The carbon market and carbon regulation: Ensuring compliance and capturing value

19 minute read
01 December 2015

Provincial and state governments have begun to regulate the emissions of greenhouse gases ("GHG"). In particular, Québec and California created Cap-and-trade schemes/systems ("Cap‑and-trade") and harmonized their rules. The Ontario government has announced its plans to join them. Alberta, for its part, has announced a carbon tax and the imposition of emission limits. These are signs that carbon value and carbon risk have been acknowledged in North America. There is also a growing interest from an increasing number of businesses to reduce their carbon footprint in efforts to demonstrate they are good corporate citizens.

The Québec government started regulating GHG emissions Jan. 1, 2013 with the entry into force of the Regulation respecting a cap-and-trade system for greenhouse gas emission allowances1 (the "Regulation"). This new regulation created Cap-and-trade to enforce and encourage reductions in GHG emissions of large emitters, being those enterprises with greater than 25,000 metric tons of carbon dioxide equivalent ("CO2") emissions per year.

While Cap-and-trade is certainly an added cost for these enterprises, the system also presents an opportunity to capture value through improved efficiency and potential profits in an emerging, yet regulated, carbon market.

Components of the Carbon Market

1.1 The Carbon Market: Summary

What is a carbon credit/emission allowance?

A carbon credit represents a permanent reduction of GHG emitted in the atmosphere.

Under Cap-and-trade, emission allowances are either issued at no-charge to emitters or sold at auction by the government. Emission allowances are issued to certain emitters at no-charge based on historical emissions. These allowances are gradually reduced for each compliance period to enforce compliance with a pre-established ceiling of GHG emissions.

How much does it represent?

Each credit or allowance is a unit of measure equivalent to one metric ton of CO2. It is associated with a year or other compliance period in which they can be applied against emissions that occurred in such period; referred to as a "vintage".

In Québec and California, emission allowances are in electronic form and recorded in the Cap-and-trade tracking system known as the Compliance Instrument Tracking System Service ("CITSS"), identified by their type and the period of their creation. There are three types of emission allowances, as follows:

  1. Emission units distributed free of charge, auctioned off or sold by mutual agreement by the government;
  2. Offset credits stemming from GHG emission reductions in sectors not subject to the Cap-and-trade system; and
  3. Credits for early reductions.

To whom does it apply?

In Québec and California, GHG regulations identify particular industries to which Cap-and-trade applies. These regulations require each enterprise operating in industries targeted by the Regulation (i.e. industrial emitters and electricity producers and fuel distributors) to participate in the system by registering on CITSS (each, a "Regulated Emitter").

Other persons (non-emitters) interested in participating voluntarily in Cap-and-trade (referred to as "Non-Regulated Emitters") can also do so by registering on CITSS. Certain entities may be interested in showing that they have a zero or reduced carbon footprint or to acquire emission units with a view to later trade them.

What is carbon value and how is it captured?

In Cap-and-trade, carbon value is the economic value that can be gained by an emitter from a reduction in GHG emissions.

Carbon value is created by improvements (whether to equipment, materials or processes) made by an emitter that have the effect of reducing its GHG emissions. This value can also be created by Non-Regulated Emitters implementing GHG emission reduction projects recognized by the government. Such projects are eligible to receive carbon offset credits which can be sold to emitters for compliance purposes. The acquisition of such credits however is limited to 8 % of an emitter's reported emissions for a given period.

The publicity of the efforts of an enterprise (whether or not it is a Regulated Emitter under Cap‑and-trade) to reduce its carbon footprint can also have a positive effect on its brand or business image, thereby enhancing its value in the eyes of consumers.

What is carbon risk?

Carbon risk is the risk associated with a current or future regulatory obligation that an emitter will have to face to reduce its GHG emissions.

In Québec, the Regulation requires each Regulated Emitter in a calendar year to have at least as many emission allowances as verified emissions. The first compliance period started January 1, 2013 and ended December 31, 2014. For the first compliance period, only the industrial and electricity sectors were subject to the Cap-and-trade system. During the second compliance period (2015-2017), fossil fuel distributors are also subject to the system.

Industrial emitters and electricity producers had until November 1, 2015 to accumulate emission allowances to cover their emissions for the first compliance period.

The failure to cover emissions is subject to stiff sanctions. Regulated Emitters who exceed their targeted GHG emissions for a given compliance period will need to purchase three times the number of emission allowances required to cover emissions for the relevant compliance period to cover emissions for the relevant compliance period. To enforce compliance, the government can confiscate future vintages belonging to Regulated Emitters (i.e. emission allowances) accumulated and reserved for future compliance periods. This constitutes significant carbon compliance risk.

In other jurisdictions where GHG emissions are yet to be regulated there is a future carbon risk to emitters that similar regulations will lead to added costs.

1.2 The Carbon Market: Capturing Value and Managing Risk

How is carbon value captured?

Carbon value is created by the conversion of a GHG emission reduction into a tradable commodity, which can have various names but which we will generically refer to as a carbon credit or an offset credit under Cap-and-trade.

Carbon under Cap-and-trade

Geographic restrictions apply under the current Québec system: only a resident of, or municipality within, Canada may register as a participant or an emitter in the system. If an application is made by a person who does not live in Québec, the name and contact information of a Québec resident who is designated to represent the applicant must be provided.

In Québec, the Ministère du Développement durable, de l'Environnement et de la Lutte contre les changements climatiques ("MDDELCC") creates emission allowances by:

  1. An annual free allocation of emission units to certain industrial emitters which effectively represented their emissions reduction target;
  2. A quarterly auction of emission units subject to certain limits;
  3. A transfer of emission units by mutual agreement between the Regulated Emitter and the government also referred to as a "reserve sale";
  4. Recognition of early reduction credits for reductions in GHG emissions made from Jan. 1, 2008 and ending on Dec. 31, 2011;
  5. Issuance of offset credits for eligible GHG emission reduction projects that began on or after Jan. 1, 2012.

Cap-and-trade requires Regulated Emitters to reduce their GHG emissions to achieve their emission reduction targets. If Regulated Emitters have excess emission allowances at the end of a compliance period, they can sell those allowances over-the counter within the system to other Regulated Emitters that have not achieved their targets.

If the free allocation of emission units is not sufficient, Regulated Emitters can participate in auctions or purchase emission units over-the-counter (both are described in more detail below). Regulated Emitters and other participants can also implement or sponsor projects that reduce GHG emissions and thereafter obtain offset credits from the MDDELCC. The conditions for the allocation of credits are described in the Regulation.

Cap-and-trade auctions

Auctions are open to all Regulated Emitters and other participants registered with the CITSS. Currently, the MDDELCC has planned to auction emission units four times each year and currently conducts joint auctions with California.

The auctions are announced at least 60 days before they are held, and participants must register at least 30 days prior to the auction and provide a financial guarantee, such as a deposit, in order to participate. The minimum price for the auction filed on November 17, 2015 was C$12.08 per unit. The minimum price is increased at a rate of 5% plus inflation every year until the end of the third compliance period in 2020.

Western Climate Initiative Inc. ("WCI Inc."), a not for profit entity constituted in the state of Delaware for the purpose of managing cap‑and‑trade in California and Québec, will review and process the applications for auction registration and will also manage the auction settlement process. The results of the auctions must be approved by the MDDELCC before they are made public. Auction results are published on an aggregate basis because individual order information is privileged and must be kept confidential.

Reserve sales

If Regulated Emitters have difficulty acquiring enough emission units to meet their compliance obligations, the MDDELCC has created the reserve sale mechanism, which may be held up to four times a year.

To be eligible to participate in such reserve sales, Regulated Emitters must have a shortfall of emission units in their general account with respect to their GHG emissions target/limit for the current compliance period. Furthermore, emission units acquired through reserve sales cannot be resold over-the-counter to the other Regulated Emitters and participants in Cap-and-trade. These last two conditions will be enforced to ensure these sales actually benefit Regulated Emitters who do have difficulties acquiring emission units.

The reserve is divided into tiers, and a price was set for each tier (CAD$40-$45-$50 per unit in 2013) and are available to Regulated Emitters that do not have sufficient emissions units and offset credits to satisfy its obligations for the applicable compliance period. These prices will increase annually by 5% plus inflation until 2020. Like for the auction sales, the reserve sales will be managed by WCI Inc., and are subject to the MDDELCC's approval.

"Over-the-counter" sales

Cap-and-trade creates a secondary market, where emission units purchased can be resold over-the-counter helping Regulated Emitters to meet their emission reduction targets if the primary market does not meet their needs. However, sellers of emission units must not sell any units acquired through reserve sales.

"Other participants", such as banks, financial institutions, funds and others, may benefit from the secondary market by trading emission units "over-the-counter" in order to profit from the spread in prices.

The California connection

The current regulation and systems in the state of California and the province of Québec are similar. The systems in the two jurisdictions have been harmonized for Cap-and-trade.

At the present time, participants in the Québec program must have an establishment in Canada and similarly, voluntarily associated entities in the case of California must be located in the United States. Also, promoters of the GHG emission reduction projects for the Québec program must have an establishment in Québec. By linking the two programs, there will be a mutual acceptance of compliance instruments, which ensures fungibility of emission units.

Cap-and-trade systems for Québec and California allow all Regulated Emitters and participants to enter bids at the auctions. The Québec-California auctions are managed by WCI Inc., which currently manages the Québec program. Mechanisms also provide for currency conversion in respect to the price.

Who are the acquirers of carbon value?

The industries initially targeted by the Regulation as requiring carbon value to offset their emissions are the following sectors: aluminum; lime; cement; chemical and petrochemical industry; metallurgy; mining and pelletizing; pulp and paper; manufacturers of glass containers, electrodes, gypsum products and some agri-food establishments and petroleum refining. These industries must comply with their emission obligations by the end of the first compliance period.

The compliance obligation of fossil fuel distributors commenced in the second compliance period.

In the voluntary market, carbon credits are generally being purchased by two groups of entities: investors who want to benefit from price fluctuations, and enterprises that are currently offering "greening" and carbon neutrality services or are looking to go "carbon friendly" or neutral on their own.

1.3 Carbon Market: Capital Projects in the Voluntary Market

In Canada, carbon credits can be recognized as a result of capital projects that lead to a permanent reduction in GHG emissions once implemented. The carbon credits are recognized based on a verification of the real-time emission reductions of GHG from these projects in accordance with ISO standards. Once created, the carbon credits and their associated project can be listed on a registry such as the one maintained by the Canadian Standards Association ("CSA").

Such a project entails: 1) the definition of a scope of GHG emissions that emanate from a defined source, such as a landfill or hog farm; 2) the application to the defined source of a change in technology or process that adheres to scientific protocols; 3) the measurement of the emissions after the application of the project to the defined source; and 4) the verification the measurements by an independent third party.

If a project proponent wants to have the credits from a project registered on a project registry such as the CSA, then the project will need to be validated according to the rules of the registry and the validation will have to be done by an entity accredited for such purpose by the registry. If the project meets the registry's standards, the GHG reductions that are created by the project will then be serialized (assigned a number) and will appear on the registry for the relevant time period associated with the reduction in emissions. Often, projects are validated and run for several years and the emission reductions are verified on an annual basis. Once the credits are registered, they can be transferred between account holders on that registry and or retired (i.e. taken out of circulation).

Two things are important to note in relation to the process described above. First, it is not necessary for emission reductions to be registered or even verified for them to have a market value. Second, the verification/validation standard that is used for the project is a key element to determining what the value of the credits generated will be. Different standards have different market values and it is important for a company that feels that it has potential carbon value to determine what standard it will use to monetize that value.

1.4 Managing Carbon Risk

Carbon risk can take various forms. Under Cap-and-trade, the most significant carbon risk is being subject to sanctions related to regulatory annual emission limits.

Evaluating the amount of emissions that will have accumulated by the end of a compliance period cannot be easily determined ahead of time. Regulated Emitters are therefore faced with uncertainty and have an interest to manage this risk that becomes more urgent as each deadline to collect GHG emissions for a given compliance period approaches.

The voluntary market is subject to price risk, i.e. the price of carbon credits that could be obtained for certain emission reduction projects may be less than anticipated at time of project planning.

Investors in carbon markets must recognize that the Québec and California Cap-and-trade systems are closed. Emission reduction credits recognized in the voluntary market cannot be sold and applied under Cap-and-trade.

Hedging and insuring against carbon risk

Enterprises can mitigate their carbon risk by entering into certain derivative contracts. A forward contract or a call option on carbon credits can secure the enterprise's right in the future to emission allowances or carbon credits while setting the price of those allowances or credits today. In such a hedging instrument, the underlying asset or interest is the emission allowance or carbon credit itself.

Note that the Québec Cap-and-trade system does not recognize or allow trading of derivative contracts on emission units within its system.

Another tool to manage carbon risk could be insurance. Enterprises, including Regulated Emitters under Cap-and-trade, may be able to subscribe to specialized insurance contracts, which in return for a premium will indemnify emitters in the event their GHG emissions exceed their emission limit. To date, we have not seen an active market for this type of insurance.

M&A transactions

An entity which does not appropriately address its carbon risk can encounter difficulties. For example, in the context of the sale of business, a buyer could factor in these liabilities in order to reduce its offer.

Banks, lenders or investors that do not conduct proper carbon due diligence fail to completely analyze the business that they are financing or acquiring.

Protecting IP

Sponsors of projects for which offset credits are issued or voluntary emission reductions are recognized have an interest to protect the intellectual property rights that are behind these projects.

The patent application processes in both Canada and the U.S. are a good start to protecting IP.

What do businesses need to do?

Businesses need to begin to develop internal processes and tools for recognizing carbon value and risk both internally and externally, since such projects involve novel technologies.

Under Cap-and-trade in Québec, as a first step, Regulated Emitters and participants must ensure they are registered on CITSS. This process requires providing detailed information about associated entities and can take some time. Therefore, both participants and Regulated Emitters should plan ahead. It is also recommended they seek advice from legal counsel.

Our legal professionals are familiar with the existing carbon markets and draft regulatory frameworks proposed across Canada and can advise clients with respect to best practices for the recognition of carbon value and its monetization.

1.5 We Can Assist Enterprises to Capture Value and Manage Risk

The members of our Climate Change Group are familiar with many of the situations in which carbon value can be captured and can provide expert advice to Regulated Emitters and participants in Cap-and-trade as well as other enterprises in the voluntary market. The process of creating carbon value at the project level is in part a scientific one. We have developed a network of professional contacts in this area and can guide clients to reliable resources for the performance of the analysis of the emission baselines, the development or choice of reduction protocol and the verification of any reductions.

Lookout for Part 2 in this series of the carbon market and trading of carbon credits in which we discuss the tax considerations of the trading of carbon credits.

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