Reducing Industrial Greenhouse Gas Emissions
with Regulated Targets-and-Trading Systems

Recommendation summary

The federal government should implement a greenhouse gas (GHG) emissions targets-and-trading system for heavy industry, domestic aviation and other large emitters, to come into operation on January 1, 2008. This system would be more effective, broader, and come into force much earlier than the system proposed in the government's Notice of Intent of October 19, 2006.

The system, based on the allocation of fixed, absolute amounts of tradable emission permits, should result in the covered sectors carrying out or paying for emission reductions commensurate with their share of national emissions. The system should include carefully-designed provisions respecting facility-level allocations, use of domestic offset credits and international GHG credits, compliance penalties, transparency and other issues. The system should be implemented by adopting regulations under the Canadian Environmental Protection Act (CEPA).

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Revenue/Cost Implications

Revenue from auctioned permits could generate substantial revenues to dedicate to additional GHG emission reduction activities, as well as covering the modest administration costs. For example, if permits were auctioned to cover only 10% of GHG emissions from Canada's large emitters, at a price of $15/tonne of carbon dioxide equivalent, that would generate annual revenues of roughly $600 million.

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Benefits for Canadians

A sufficiently robust targets-and-trading system will:

  • Ensure that heavy industry, responsible for close to 50% of Canada’s GHG emissions, plays an appropriate part in Canada’s contribution to the global effort to prevent dangerous climate change,
  • Prevent an unacceptably large emission reduction burden from falling on taxpayers and other sectors of the economy,
  • Harness the power of the market to maximize emission reduction opportunities and minimize economic costs, and
  • Play a pivotal role in Canada making an adequate contribution to the global effort to prevent the worst impacts of climate change.

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Background and Rationale

To meet its international obligations and play its part in preventing dangerous climate change, Canada needs to put itself as soon as possible on a path leading to deep reductions in GHG emissions. Since close to 50% of Canada’s GHG emissions come from heavy industry (including electricity generation), policies capable of securing substantial reductions in industrial emissions must be at the heart of any credible Canadian climate change plan. Voluntary programs are not capable of achieving such reductions. Government-funded financial incentives would have to be very large to do so, and this is neither politically feasible nor acceptable from a polluter-pays perspective.

Governments worldwide are therefore turning to systems of regulated GHG targets for industry, combined with emissions trading to harness the power of the market to locate the lowest-cost emission reduction opportunities. Such systems have already been implemented across the European Union, in Norway and New South Wales, and agreed to in ten US states. They are also under serious consideration by all Australian state governments, in Switzerland and in Japan. In June 2005, a majority in the US Senate voted in favour of a non-binding resolution calling on Congress to “enact a comprehensive and effective national program of mandatory, market-based limits and incentives on emissions of greenhouse gases.”

Canada’s federal government has the power to implement a national GHG emissions targets-and-trading system by adopting regulations under CEPA.

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Recommendation Details

Start date
In light of Canada’s international legal obligation under the Kyoto Protocol to limit its GHG emissions between 2008 and 2012, Canada’s GHG emissions targets-and-trading system should come into operation on January 1, 2008. Since federal officials have been working on the details of such a system since early 2003, sufficient time remains to finalize and adopt the necessary regulations before 2008.

Period of applicability of targets
To provide certainty to business, and the clearest possible signal to reduce emissions in the long term, it is desirable to establish targets in advance for a long time period. However, for reasons of equity, it is not appropriate for the federal government to commit to GHG emission targets for industry for any given period before Canada understands what its overall emissions target will be in that period. Targets should therefore be established in the first instance for the period 2008–12 but extended further into the future as soon as Canada commits to an adequate GHG reduction target for the post-2012 period.

Sectors covered
At a minimum, the system should cover all heavy industry sectors (including electricity generation) that were subject to the previous government’s proposed Large Final Emitters (LFE) system. Additionally, the system should cover other facilities that emit more than 100 kilotonnes of carbon dioxide equivalent (CO2e) annually,(1)as well as domestic aviation.(2) The desirability of subsequent extension of the system to cover emissions from fossil fuel consumption outside these sectors should be examined.

Permit trading versus baseline-and-credit
Targets should be implemented in the form of allocations of tradeable emission permits(3) (each worth one tonne CO2e), and compliance achieved by surrendering one permit for every tonne emitted. A permit system signals that rights to emit can and will be withdrawn over time, as will be necessary if Canada is to achieve deep emission reductions. The alternative, a “baseline-and-credit system,” would send an undesirable signal that rights to emit are entrenched up to the level of targets. In addition, a baseline-and-credit system would be inconsistent with the systems emerging in other important jurisdictions (notably the EU and US states). A permit system would also likely facilitate more efficient emissions trading.

Overall target or permit allocation
The overall emissions target for the system (i.e, the total number of permits allocated) should be set at a level that requires the covered sectors to carry out, or pay for, emission reductions commensurate with their share of national emissions. In other words, heavy industry should be responsible for a proportion of total Canadian emissions reductions related to their close-to-50% share of national emissions.

Facility-level targets or permit allocations
In keeping with the polluter-pays and ability-to-pay principles, free permit allocations (i.e. targets) should be established for existing facilities by taking into account their sectors’ historical emissions trends and their financial capacity to pay for (or pass on the cost of) emission reductions. Allocations should be fixed at an absolute level in advance of a given compliance period, i.e. targets should not be set in terms of emissions intensity or otherwise adjusted in light of production levels. Targets set in terms of emissions intensity are not acceptable because they transfer to the government liability for emissions resulting from higher-than-expected production levels. Also, emissions intensity targets which are differentiated between sub-sectors that produce the same product (e.g., coal- and gas-fired electricity) reduce the incentive to switch to cleaner technology. Finally, experience in developing the previous government’s proposed LFE system shows that allocations should not be tied to future “business-as-usual” emissions projections because of the uncertainties and lack of transparency associated with such projections.

Treatment of new facilities
Permit allocations to new facilities should be made out of a fixed-size “new entrant reserve” of permits, to ensure that the system applies a predictable overall cap on emissions. Formulae for making allocations to new facilities should be designed to maximize emission reduction opportunities from capital turnover and new investment. EU member states’ governments “national allocation plans” for allocation of GHG emission permits (4) can provide useful models for allocation of permits to both existing and new facilities.

Auctioning of permits
In keeping with the polluter-pays principle, a steadily-increasing proportion of permits should be auctioned by the government, with the resulting revenues dedicated to additional GHG emission reduction activities. Experience in the EU shows that it is particularly important to auction permits for sectors that can easily pass on costs to customers. This is because such sectors will otherwise reap windfall profits by passing on to customers the GHG permit price applied to 100% of their emissions while only having to pay that price for the portion of their emissions that exceeds their free permit allocation. During 2008–12, under the EU’s GHG targets-and-trading system the UK plans to auction 7% of its total allocation and France 10%. Under the Regional Greenhouse Gas Initiative (RGGI) agreed to by eight north-eastern US states, 25% of the total allocation will be auctioned.

Compliance options
In addition to on-site emission reductions and purchase of extra permits, companies should be allowed to make use of two further options for compliance – purchase of domestic offset credits and purchase of international GHG credits – subject to the qualifications detailed below. Companies should not be allowed to count investments in technology development as a compliance option (except, of course, to the extent that those investments result in quantifiable emission reductions in the compliance period in question). Technology investments intended to achieve emission reductions in a future compliance period will be automatically rewarded by the targets-and-trading system in that future period if they do result in reductions; crediting such investments at the time they are initiated undermines the environmental integrity of the system by counting the reductions early and twice. If there is a need for an further, more immediate incentive for technology investments, it can be provided under a separate government program.

Domestic offset credits
If it is subject to strict rules respecting environmental integrity, it is desirable to establish a mechanism for granting “offset credits” in respect of GHG emission reductions from projects undertaken in Canada outside the sectors covered by the targets-and-trading system. Purchase of offset credits by sectors covered by the system would create a potentially powerful market mechanism to capitalize on a broader range of domestic GHG reduction opportunities. Given the need to maximize domestic emission reductions, it is also important to provide for domestic offset credits to compete with international credits if the latter are allowed as a compliance option. To ensure environmental integrity, it is essential that offset credits be denied to “non-additional” projects that would be expected to proceed without the sale of GHG credits – either because they are already sufficiently profitable on their own or sufficiently incented by another government program (federal, provincial/territorial or municipal). The Kyoto Protocol’s Clean Development Mechanism (CDM) already includes a practical tool for screening out non-additional emission reduction projects.

International credits
Given the large increases in Canada’s GHG emissions since 1990, for the next several years it is not likely that Canada will be able to meet the kinds of national GHG reduction targets that are needed (such as the target set by the Kyoto Protocol) at a reasonable cost purely through domestic action. Canada therefore needs to finance good quality foreign GHG emission reduction projects as a complementary way to meet its targets. For reasons of equity, this financing should be shared between government and Canada’s largest GHG emitters. It is therefore appropriate to include the purchase of international GHG credits as a compliance option under the targets-and-trading system for industry. This option should be restricted to credits from CDM and Joint Implementation (JI) projects under the Kyoto Protocol because these credits come from the poorer countries most in need of this kind of financing and because they are subject to strict rules regarding “additionality” (see above). Limits should be placed on the extent to which international credits can be relied on as a compliance option.

Compliance penalties
As is usual practice in emissions trading systems, Canada’s targets-and-trading system should include penalties for non-compliance set at a level substantially higher than the highest likely permit price, to ensure full compliance.

Price cap
A cap on the permit price set at a low level – such as the $15/tonne CO2e cap proposed under the previous government’s LFE system – would stifle innovation by removing any incentive to develop and deploy emission reduction technologies that cost more than the cap price. It would also expose the government to a potentially very large and unacceptable financial liability if the market price of permits rose above the cap price. At the same time, industry has an understandable need to place an upper bound on its financial exposure to a targets-and-trading system. There may therefore be justification for a partial price subsidy if the market price of permits rises above a certain threshold. For instance, if the permit price rose above $40/tonne, the government might provide a subsidy to cover 50% of the excess price.

Preventing double counting
To protect environmental integrity and ensure accountability, it is essential that emission reductions both intended to be achieved, and actually achieved, from (i) the targets-and-trading system and (ii) other government programs, are accounted for clearly and separately. If, for instance, a government subsidy program is intended to result in industrial emission reductions above and beyond those from the targets-and-trading system, it will be necessary to withdraw a number of permits from the affected facilities equal to the emission reductions resulting from the subsidy program. If this is not done, these emission reductions will occur just once but be counted twice, once under the subsidy program and a second time under the targets-and-trading system.

Quantification and reporting
To earn the confidence of citizens and opinion leaders typically skeptical of emissions trading, to ensure that necessary lessons are learned and to ensure efficient trading, it will be essential for Canada’s GHG emissions targets-and-trading system to display the greatest possible degree of transparency. This will require timely public reporting of all relevant data including facility-level emissions and the amounts and origins of all permits and credits used by each company for compliance. If, contrary to the recommendation made above, the system uses emissions intensity targets, facility-level production data will also need to be publicly reported.
Recent experience in the EU shows the importance of having good facility-level emissions data available as a basis for target-setting before the system comes into operation. Environment Canada should accordingly increase the rigour of the mandatory facility-level GHG reporting already in place under CEPA as soon as possible.

Legislative authority
The federal government can implement a national GHG emissions targets-and-trading system by adopting regulations under CEPA – since GHGs were already added to CEPA’s Schedule 1 in November 2005. Any desire for new legislation designed more specifically for such a system cannot justify delaying the system’s implementation. If necessary, legislative authority could be switched to new legislation later.

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Alternative and complementary policies

A GHG emissions targets-and-trading system puts a price on emissions. This could alternatively be achieved with a carbon tax or GHG tax applied to the same emission sources. The implications of these options include the following:

  • A targets-and-trading system provides certainty as to the resulting amount of emission reductions, while a tax provides certainty as to the price of emissions.
  • A targets-and-trading system allows for allocation of a portion of permits free-of-charge, while a tax requires all emitters to pay for 100% of their emissions.
  • In a targets-and-trading system, money flows directly from emitters who exceed their targets to those carrying out emission reductions. With a tax (and when emission permits are auctioned), money flows from emitters to the government before being redistributed.
    As noted above under “Preventing double counting,” it is essential that emission reductions both intended to be achieved, and actually achieved, from (i) a targets-and-trading system, and (ii) other government programs, are accounted for clearly and separately.

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Contact:
Matthew Bramley
Director, Climate Change
Pembina Institute
819-483-6288, ext.26
matthewb@pembina.org

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1. All such facilities are already required to report their emissions under CEPA. (back to text)

2. The EU is expected to add aviation to its GHG emissions targets-and-trading system within the next few years. (back to text)

3. The units referred to here as permits are often referred to as “allowances” in existing emissions trading systems. (back to text)

4. Called allowances in the EU. (back to text)