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 May 04, 2007
Tools For Surviving And Thriving In A (Low) Carbon World

 This article by Selina Lee-Andersen of Blake, Cassels & Graydon LLP, is an informative tool for busy executives who would like to understand the complex world of emissions and emissions trading. It was Originally published in Blakes Bulletin on Energy - Oil & Gas, March 2007.

It was once said that "Like it or not, we live in interesting times." In recent months, there has been a palpable shift in public opinion on the topic of climate change. Canada has been slow out of the starting gate on the climate change issue, however Canadians have indicated their desire for action and this has resulted in a flurry of activity at both federal and provincial government levels. While the federal government still lacks a coherent strategy to tackle climate change, there is no doubt that, like it or not, new rules and regulations directed at managing our greenhouse gas (GHG) emissions are coming.

Finding the Right Tools

There has been much speculation on how the federal government, currently led by a Conservative minority, is going to design its response to climate change. The federal government has, at its disposal, a range of policy tools with the potential to turn the climate change challenge into an opportunity for economic growth and technological innovation with the ultimate goal of turning Canada's economy into one based on low carbon emissions. Whatever the approach, it is clear that Canada's industries and citizens are looking for leadership on the climate change issue.

This article will consider some of the tools that are available to policy makers and look at how these tools are being used in regions around the world. With a growing number of policy tools being implemented around the world to combat climate change, there is no need to re-invent the wheel. The most likely scenario is that Canadian policy makers will use a combination of mechanisms to meet our climate change obligations, rather than a single one. The three tools with the most potential in Canada, both economically and politically, are: (i) emissions trading; (ii) voluntary carbon markets; and (iii) carbon capture and storage.

Emissions Trading

For many governments and businesses worldwide, the carbon market and emissions trading have become key tools in managing the financial risks and opportunities associated with meeting one's GHG emissions obligations. In particular, emissions trading is seen as a complementary activity to increasing efficiency.

According to the International Emissions Trading Association (IETA), by the end of 2005, carbon funds totalling over USD 3.7 billion had been assembled by governments and private banks. Generally speaking, the term "emissions trading" encompasses two main types of systems --the first is a "cap and trade" system and the second is an offsets or "credit trading" system. The Kyoto Protocol provides for both types of systems at the national and international levels. For more information on emissions trading under the Kyoto Protocol, please see Blakes Bulletin on Energy--Oil & Gas, December 2005: Emissions Trading under the Kyoto Protocol: Giving Credit where Credit is Due.

Cap and Trade Systems

Under a cap and trade system, a group of emitters has a quantitative limit placed on their aggregate emissions over a fixed period of time. The overall cap may be fixed where an absolute amount of tonnes of emissions is established at the outset. Alternatively, the cap may be dynamic where there is an indexed variable (for example, emissions per GDP).

With a dynamic cap, the total amount of tonnes of the cap will not be known until the end of the period when the performance of the variable is also known. Once the cap is prescribed, it is allocated in the form of tradable emission units, or allowances, among the group of emitters. The emitter will have the obligation to match the emissions of its sources with emission units. In practical terms, this means that the emitter must hold and retire a number of emission units equal to their emissions over the prescribed period. Units are typically held and retired in a registry, which may be established and administered by a governmental authority. Once the emission units are retired, the units cannot be used again.

Under a domestic cap and trade system, emission units may be allocated not only to the source emitters, but to other parties in order to facilitate a trading market. It is important to note that an emitter's target is not an individual cap. This is where the trading market comes in. Trading of emission units enables flexibility by allowing the trading of "unders and overs". For example, one emitter may find it too costly to reduce emissions to its initial target. Since it will not be able to lower its emissions to comply with its initial quantity of emission units, it will be short of units. Another emitter may find it easier to reduce emissions and end up with a surplus of units. This dynamic between the emitters sets the stage for the carbon trading market. The key elements of a carbon trading market are: emitters willing to buy emission units; emitters willing to sell emission units; ability to accurately measure and verify emissions; a registry system to track and hold emission units; and compliance and enforcement procedures to ensure the viability of the market. Emitters will typically enter into arrangements where one party pays another party in exchange for a specific quantity of GHG emission reductions, either in the form of allowances or credits that the buyer can use to meet its compliance objectives. Payment for emission reductions can be made using cash, equity, debt or in-kind contributions such as providing technologies to abate GHG emissions. For more information on emissions trading contracts, please see Blakes Bulletin on Energy--Oil & Gas, March 2006, Constructing Carbon Contracts: The Building Blocks of an Emissions Trading Contract.

Offset Trading Systems

Another form of emissions trading is the offset trading system. Often referred to as "credit trading programs", these systems have built-in flexibility that enable emitters to meet their obligations through alternative "offset" activities. Carbon offsetting refers to the purchase of GHG emission credits to compensate a carbon footprint, i.e., the GHG emissions associated with a given activity, product, production process, country, region, company, or individual. These credits, which are tradable, are generated from projects that reduce GHG emissions. For example, the Kyoto Protocol allows for offset trading through the Clean Development Mechanism (CDM), where investment in projects in developing countries that reduce emissions are considered an acceptable offset to emissions reductions that could occur in industrialized countries with Kyoto targets. Therefore by investing in CDM projects in developing countries, industrialized countries can earn credits that can be applied to their own emission reduction targets.

Under the previous Liberal government, the implementation of a domestic offset credit system represented a key program in its climate change strategy. When the minority Conservative government came into power in early 2006, plans for such a system were shelved. However in recent months, there has been renewed interest by the federal government in setting up a domestic offset credit system that would enable emitters to generate offset credits by reducing or removing emissions. Under a credit trading system, the process for creating credits typically consists of the following steps: (i) project validation; (ii) verification of emission reductions; (iii) issuance of offset credits; and (iv) trading of offset credits. The actual trading of credits takes place through institutions established by the private sector, such as brokers or exchanges. To ensure that the credits are only used once, they are tracked through a national registry.

Voluntary Carbon Markets

Parallel to the growth of Kyoto-based compliance trading markets has been an increase in the number of corporate and voluntary offset buyers who have developed Voluntary Carbon Markets (VCMs).

The main driver behind VCMs is the use of project-based emission reductions by pro-active corporations seeking to achieve self-imposed carbon reduction commitments. VCMs are becoming an effective means for corporations to manage climate change issues and demonstrate to the public that they recognize that climate change can and should be addressed beyond the scope of existing regulations. In particular, corporate offset initiatives offer an additional level of flexibility to allow corporations not only to mitigate emissions, but to avoid more intrusive regulation.

Corporate offset programs raise consumer awareness and serve to increase a consumer's understanding of his/her carbon footprint (i.e., the amount of GHGs emitted by that consumer's direct and indirect actions) and contribution to the climate change problem. Voluntary offset programs will play a greater role in the future because they work hand in hand with the notion of a personal carbon budget, one of the proposed fundamental principles for a post-Kyoto climate strategy in the international arena.

VCMs hold great potential for Canadian businesses and consumers given the slow pace of regulatory development and lack of schemes that are designed for industries other than large emitters. To reach the full potential of VCMs, greater certainty is needed in the market infrastructure to boost corporate and consumer confidence in VCMs. In particular, a uniform or globally-accepted standard of certified emission reductions is needed. As a first step towards creating a credible standard, the Voluntary Carbon Standard (VCS) has been launched by IETA, the World Economic Forum and the Climate Group. The VCS makes use of a wide range of project-specific methodologies that have been tested with CDM projects and builds on GHG audit guidelines from the International Organization for Standardization (ISO). The VCS addresses the need for liquidity and a fully fungible commodity in a voluntary market through the Voluntary Carbon Unit (VCU). The objective of the VCS is to create a public standard to ensure the integrity of emission reduction projects, credible verification procedures, high quality emission reductions and a strong registration system. This will enhance confidence among market users, ultimately giving equal value to all VCUs.

Carbon Capture & Storage

The sequestration of carbon dioxide (CO2), or carbon capture and storage (CCS), is becoming an increasingly attractive option for industry to address GHG emissions. CCS is an approach to mitigating climate change by capturing CO2 from large point sources such as power plants and storing it rather than releasing it into the atmosphere. In CO2 capture, carbon dioxide is collected from industrial processes and the CO2 is stripped out by chemical methods. In CO2 storage, the captured gases are directed to various sinks for storage. CO2 can be stored underground or it can be used in chemical production. Technology for capturing CO2 is already commercially available for large CO2 emitters. The storage of CO2, on the other hand, is a developing area and research is ongoing to find suitable storage sinks while addressing environmental concerns such as leakage. CCS holds particular promise for Canadian industry given the proximity of large point sources of CO22 and potential geological sinks for CO2. Canada has been active in developing techniques to implement CCS and is promoting the inclusion of CCS in the United Nations Framework Convention on Climate Change.

One project of particular significance is the Weyburn Carbon Dioxide Monitoring Project, the world's largest, full-scale, in-the-field scientific study ever completed involving CO2 storage. Conducted with the support of the International Energy Agency Greenhouse Gas Research and Development Programme (IEA GHG), the research took place in the Weyburn area of south-eastern Saskatchewan, Canada. The four-year, multi-discipline research study concluded that large volumes of CO2 can safely be stored in oil-bearing geological formations. The IEA is an energy forum of 25 countries whose objectives include global energy policy development and the integration of environmental and energy policies.

While carbon sequestration is an end-of-pipe solution, it has the potential to facilitate the storage of significant volumes of CO2 that would otherwise be emitted into the atmosphere. Efforts made concurrently to reduce emissions at large point sources will complement efforts to capture and store CO2. With CCS, the stored CO2 becomes a purchasable commodity that can be traded, thus creating added value as opposed to added cost. Once carbon credits or other economic incentives are introduced, the ability to measure the economic impact of CO2 storage will be limited. The challenge lies in finding appropriate storage sites that will meet the requirements of CO2 mitigation. Apart from storage in geological formations, storage in depleted oil and gas reservoirs and deep saline aquifers are viable possibilities. Research continues in this area and both Alberta and Saskatchewan offer strong potential for saline aquifer storage. To realize the full potential of CCS, governments will need to facilitate the development of uniform standards to implement and operate storage projects and to monitor and verify the stored CO2. This will boost confidence in CCS and give industry the opportunity to acquire carbon credits for trading.

Learning from Others - A Look at Trading Systems Around the World

The European Union's Emissions Trading Scheme (EU ETS) represents the most advanced effort to formally establish a carbon market which creates monetary value from reduction initiatives. A mandatory cap and trade system in operation since January 2005, the EU ETS covers almost half of EU carbon dioxide emissions and saw the completion of its first full compliance cycle in May 2006 with the publication of verified emissions data for 2005. The EU ETS is widely viewed as a successful system, having established a market price signal for emission reductions, accelerated CDM projects and provided a verified baseline of actual emissions which will be used to assess planned reductions for the second phase of the scheme. Currently halfway through its first phase, the ETS has seen weekly traded volumes grow from approximately 1 million to 15 million tonnes. While the market continues to mature, the role of EU governments will be crucial as the market is completely reliant on regulatory issues. In particular, the EU governments will need to set strict guidelines to ensure co-ordination around the establishment of National Allocation Plans and the release of emissions data by EU member states.

On the other side of the Atlantic, there are a series of carbon trading initiatives that are evolving rapidly. In addition to the development of voluntary markets, the first state and regional cap and trade programs have emerged within the northeast (Regional Greenhouse Gas Initiative) and western (California) United States. Perhaps not surprisingly, a large component of the existing emissions trading market in the U.S. consists of voluntary, over-the-counter (OTC) trading among companies in the U.S., particularly in energy intensive sectors (such as electricity providers and oil and gas companies). OTC trades are typically monitored and supported by non-profit independent organizations (for example, The Climate Trust), but can also be brokered between companies or even within the same company. In addition to OTC trading, trading platforms have emerged in the U.S., the largest one being the Chicago Climate Exchange (CCX).

At the moment, the CCX is the only legally binding, voluntary emissions trading platform in North America. However in July 2006, the Montréal Exchange announced jointly with the CCX the establishment of the Montréal Climate Exchange, the first environmental products market in Canada. The Montréal Climate Exchange is anticipated to be up and running once the federal government sets out guidelines for trading. Under current CCX rules, members with direct emissions commit to one percent reduction per year over the period 2003 to 2006 (the baseline is calculated on an average taken from 1998 to 2001). In 2006, net emissions must be 4% below baseline and by 2010, members will be required to reduce their emissions to 6% below their average baseline.

January 1, 2009 will mark the implementation date of the first mandatory cap and trade system in the United States. On that day, the Regional Greenhouse Gas Initiative (RGGI) will come into effect. The RRGI currently encompasses seven states: Connecticut, Delaware, Maine, New Hampshire, New Jersey, New York and Vermont.

It is anticipated that Maryland, Massachusetts and Rhode Island may also join by the implementation date. The RGGI states have developed a rules for the program which must be established at the state level through legislation or regulatory administration. The program covers CO2 from the electric power sector emitted from generators of 25 megawatts or greater which burn 50% or more fossil fuel. While the RGGI is limited to the electricity-producing sector, it serves as an important precedent and possible precursor to a nation-wide GHG compliance trading system.

In the context of climate change action, much of the focus has recently centred on California. In recognition of its position as the 12th largest emitter of GHGs in the world, California launched a series of legislative initiatives in August 2006 to reduce its carbon footprint. The legislation enables the California Air Resources Board (CARB) to adopt market-based compliance mechanisms. However it is unclear how, if at all, CARB will adopt market mechanisms and the regulatory authorities have until 2010 to work out the details. The California Public Utilities Commission and California Energy Commission have been pro-active in addressing GHG emissions and a number of their programs are expected to use trading and offset mechanisms as part of their compliance options.

In Australia, proposals are underway to implement the Australian Greenhouse Gas Emissions Trading Scheme (AETS), which is aimed at reducing Australia's GHG emissions to 60% of 2000 levels by 2050. The proposed AETS will be a cap and trade system, with provisions for offsets to be separately created from domestic emission reduction projects and the potential to link with the global carbon market. The AETS, which will operate with permits that represent a right to emit one tonne of CO2 equivalent, will begin in 2010 with the participation of electricity generators. By 2015, the AETS will be extended to stationary energy sources that emit more than 25 kilotonnes of CO2 per year (including installations burning fossil fuels, gas retailers, gas transmission and distribution companies). Once extended, the AETS will account for 45% of Australia's GHG emissions.

A unique feature of the AETS is that it acknowledges the vulnerability of certain companies (i.e., energy-intensive companies) that may be placed at a competitive disadvantage as a result of having to reduce emissions.

The proposed AETS will extend breaks to these companies through the free allocation of permits to compensate for increased costs. Australia is also a member of the Asia Pacific Partnership on Clean Development and Climate along with China, India, Japan, the Republic of Korea and the United States. Designed to complement the Kyoto Protocol, this partnership is still in its early stages and the parties are in the process of developing guidelines that focus on low emission technologies and improving energy security.

Getting our Act Together

Under increasing pressure both nationally and internationally, Canada is finally embarking on its journey to become a low carbon economy. With its vast forests, unique geological formations, and agricultural production, Canada has significant market potential for the generation of biological and geological offset credits. Long governed by regulatory uncertainty, Canadian industry and individuals alike are looking ahead to some long-anticipated leadership on the climate change issue.

(c)Blake, Cassels & Graydon LLP

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Source: Mondaq .