Canada's Revamped Carbon Pricing System

Canada is leading the world in pricing carbon. In December 2020, Canada proposed its Healthy Environment and a Healthy Economy plan. The plan will increase the price on carbon at a rate of $15 per tonne of carbon dioxide from 2023-2030. The price on carbon, currently set at $50 per tonne, will reach $170 per tonne by 2030. This makes Canada among the world leaders in setting a price on carbon.

In addition to the headline carbon price, the other critical component of any carbon pricing system is the method used to allocate emissions permits. The pan-Canadian approach to pricing carbon pollution established an initial design that was required to be adopted by all provinces and territories. In 2019, provinces and territories were required to implement a system that met the minimum national stringency standards, or ‘benchmark’ criteria, but had the flexibility to implement the type of system that made sense for their specific circumstances and economy.

Approaches varied from a cap-and-trade system in Quebec and Nova Scotia, to a flat carbon tax in British Columbia. Most provinces and territories however adopted a baseline and credit approach. This type of system was first adopted by Alberta in 2007. A baseline and credit system was also used by the federal government in its backstop Output-Based Pricing System (OBPS) for jurisdictions that did not meet the minimum national stringency standards.

In August 2021, the federal government released new 2023-2030 federal carbon pricing benchmark criteria for industrial carbon pricing systems that is set to apply at the beginning of 2023. Provinces and territories are required to meet this new federal benchmark or have the federal backstop imposed. The new federal benchmark signals ECCC’s (Environment and Climate Change Canada) intent to hold provincial and territorial carbon pricing systems to more stringent minimum national criteria. In particular, ECCC will require all carbon pricing systems to include:

• Common scope and coverage – All systems must cover the same proportion of emissions as would be covered under the federal backstop system. This includes things like flaring and industrial process emissions which may have been previously excluded from some provincial programs.
• A clear price signal – Government measures must not reduce the carbon price signal by giving instant rebates that are tied to the carbon price being paid. Programs must also insure there is a positive price signal that allows facilities to generate credits if emission performance is better than the benchmark level.
• Ensuring that protections against carbon leakage are restricted to sectors at risk – Protection should only be extended to facilities that are in emissions-intensive, trade-exposed industries.
• Offset credits meet best practices for quality – Quality standards should meet or exceed best practices identified by the Canadian Council of Ministers of the Environment.
• Increase stability be moving to a multi-year assessment period – To provide certainty to investors all jurisdictions must establish a system that aligns with Canada’s carbon price trajectory and benchmark requirements out to 2030. Once systems are in place in 2023, they will stay in place until at least 2027.

In December 2021, ECCC provided a little more information on the review process. A consultation paper was published describing key proposed amendments to the OBPS Regulations. Perhaps the most significant change was to the proposed tightening rate for output-based standards. ECCC is proposing an annual tightening rate of 2% per year beginning in 2023. This rate is being set so that credit supply in the OBPS market does not outpace demand.

As the price of carbon increases to $170 per tonne by 2030, it is expected that more companies will undertake action to reduce the amount of GHGs emitted. This could include mitigation levers such as electrification, fuel switching, energy efficiency, or carbon capture and storage. As companies decarbonize, they will reduce their emissions intensity and begin to outperform their benchmarks under the OBPS system. When the emissions intensity of a facility is lower than the prescribed benchmark the facility is eligible to generate performance credits. If too many of these performance credits are generated, supply will out stripe demand.

The tightening rate will, in effect, increase economy-wide demand for credits. In the event that increased performance credit supply is not counteracted by increase demand from regulated facilities, the supply glut would result in a reduced price for carbon emissions permits in the secondary market. This muted price signal would undermine the government's plan for the effective carbon price to meet $170 per tonne by 2030. Rather than decarbonize, companies would make the rational investment decision to simply keep emitting carbon and pick up credits on the cheap. As ECCC put it, the annual tightening rate of 2% is set to “ensure the marginal price holds” and that the “the total compliance obligation must exceed the total credits available.”

It remains to be seen what the implications of this proposed OBPS change will mean for equivalent programs that provinces and territories have put in place. Are these systems required to adopt the 2% annual tightening rate or are they simply required to keep the credit market in balance? Alberta, Saskatchewan, Ontario, and Newfoundland are all provinces that may need to reassess benchmark stringency in their carbon pricing programs in order to maintain credit market balance.

Increased benchmark stringency becomes further necessitated if the federal government makes good on their promise to introduce an investment tax credit that accelerates carbon capture, utilization, and storage (CCUS) projects. If a broad range of industries (e.g., concreate, power, plastics) begin to deploy CCUS technology we could be in a situation where benchmark stringency may have to tighten even faster than 2% per year. This would put large final emitters in the precarious position of making CCUS investments to not fall behind (rather than get ahead) from a compliance perspective. This make be an effective tactic for decarbonizing installed industrial capacity but could ultimately undermine Canada’s ability to attract new capital investment in heavy industry. Canada should proceed cautiously to avoid the unintended consequence that new industrial growth capital flows to other nations with weaker environmental standards.

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