighter. In terms of encouraging investment, it is the future price that matters.

The ferocity of the economic downturn has also highlighted two structural weaknesses in Europe’s carbon market. First, the EU fixed the supply of carbon allowances until 2020. This was done for sound economic and policy driven reasons. Investors needed to be convinced that the cap on emissions would be sufficiently tight to ensure consistently high carbon prices. However, the lack of a mechanism to amend the emissions allocations in the light of changed economic circumstances is now leading to the volatility in prices that the Commission sought to avoid.

Second, the method of distributing the allowances is exacerbating the weakness of carbon prices. In phase two of the ETS (2008 to 2012), the vast majority of allowances will be allocated for free. In phase three (2013 to 2020) energy generators will have to purchase them through auctions. But auctioning will only be introduced gradually for the other industries covered by the market. The upshot is that very few businesses are actually paying to emit carbon dioxide at present. And as it becomes apparent that emissions will remain weaker than projected for a number of years due to the recession and its impacts, they will be able to put off buying allowances until well into phase three. If all businesses had to pay to emit carbon dioxide now (or at least from 2013), prices would have declined by much less. It is worth noting that the EU economy is likely to shrink by more than 3 per cent this year and that the release of CO2 by industries covered by the carbon market could decline by as much as 10 per cent.

Cap and trade may happen in the US, though not as quickly as Obama would like. A US-Canada scheme makes sense if it is going to happen, but the compromises and trade-off’s required to get this law on the books will probably limit its impact on CO2 emissions. It will become more about appearances than reality. What it will not do is have real impact on the climate.