Outsourcing Ontario’s Carbon Pricing is OK

Tomorrow, Ontario will release its much-anticipated discussion paper on the future of carbon pricing in the province. Figuring prominently in the discussion paper will be a nod to joining the Quebec-California cap and trade system, effectively outsourcing key elements of Ontario's carbon pricing policy.

This of course is no suprise given Ontario’s long involvement with the Western Climate Initiative, its use of emissions trading under Regulations 195 and 397 for air pollutant emissions from its electricity sector, and its two MOU’s (2008 and 2014) with Québec to pursue cap and trade cooperation.

Given the nod to policy alignment, it is a good time to look at the Québec and California emission trading system and asked two important questions related to Ontario’s outsourcing of carbon pricing policy:

  • First, what is Ontario getting by outsourcing its carbon pricing?

  • Second, what are the elements of the WCI under Ontario’s control?

So how does Ontario gain from alignment with Quebec and California?

Ontario first and foremost will benefit from the considerable effort that Québec and California have put into the design of a functioning cross-border cap and trade system. Detailed design architecture on critical pieces necessary to implement cap and trade have been long thought through and are now operational. This takes off the table one of the major barriers to implement cap and trade, namely the complex and tricky business of developing policies, guidelines and rules for establishing a new and complex market for trading emission rights.

Ontario is also getting the political cover that comes with aligning its policy with a manufacturing economy right next door and the largest state economy in the US. The benefit of this can’t be underestimated, with media lines that will likely talk down competitiveness impacts while highlighting a North American trend towards linked subnational cap and trade systems.

Ontario also gets price certainty. While most economics textbooks will tell you that emissions trading fundamentally provides price uncertainty given emissions are capped while abatement costs are unknown, in the WCI carbon price futures are known out to 2017. Ontario can therefore be confident that carbon costs will be in the order of $13 per tonne in the foreseeable future. This of course could change in the longer term, but with allowance prices converging on a stable price floor, price stability may be baked into this WCI system.

The second question to ask with outsourcing is what WCI design elements are under Ontario’s control?

The first area of choice is the program emission limit. Ontario can choose its own program emission limit (or jurisdictional target). Both California and Québec have different targets, with Québec’s target more stringent than California. This indicates that the relative level of abatement effort in Québec will likely be greater than California, and could result in a net sale of allowances from California to Québec. Ontario’s emission limit choice really determines how it interacts with the two linked markets in California and Québec.

The next area of choice is program coverage, where Québec and California are virtually identical with only minor differences between covered sectors. Both jurisdictions started with a narrow scope of coverage focusing on manufacturing and industrial facilities with emissions greater than 25,000 tonnes of CO2e annually. In 2015, they both moved to a broader scope where liquid fuel distributors are covered, now representing 85% of California’s emissions and 77% of Quebec’s GHGs. Ontario has the choice of either starting with a narrow scope and later transitioning to a broader scope or immediately covering a significant portion of provincial emissions to align with California and Quebec’s broad scope.

The next area of potential alignment is compliance flexibility. The WCI enables a number of price control mechanisms to allow governments to contain costs, including the auction price ceiling, allowance banking, holding limits, multiyear compliance periods and offsets. Québec and California have aligned these compliance mechanisms in all but offsets. This really implies a high degree of compliance flexibility for emitters, which will likely result in containing compliance costs in Ontario.

Another area of choice for Ontario is how it allocates the emission allowances to emitters. Both California and Québec have chosen different allocation approaches. The California allocation process is somewhat complex and tied closely to sector level emission intensity benchmarks (perhaps more so than the Québec system). Another significant difference is electricity, with the California allocation process much more complex. California’s experience with NOx and SOx trading and market manipulation by Enron likely underscores a greater degree of control in California.

At the heart of the allocation of emission allowances is the choice whether or not to freely allocate allowances or to require emitters to obtain their allowances at auction. Both California and Québec have implemented free allocations for industrial emitters, effectively only placing carbon costs on the emission reduction target, and not on all remaining emissions. This differs from fuel distributors, who must abtain at auction or from the market allowances sufficient to cover all of the embedded carbon in the fuel they sell.

Ontario has the choice here to set which sectors get free emissions and for how long. This choice triggers competitiveness impacts as it raises the average cost of the program to the extent emissions are not freely allocated. It also impacts the revenue that is raised and available to fund government priorities.

Which leads to the next point on the auction itself and how the proceeds of the auction are distributed. Auction design is totally aligned between Québec and California, with several bidding limitations related to the Auction Reserve Price, bid guarantee submitted, purchase limits, and holding limits. Joint auctions are now occurring with the proceeds of the auctions distributed to each jurisdiction based on what their respective emitters purchase.

Revenue use however is significantly different between the two jurisdictions, with this being a major flexibility in the WCI system. Ontario has complete control over how it spends its auction revenue, which could be well over $1 billion annually. There are really three choices on how revenue is recycled, where income taxes can be reduced for households and industry, lump sum payments can be made to households or other constituents to address regressive impacts, and proceeds can be spent on government priorities. Ontario’s clear preference and need to fund transportation infrastructure likely points to profiling some of the auction proceeds towards transportation priorities. But there will be a need to “bribe” households and businesses to gain political cover for the carbon price, as was the case in BC’s when the carbon tax was implemented. How auction revenues are recycled can have a major impact on emitter cost, on the distributive outcomes of the policy and on other outcomes benefiting from auction proceeds. Ontario has complete control here.

Offsets differ between Québec and California. While both jurisdictions have agreed that no more than 8% offsets can be used to meet an emitter’s compliance obligation, the WCI allows for much greater use at 49%. A question for a jurisdiction contemplating WCI participation is whether or not linking partners would accept a higher level of offsets in compliance. This acceptance would be strongly linked to offset integrity rules.

Key offset program differences between California and Quebec include:

  • No forest or land use offsets in California;

  • The way liability is implemented, with California placing onus buyers while PQ is more flexible using a liability account as effectively liability insurance;

  • Differing protocol standards authorities.

Offsets are clearly a point of negotiation, and Ontario has the choice to either align with the WCI partners or to set up its own protocols that enable emission reductions from targeting sectors not covered by the trading system. Again the integrity of the protocols would be the heart of the partner jurisdiction’s acceptance of the proposed offset regime.

In looking at opportunities for Ontario to chart its own course under a WCI system with California and Québec, there are three summary points worth noting:

  • First, there are identical design features for governance, trading rules and reporting and verification. Common design features are really oriented to smoothing linkage and ensuring that consistent reporting practices and trading rules are developed across the two markets. These similarities have very little impact on a regulated entity, except that design improvements could reduce transaction costs for regulated entities.

  • Second, rules related to stringency and cost impact differ across jurisdictions. Clearly jurisdictions are able to set their own overall targets and caps and allocate emissions according to political economy issues, notably concern over competitiveness and production leakage. Revenue recycling from auction proceeds also is clearly at the discretion of subnational jurisdiction. How emissions are allocated has the single largest impact from a financial perspective on the regulated entity.

  • Third, offset systems can differ or be aligned. There is latitude here for different types of protocols, as long as core principles of additionality and permanence are demonstrated. In the case of Québec and California some protocols are aligned while some are entirely different. Offset limits for compliance, while aligned by California and Québec, could differ under WCI rules.

Clearly the implementation of cap and trade in Ontario is no simple matter. There are a number of key design choices that will need to be carefully considered by the government in order to ensure the smooth functioning of the market, to satisfy partner jurisdictions that the proposed program is credible, and to gain political cover for the government. But by outsourcing its carbon pricing to align with Québec and California, Ontario is clearly gaining both political cover and design experience that will ultimately increase policy success. Containing carbon costs through efficient policy also can't be overlooked. Ontario’s outsourcing of carbon pricing policy is therefore a very good move.

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