Strategy

Canada in 2020 – Emissions: Cloudy skies

Corporate Canada wants a firm, long-range plan on how to deal with greenhouse-gas emissions.

Wishart Robson, Nexen Inc.’s senior adviser on climate change, has a countdown silently running in his mind: the number of days remaining until Jan. 1, 2010. That is the date the federal government’s regulations on industrial greenhouse-gas emissions comes into effect, and it looms large, not only because the plan has been a long, frustrating time coming, but because so many details are still to be revealed. “It’s not easy,” says Robson. “We still don’t know what the rules are.”

The plea for a firm, long-range plan has been a common refrain of Corporate Canada’s, and one even voiced by oilsands producers such as Nexen (TSX: NXY), which owns 7.23% of Syncrude. Gradually, a proposed regulatory framework is emerging, but Robson is uneasy about how the Conservatives’ attempts to engineer greenhouse-gas emission reductions will play out; Nexen, like a handful of other Canadian companies, has lived through the dawning of a new carbon regime before — in Europe. And that wasn’t without its ups and downs.

The European Union Emissions Trading Scheme (EU-ETS) is the first and largest international system designed to set a price on the carbon-dioxide pollution that many scientists say is altering the Earth’s climate. All 27 EU member states are participating, as are three nations from the European Economic Area. More than 10,000 sites in the energy and industrial sectors are covered, accounting for nearly half of the EU’s CO2 emissions. Now in its first year of a five-year full compliance period, the EU-ETS stands as the world’s most aggressive attempt to reduce greenhouse-gas emissions using market-based mechanisms to ease economic costs. As a World Bank report recently noted, “The EU-ETS … is the engine, perhaps even the laboratory, of the global carbon market.”

The EU-ETS is the de facto global standard of emission reduction schemes, and the Canadian government, like those in other countries or regions now crafting emission-trading systems, needs to learn from Europe’s experience and consider how one day the various systems might work together to form an efficient global carbon market.

The EU-ETS is already a remarkable achievement in itself, given its geopolitical scope and how quickly it was up and running. The European legislature received the first draft proposal in October 2001, and by 2007, a vibrant carbon-finance industry had begun to emerge: some US$50 billion worth of European Union Allowances changed hands that year, nearly six times the volume and the value transacted in 2005.

How has the EU done it? Wisely, it kept its cap-and-trade system relatively simple. First, the EU-ETS is only for CO2, and from narrowly defined emission sources. Secondly, absolute limits are set by the individual member states (and approved by the EU). Member states also distribute their pots of free allowances, known as EUAs, to the affected plants and companies in whatever way best suits their national economies. Companies such as Nexen, which operates two North Sea drilling platforms in U.K. waters, face straightforward choices if they’re above their cap: undertake internal emission-reduction projects or buy EUAs on the market. The EU also used a phased approach, so that the first trading period, from 2005 through 2007, was a trial run — and a good thing, too, because there were growing pains, and adjustments were necessary for Phase 2, which started in January.

By contrast, Canada’s proposed system would cover multiple greenhouse gases, and the federal government still needs to negotiate how it will harmonize its national plan with the many provincial and regional North American regulatory systems now emerging. Companies may also have a laundry list of ways to comply with their emission targets, including a domestic emissions-trading system, but with only about 700 firms covered by industrial caps, the market may lack liquidity.

Another critical difference is that those emission caps will be based on intensity relative to total production — a gauge more favourable to economic growth, but it may make it hard to forecast supply and demand, and establish the stable carbon price companies need to plan ahead. As well, the proposed Climate Change Technology Fund sets an effective price cap of about $15 per tonne in 2010, which even Environment Canada estimates will be the cheapest compliance option early on. The result? Emissions trading will likely be limited and risky.

“The EU is a very simple system, unlike what is being talked about in Canada,” says Robson. “If we’re going to use a market system, it perhaps would have been better to start it the way the EU did, and get all those really disruptive lessons out in a less challenging way than starting with a very complicated system and hoping it works out better than the EU’s first attempt.”

Phase 1 of the EU-ETS, from 2005 through 2007, did not go particularly well. When compliance data revealed in April 2006 that governments had over-alloted EUAs, the price of carbon plunged from about €30 per tonne to below €10 in a few weeks. A year later, the price had slipped to nearly zero, because Phase 1 EUAs could not be used after 2007.

Changes are now in place for Phase 2, however, and EUAs can be “banked” for Phase 3. The carbon price has remained relatively stable, mostly trading between €18 and €25 a tonne, reflecting confidence that improved forecasting of emission levels will lead to the desired shortfall in allowances — although the first proof won’t come until 2008 compliance results are released next March or April.

“There is a fairly well-shared feeling that emissions trading is definitely the best, or at least the least-worst, policy instrument to put emissions from energy-intensive industries under control,” says Alexandre Marty, who heads up consulting firm ICF International’s climate-change division in London. But, he adds, it’s still an open question how effective the EU-ETS has been at reducing emissions. (Preliminary analysis by two experts from the Massachusetts Institute of Technology does suggest modest emission abatement did occur.) “It’s more likely because the policy-makers didn’t get the allocation levels right in the first place, rather than poor reaction from ETS participants to the signals of the policy instrument itself.”

Challenges remain. Marty argues the market still lacks maturity in how the price of carbon is factored into operating costs and investment decisions. “Everybody is reacting to short-term signals,” he says, especially the spread between prices for coal and gas, because utilities are cutting emissions by switching between these two fuels. For now, other market-based signals as to the future price of carbon are too difficult to interpret.

Uncertainty also surrounds how the regime evolves for Phase 3, beginning in 2013, and whether member states move to protect trade-exposed industries, especially if emissions trading in the U.S., Canada, and Japan doesn’t take off.

So far, though, the EU-ETS has not put the European economy at a disadvantage — proof, some say, that emissions trading works. But the EU-ETS has also demonstrated the importance of liquidity and transparency for a properly functioning market. The steep learning curve the EU continues to ride should give Canadian executives pause about what the next 11 years hold as they try to make sense of Canada’s attempts to engineer a domestic solution to greenhouse gases.