This is the fourth blog in a series where we look to dive deep on the proposed Clean Fuel Standard (CFS) regulation. The CFS was announced in 2016 as part of the Pan Canadian Framework on Clean Growth and Climate Change. The proposed CFS regulation will require greenhouse gas (GHG) emission reductions through the use of lower-carbon fuels, energy sources, and technologies. The CFS uses a lifecycle approach. This means that reductions can happen during the extraction, production, distribution and use of fossil fuels. Environment and Climate Change Canada (ECCC) has stated they will first regulate liquid fuels (i.e. fuels like gasoline and diesel that are used mainly in transportation). In June 2019, a Proposed Regulatory Approach was published for liquid fuels [1]. Phase 2 of this regulation will cover gaseous fuels (i.e. natural gas and propane) and solid fuels (i.e. petroleum coke) used mainly in industry and buildings.
The CFS has a complex regulatory design, so we look to break it down piece-by-piece. In previous blogs, we provided a recap on the CFS regulatory development process [2], detailed the CFS requirements [3] and outlined rules for credit creation [4]. In this update, we will look at the CFS credit trading system, discuss market flexibility and stability mechanisms, and briefly overview verification requirements.
Credit trading system
Credit trading system will include participation from both primary fuel suppliers and voluntary credit creators. These participants will be able to create, own, transfer and acquire credits. Other parties will be allowed to participate in the credit trading system, but they must enter in an agreement with entities that create credits. Speculators or financial intermediators will not be permitted to create, own, transfer or acquire credits.
ECCC will maintain an online electronic trading platform to enable the Credit Trading System. Three different types of accounts will be permitted in the platform: 1) a liquid fuel class credit account; 2) a gaseous fuel class credit account; and 3) a solid fuel class credit account. Entities will only be able to make transfers between the same types of account to ensure cross-class trading requirements are respected. The platform has also implemented measure to support the integrity and liquidity of the system. These measures are listed in Figure 1.
Figure 1 - Provisions to support the integrity and liquidity of the trading system
Market flexibility and stability mechanisms
ECCC has spent a significant amount of time developing market flexibility and stability mechanisms. Remember that remitting a CFS credit is the only way for a party to comply with the CFS requirements. So, what happens if there simply is not enough CFS credits in the market to comply? This is where the market flexibility and stability mechanisms come into play. The mechanisms are designed to work together to give regulated parties access to lower-cost compliance opportunities, provide a price signal for the development of low carbon intensity (CI) fuel alternatives, and support market stability. These mechanisms are summarized in Figure 2.
Figure 2 - Summary of market flexibility and stability mechanisms
The compliance unit bank roll-over of credits generated under the Renewable Fuel Regulations provides a golden opportunity for primary fuel suppliers. Many of these primary fuel suppliers will already be subject to requirements under the Renewable Fuel Regulations and may be sitting on a surplus of compliance units or physical renewable fuels. At the very least the supply chain for procuring renewable fuels will be established. Credits under the CFS program are likely to trade at a huge premium. Credit prices in similar programs California [5], Oregon [6], or British Columbia [7], trade above CAD $300 per tonne of carbon dioxide. Buying excess pre-compliance units and rolling them into CFS credits is a classic buy low, sell high opportunity. Be an early actor to capitalize on this opportunity.
The provision for early credit creation is another reason why market participates should act now. Credit creation will be permitted following the publication of the final regulations in Canada Gazette, Part II until the time the regulation comes into force. Based on ECCC’s revised development timeline, this means that early credit generation can occur from fall of 2021 to mid-year 2022. The ability to generate early action credits could provide a huge financial uplift to projects. However, these credits can only be generated if your project is up and running. Given project lead times, it might make sense to act now and capitalize on this opportunity to earn early action credits. This will be especially true if there is a dearth of CFS credit in the early years of the program. Under a supply constrained credit market, prices will be high and you will benefit from your decision to act early.
The Credit Clearance Mechanism (CCM) will be mandatory for a primary supplier with a credit shortfall. This is the primary tool that ECC will use to address a dearth of compliance units. However, there is no guarantee that the CCM will be sufficient to meet compliance. Once CCM is depleted of all pledged credits, a primary supplier is still on the hook for any remaining compliance units. If this is the case, the next step is to look to the Compliance Fund Mechanism (CFM) or carry forward any outstanding deficit into a future compliance period. For credit creators, there is an opportunity here to benefit from the CCM. Trading system participants may pledge credits into the CCM at a specified price. This price is expected to be $300 per tonne of carbon dioxide equivalent. This may be a great way for credit creators to monetize the value of their CFS credits in a tight compliance market.
As mentioned, the next step after the CCM is exhausted is the CFM. Primary fuel suppliers can use the CFM to offset up to 10% of their annual liquid class obligation. The primary fuel suppliers must contribute to an approved fund that invests in, and obtains greenhouse gas emissions reductions, in the short term. The price of these “fund credits” is expected to be $350 per tonne of carbon dioxide equivalent. To be approved as an eligible fund must:
- Only finance projects or activities in Canada
- Support the demonstration, commercialization or deployment of technologies or processes that reduce GHGs
- Finance projects that will achieve emission reductions in the short term:
- Establish and publish policies, criteria or procedures for distribution of the monies in the fund, including a policy for avoiding conflicts of interest when making decisions regarding that distribution
- Publish and annual report that provides specified project details
- Maintain financial and management control systems, information systems and sound management practices
- Undertake an annual independent financial audit
ECCC has already stated that they will operate a fund. This will likely be the default option for primary fuel suppliers that need to access this flexibility mechanism. However, it may be possible for primary fuel suppliers to set up their own fund to finance emission reduction projects within their own operations. The $350 per tonne of carbon dioxide equivalent price tag could be much more palatable if this is effectively a self-tax with all proceeds remaining with the primary fuel supplier. There are many projects that can be undertaken at $350 per tonne that can reduce emission in the short-term. Even some of the higher cost emission reduction technologies, like direct air capture, may be economic at this rate. Setting up an internal fund and applying for eligibility under the CFS program is something regulated parties should consider exploring.
Verification
The last section of this blog will discuss verification requirements. The CFS program will mandate verification requirements for the key elements supporting the reporting of information, creation of credits, carbon intensity values and trading system. Figure 3 provides a summary of the major provisions related to this program.
Figure 3 - Summary of the major verification provisions
Conclusion
This blog discussed perhaps the most important design elements of the CFS: credit trading, market flexibility and stability mechanisms, and verification requirements. These policy design features will help to offer compliance flexibility and should lower compliance costs. It is important that industry understand these compliance flexibility mechanisms (in addition to the broader regulatory design) in order to prepare a CFS compliance strategy that allows for mitigation of high compliance costs. However, high compliance costs can also create financial opportunities for credit creators. We discussed potential strategies for maximizing values under the following mechanisms: compliance unit bank roll-over of credits generated under the Renewable Fuel Regulations, the ability to generate early action credits, the ability to nominate credits under the Credit Clearance Mechanism, and the option to create an internal fund under the Compliance Fund Mechanism. Regulated fuel suppliers should look to hedge against the possibility that compliance costs will be high. The best way to do this is to self-generate credits that can be used to offset the CFS compliance obligation. Acting now will allow regulated partier to capitalize on early action incentives.
References
[1] https://www.canada.ca/en/environment-climate-change/services/managing-pollution/energy-production/fuel-regulations/clean-fuel-standard/regulatory-design.html
[2] https://us12.campaign-archive.com/?u=9260b91e2aab82400d1bb3232&id=495be97354
[3] https://mailchi.mp/fb41d2084fd7/canadas-clean-fuel-standard-requirements-and-reporting
[4] https://mailchi.mp/d8c7150d15ed/canadas-clean-fuel-standard-credit-creation
[5] https://ww2.arb.ca.gov/our-work/programs/low-carbon-fuel-standard
[6] https://www.oregon.gov/deq/aq/programs/Pages/Clean-Fuels.aspx
[7] https://www2.gov.bc.ca/gov/content/industry/electricity-alternative-energy/transportation-energies/renewable-low-carbon-fuels