Emissions trading is a market-driven approach, enabled by legislation/regulation, to address environmental issues such as climate change. The Canadian greenhouse gas (GHG) emissions trading system provides economic incentives for reducing emissions at the least total cost.

Emissions trading originated in the United States (U.S.) to address acid rain caused by sulfur dioxide (SO₂) emissions. The Acid Rain Program, implemented through new federal legislation under the Clean Air Act, set a cap/maximum amount of allowed emissions from electric power plants across the country. The success of the program speaks for itself with 2002 SO₂ emissions recorded at 41 per cent lower than those in 1980 (prior to program). With human health benefits valued at $70 billion annually, the program’s social and environmental benefits clearly exceeded costs by more than 40 to 1. In fact, the cost of meeting the emissions cap was also a quarter of original government estimates and, as a result, the program has encouraged governments to use the emissions trading model to address other pollution types (i.e. GHGs).

While the Acid Rain Program addressed pollutants with relatively localized impacts, GHG emissions are global pollutants. This means a tonne of emissions from Canada, the U.S., Africa or China have exactly the same impact on the environment, in terms of contributing to climate change. Thus, the geographic location of a GHG emission reduction does not matter with respect to the atmosphere. With disparate costs to reduce emissions in different sectors and countries, emissions trading provides a strong economic signal to cost effectively achieve emission reduction targets.

An emissions trading system allows society to address three key policy objectives. First, a government authority sets a target level on the specific pollutant or gas. This sets the jurisdiction’s optimal scale of emissions based on environmental considerations.

Second, the government authority must set out how the target level will be implemented. One way the government could distribute permits to companies is based on their past emission levels (known as grandfathering). These permits could also be auctioned/sold to companies. Another approach is the baseline system, using a forecast of a company’s future emission levels to determine their targets. These allocation strategies address the question of equity because the cost of meeting the emission reduction is determined by how the target level is implemented.

The third policy objective is met when private decision-makers face a common price signal and have an incentive to minimize their own costs. In this scenario, an emissions trading market that creates a price for each unit of emissions can be established. As with all other markets, the price is created through the interaction of supply and demand. The emissions target creates demand for emission reductions. Supply is created based on the distribution of permits or the use of a baseline system. This establishes who has to make reductions and by how much. Groups that exceed the limit may buy emission reduction units to meet compliance. In a cap and trade system the unit is a permit or an allowance. In a baseline system, these units are called credits. Organizations use the price of units traded to measure the value of making internal emission reductions and/or trading permits or credits.

When a government or a company has an emission reduction target, it may only have a certain number of projects or opportunities for reducing emissions within its own operations. These projects or opportunities may also be relatively expensive compared to potential reduction opportunities for another company, sector or even another country. Emissions trading creates a way for organizations to meet their reduction targets at a lower cost by essentially paying others to undertake emission reduction projects. While this may seem like the system allows polluters to simply pay to continue polluting, as long as GHG emissions are being reduced by someone, anywhere in the world, climate change is being addressed. An emissions trading market can be an effective component in the fight against climate change.

The GHG market, particularly in Canada, is still in its infancy. With rules slowly emerging around the offset system and demand being created by regulated and potentially regulated entities a Canadian emissions trading market now has the means to develop.

While GHG emissions trades have already occurred in Canada, these transactions are low in number. They generally comprise bilateral agreements for forward or option streams of emission reductions. Early, higher risk transactions were done in hopes the contracted emission reductions would one day meet the criteria of an anticipated offset system. This transaction process, where buyers and sellers agree to terms, negotiate contracts and deliver offset credits, continues.

Players in the Canadian Market

Aggregator
Ideally, projects are of a sufficient size to justify transaction costs. Sometimes however, buyers will have a larger purchase need than a seller can offer, making the transaction costs too high to justify the sale. Aggregators can solve this problem by bringing several sellers with similar projects together to sell as one, larger project. In addition to increasing the attractiveness of a sale, this process spreads the transaction costs across more sellers. Aggregators may also address the issue of creditworthiness because many are large enough and carry sufficient security to satisfy buyers’ creditworthiness requirements.

Broker/Marketers
Independent brokers will act in any emissions trading system to bring buyers and sellers together and may act on behalf of either party. Brokers are generally paid through a commission on the sale, like a real estate agent, but alternative arrangements are possible. Marketers may also be available to facilitate the process at any other point, such as the production of documents or in project development.

Project Proponent
This is the individual or entity bringing the project/eligible emission reductions through the offset system. The Project Proponent is responsible for all fees and reports to be submitted and must provide proof of his/her claim to the reductions/offsets. Offset credits will be issued to the Proponent. Note: The Project Proponent does not have to be the person undertaking the project. Someone representing the party undertaking the project can serve as the Project Proponent.

Verifiers
All potential offset credits must be verified by an independent third party. The verifier will ensure the quantification protocol or methodology was followed and supporting information to verify a GHG reduction claim is available. When completed, the verifier will produce a verification report for submission to the Offset System Program Authority on the project proponent’s behalf.

Please visit our section on market service providers for more information.

The Emissions Trading Process

In some detail, here are the steps a potential seller could take to negotiate a sale of offset credits in the Canadian market.

1. Evaluate options
2. Prepare an offer/bid
3. Negotiate terms
4. Negotiate contract
5. Delivery

Before rushing into the market, all buyers and sellers should evaluate the options and opportunities before them. Buyers/sellers must evaluate their appetite for risk, the opportunities available and the costs (for the project and transactions) associated with taking action. Entering the negotiating process with a clear understanding of these aspects will ease the negotiation process.

Once the buyers/sellers understand their profile, it is time to create an offer to sell or a bid to buy. If creating an offer to sell, the seller would present the type of project, the number of potential offset credits available, the sale price and any specific terms required. These additional terms could include comments related to securities or defaults. A bid to buy offsets will likely include similar information but will state the price the bidder is willing to pay for potential offset credits.

Finding the other party (buyer or seller) to initiate a transaction can be as simple as a phone call or as involved as hiring a broker to pitch on the seller’s behalf. Until there is a liquid and spot market, finding the other party to the transaction will likely involve some legwork and a lot of phone calls.

The offer/bid produced is not necessarily binding but the final terms of the offer/bid are often agreed to before contracting begins. During this stage, parties may start or even complete the due diligence process. The business terms of the transaction are also signed off by all parties during this stage.

Contracting can be a formality once the terms of the offer/bid are negotiated or it could be a more drawn-out process. The transaction speed will be heavily influenced by the sophistication of the parties, the nature of the transaction and the risk sharing profile.

Transactions for offset credits can occur at any point in the process. That decision is ultimately up to the seller. Some examples of different times for transactions include:

• Prior to the start of the project – provides upfront funding to Project Proponent but carries a higher risk that offset credits will not be rewarded or the anticipated volume will be less than initially proposed. Will likely take the form of an option purchase and the value will not be as high as reductions/removals sold later in the process.
• Following Validation – the value of the transaction increases with some assurance the anticipated volume of offset credits will be accepted. This will likely also take the form of options but a forward stream might be expected.
• After Issuance – once offset credits are actually issued by a designated government authority the value should increase significantly. At this point, transactions are likely to occur on the spot market, in addition to forward stream purchases.

Delivery of the offset credits will vary slightly in Alberta. No credits, per se, will be issues. Rather, it will be up to a regulated entity to report the use of offsets in meeting their compliance requirements. These offsets must meet eligibility criteria and quality assurance as laid out in the Specified Gas Emitters Regulation.

Price Determinants

The price a seller can get for their offset credits will vary according to when they sell, in addition to other factors such as project type, location, securities in the contract and creditworthiness of the seller. Some project types may be more attractive to buyers than others. This could be attributed to the volume of previous offset credits issued for that project type, the attractiveness to buyers or the total number of projects available to purchase from.

Location will be a factor in the value of potential offset credits due to the perception of buyers. For example, a Nova Scotia-based company may prefer Nova Scotia-based offset credits. For the buyer, this scenario would potentially value the Nova Scotia-based offset credits higher than ones from, say, Alberta. Any provincial or international rules, in addition to federal requirements, could also impact value.

The value of the contract will be influenced by the securities provided by both the buyer and the seller. Securities are the guarantees provided in the event of a failure to deliver offset credits. The more security a seller can provide, the higher the value of the contract.

Creditworthiness of the seller is also important. Many LFEs have requirements determining creditworthiness and will not work with sellers that do not meet these requirements. Many sellers do not generally fit these requirements. A seller with the backing to meet such creditworthiness requirements can generally demand a high price in their transaction.

These are only a few of the factors that can impact the value of an offset credit. It is important to take into account project cost and transaction costs in addition to these other factors when determining price.