IN MARCH 2008, the Canadian government released the latest details of its proposed action plan for tackling climate change in Turning the Corner: Regulatory Framework for Industrial Greenhouse Gas Emissions. It doesn’t include provisions to reach Canada’s Kyoto target of a six-per-cent reduction from 1990 levels by the 2008 to 2012 reporting period. Instead, it outlines proposals for reducing emissions of carbon dioxide (CO2) and other greenhouse gases (GHGs) by 20 per cent below 2006 levels by 2020, and by 60 to 70 per cent below 2006 levels by 2050.

Three years earlier, in January 2005, the European Union launched its Emissions Trading System (EU ETS) as a cornerstone of its efforts to meet its Kyoto commitment of eight per cent below 1990 levels by the reporting period. The EU ETS dominates trading in the $62-billion global carbon market, representing 80 per cent of volumes by value traded in 2007. While the EU ETS has experienced some ups and downs since its launch, on most dimensions it has been a success. It has generated real reductions in carbon emissions while developing a deep and liquid market that is a model for other countries.

Absolute or relative targets

In 2003, the European Commission (EC) set mandatory caps on aggregate CO2 emissions for the EU’s 15 member countries, later extended to 27 countries. The combination of an absolute cap on emissions with the ability to trade allowances is known as a cap-and-trade system. Individual countries are allocated caps on their total GHG emissions over three trading phases. Phase I ran from 2005 to 2007, while Phase II, from 2008 to 2012, is underway, and Phase III will start in 2013.

Each member state is responsible for allocating EU allowances to the regulated facilities within its borders, where an EU allowance is a permit to emit one metric tonne of CO2 equivalent (CO2e). Regulated facilities choose the means to meet their targets – either by improving their production processes or by purchasing excess EU allowances from other firms. For example, a facility that emits 100 metric tonnes of CO2e, but has a target of 90 CO2e, is allocated 90 allowances, implying that they need to abate emissions by 10 per cent or purchase 10 EU allowances.

In contrast to Europe’s absolute cap-and-trade system, the Harper government has proposed a baseline-and-credit scheme that targets relative intensities of GHG emissions (volume of emissions per tonne of output). Operationally, an emissions-intensity target will be set for a given product with reference to a base year. Facilities that reduce their emissions intensity below their target will be allocated tradable credits, which they can either bank for a future compliance obligation or sell. Facilities that emit more than their target can use their previously banked credits, buy credits from other regulated facilities, or buy offsets from companies outside the regulated system.

For example, assume that a company’s emissions-intensity target is 1.0 kilo tonne (kt) CO2e for every tonne of widgets it produces. If a facility has an emissions intensity of 0.8 kt CO2e per tonne of widgets and produces 100 tonnes of widgets during the year, it would receive tradable credits equal to the difference between the target (1.0 kt CO2e per tonne) and its actual emissions intensity (0.8 kt CO2e per tonne) times its production in that year (100 tonnes), or (1.0-0.8) x 100 = 20 credits received. Conversely, a facility with an emissions intensity of 1.1 kt CO2e per tonne of widgets, that produced 100 tonnes of widgets, would be short 10 credits.

Ability to reduce emissions

The varying abilities of cap-and-trade systems and baseline-and-credit schemes to reduce emissions depends on the level of the cap or the stringency of the intensity targets, respectively. If the level of the cap (or the intensity target) is too high, then allowances (or credits) will be oversupplied, prices will be low and firms will not have an incentive to improve their operations. If the levels are too low, prices will be too high, with potentially undesirable economic effects.

A key difference between the EU’s design and Canada’s proposal relates to aggregate GHG emissions. The EU’s scheme sets fixed targets over different phases, designed to reduce aggregate emissions to their Kyoto commitments. Canada’s baseline-and-credit proposal does not guarantee emissions reductions, only improvements in efficiency. Supporters say that this feature makes it compatible with economic growth. Critics, however, argue that it will not limit the absolute volume of GHG emissions. If a business grows, its total emissions may increase even though the intensity at which it consumes energy decreases.

Allocating carbon credits

One problem faced under a cap-and-trade scheme is how to allocate allowances across regulated firms. Allowances can be distributed free of charge based on historical emissions (known as grandfathering), by providing them to emitters based on specific benchmarks or by auction.

Under Phase I of the EU ETS, most allowances were allocated free of charge. This approach has been criticized for giving rise to windfall profits (particularly for firms in the energy sector), being less efficient than auctioning and not providing enough incentive for investment in emissions reduction. In the absence of information on supply and demand, EU regulators overallocated allowances, leading to a crash in the price of EU allowances in April 2006, as shown in Figure 1. The catalyst was the release of the EU-verified emissions report, which showed that 2005 emissions were actually lower than the number of allowances distributed. Given that excess allowances from Phase I could not be banked for use in Phase II, the demand for Phase I allowances collapsed, with spot EU allowance prices hovering near zero until Phase I expired. While such volatility is undesirable, it sent a clear message to regulators that they needed to reduce allocations in the next phase.

The design of Canada’s baseline-and-credit scheme may appear to avoid the overallocation problem, but it increases uncertainty due to greater complexity and a lack of transparency. Rather than set an aggregate cap, regulators must assign intensity targets for each good that, when combined with production estimates, results in desired aggregate emissions reductions. Setting an emissions target may be straightforward for simple goods such as commodities, but is more difficult for complex goods that require a variety of inputs. Emissions credits are allocated free of charge to regulated firms that reduce their energy intensity beyond the target. The supply of credits available for trading, therefore, is a function of the stringency of the intensity targets and will not be known in advance of trading.

Data collection, registration and emissions verification

In “The Allocation of European Union Allowances: Lessons, Unifying Themes and General Principles,” a 2006 working paper published in FEEN (Fondazione Eni Enrico Mattei), author Barbara Buchner indicates that the absence of data, caused by the lack of legal authority to collect it, was the main reason for the overallocation of EU allowances. Recognizing this weakness, EU policy makers launched Phase I of the EU ETS early. As a result, it generated data that was used to improve the allocation of allowances in Phase II when the EU will have to meet its Kyoto commitments. The EU has also developed national registries and third-party verification processes, which will support the growth of the EU ETS and ensure compliance.

Canada has taken initial steps to collect good data, although it is not clear whether we have gone far enough. Environment Canada is working on a national GHG inventory and has collected data on facility-level emissions for 2006. This data will provide an initial benchmark for its baseline-and-credit system. Canada still has work to do on registration and verification, however. A UN compliance committee recently noted that Canada’s failure to establish a national registry that will track its GHG emissions violates the Kyoto Protocol. Canada has not clarified how it will verify emissions, but has seemingly ruled out a third-party system.

Diversity of players and timing

If all firms involved in a trading scheme face similar costs to reduce emissions, there is no incentive to trade. In a successful market some players have low-cost opportunities to reduce their emissions, which gives them an incentive to reduce what they emit and sell excess allowances to players with higher abatement costs. The EU ETS encompasses a diverse group of more than 11,500 energy-intensive installations. The entry of financial actors that trade for speculative rather than compliance purposes adds more diversity and generates liquid markets.

In Canada, public and private estimates suggest that only 700 firms will be covered by emissions caps. These players will be allocated credits only for their reductions relative to their intensity targets, resulting in a limited supply of excess allowances. In addition, credits will be allocated only after emissions have been verified, creating a timing problem since trading will take place based on estimates of the supply of credits, before the final allocation is known. The resulting uncertainty and low liquidity may hamper the development of active trading.

Alternative compliance mechanisms

One way to encourage liquidity is to allow firms to purchase offsets from unregulated facilities or to import credits produced by developing countries, as part of a program called the Clean Development Mechanism (CDM). Phase I of the EU ETS set insufficient limits on the number of CDM credits that could be imported, although this source of offsets was not widely used. Phase II allows importing of CDM credits up to an average of 13.5 per cent of targets. Canada will allow a firm to access the CDM for up to 10 per cent of its obligation. Only time will tell if this level proves to be appropriate.

Canadian firms, however, have access to two other compliance mechanisms that are not available under the EU ETS. One option is to purchase domestic offsets, which are credits issued for domestic emission reductions, created by industries in Canada that are not regulated by the government’s baseline-and-credit scheme. Carbon prices must be high if domestic firms are to create these offsets. In the early years, however, Canadian carbon prices may be suppressed due to the existence of a second compliance mechanism, the Climate Change Technology Fund (CCTF). Firms will be able to meet up to 70 per cent of their obligation in 2010 by purchasing CCTF credits, with the limit declining every year, reaching 10 per cent by 2017. The price of these contributions has been set at $15 per tonne in 2010-2012, $20 in 2013, and will escalate with GDP thereafter.

By providing a cheap alternative to in-house reductions or emissions trading, CCTF credits, in effect, put a price cap on carbon credits. Many experts believe that this is a major flaw of the Canadian scheme, which will have a negative impact on the price and liquidity of credits.

Linking with other national schemes

One way to increase liquidity in emissions trading is to link with other cap-and-trade schemes to create a global market. The EU ETS does not have any immediate plans to link with other trading systems. Canada says it will explore opportunities in the US and Mexico. The design of Canada’s baseline-and-credit scheme, however, may prevent linkages with the cap-and-trade system proposed in America’s climate security act. Although the Senate rejected this bill in June 2008, it stated that US firms would only be allowed to purchase allowances from foreign systems that impose mandatory absolute tonnage limits. Under such an act, Canada’s intensity-targeting system would be excluded. The fate and design of a US cap-and-trade scheme will not be known until after the US 2008 presidential election.

Compliance and enforcement

Emissions trading relies on compliance and enforcement. At the end of each phase of the EU ETS, each regulated facility must either reduce its GHG emissions to a level at or below its firm cap or deliver EUAs or CDM offsets equal to its excess emissions. Under the EU ETS, firms that fail to meet their targets are fined. In Phase I, the penalty was €40 (about $60) per allowance shortfall, rising to €100 (about $150) in Phase II. Without effective enforcement, the incentives will not ensure emissions reductions. Details on the compliance and enforcement mechanisms for Canada’s scheme have yet to be clarified.

Eye on Canada

Some of the features of the EU ETS have been taken into account in Canada’s proposed baseline-and-credit scheme, but others have not. Canada’s scheme addresses allocation, data collection and flexibility of compliance mechanisms, but appears to have weaknesses in the areas of diversity of players, liquidity, linking with US schemes, verification, registration and enforcement. The availability of cheap CCTF credits, the absence of surplus tradable credits and the greater complexity may hamper the system in its early years. The stringency of the intensity targets and the reduction in GHG emissions that will be realized are also uncertain. Given the lack of precedents with intensity targeting, Canada’s experiment is sure to be closely watched.


At the time of writing, Michael R. King was the assistant chief in the International Department of the Bank of Canada. He is currently working for the Bank for International Settlements in Switzerland.

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