Ontario’s cap and trade fraught with regulatory and market challenges

June 3, 2016 - On the second floor of Royal Bank of Canada’s headquarters in Toronto’s financial district, traders Ryan Holm and Rostik Radik buy and sell allowances in a carbon market that will serve as a crucial element in Ontario’s ambitious effort to reduce greenhouse gases.

Under the province’s recently adopted cap-and-trade system, Ontario plans to link its carbon market with that of California and Quebec in 2018 under the Western Climate Initiative. The market-based approach is touted as economically efficient because it reduces compliance costs by allocating capital to those companies that get the most bang for the buck in terms of greenhouse gas (GHG) reductions.

Indeed, Ontario companies that face GHG caps are expected to rely heavily on imported allowances that are cheaper than the cost of reducing emissions themselves. Ontario companies could send an estimated $250-million (U.S.) a year to California by 2020 to purchase the right to emit carbon pollution – just as Quebec-based firms are now able to buy allowances generated in the state.

Getting it right is critical for the country’s largest economy, which has already taken a big hit to its industrial base from the recession and competitiveness challenges.

Toronto’s financial sector could emerge as a major trading centre for the North American carbon markets. “Given we are going to have an Ontario cap-and-trade, everybody should see this as an opportunity for Toronto and Ontario to be at the forefront of this climate market,” said RBC Dominion Securities’ Mr. Radik, who trades emission credits from Europe, the Western Climate Initiative, and a northeastern U.S. states’ electricity market.

A spokesman for Environment Minister Glenn Murray said the government is eager to bolster Toronto’s financial strength as it pursues carbon markets. “As the second-largest financial services centre in North America and home to the Toronto Stock Exchange, Ontario’s financial sector is well positioned to provide these services and then leverage this expertise to serve other growing carbon markets in Canada and internationally,” David Mullock said in an e-mail.

But companies that distribute and burn fossil fuels are anticipating rising energy costs that they will pass through to their customers. Enbridge Gas Distribution, Union Gas, Suncor Energy Inc. and Imperial Oil Ltd. will have to account for carbon dioxide emitted by the burning of natural gas – whether in home heating or power generation – or by the combustion of gasoline and diesel in cars and trucks.

The Liberal government is determined to hit its target of reducing GHGs by 15 per cent from 1990 levels by 2020, meaning the province has to cut annual emissions by another 18 megatonnes over the next four years. Linking markets with California and Quebec would dramatically reduce the costs of achieving that goal, according to economist David Sawyer, who consulted with the government on the plan.

An Ontario-alone approach would require an effective carbon price of $157 (Canadian) a tonne by 2020, compared with $18 in the linked-market approach, Mr. Sawyer calculates. Hitting the 2020 target under part of the Western Climate Initiative would have a negligible impact on provincial GDP, the economist said, while a go-it-alone strategy would shave nearly half a point off the Ontario economy in 2020.

However, lawyers working in the field warn that, in designing the trading system, the province has imposed regulations that will reduce its effectiveness.

In a letter sent to the Ontario Ministry of Environment and Climate Change in March, three lawyers working with the University of Toronto’s Environmental Finance Advisory Committee laid out a series of concerns.

In legislation that was passed into law last week, the lawyers say it’s unclear whether allowances and credits will be deemed as property, an uncertainty that creates a disincentive for people to trade and hold them. There is a prohibition on “beneficial ownership,” a common securities practice that facilitates financing by reducing holding costs. And market participants face overly onerous registration requirements that will discourage activity and reduce liquidity, they say.

“There’s no point in creating a market and then not making it operate efficiently,” Gray Taylor, one of the co-authors of the brief, said in an interview. “If we’re going to do this thing on a cost-effective basis, the focus on making the market work is very important.”

The government maintains it has to balance efficiency with regulations that ensure market integrity. “Those who participate in the market will be required to adhere to rigorous reporting standards,” Mr. Mullock said. “As our program matures, we will review the program to ensure processes are streamlined as much as possible while maintaining market integrity.”

Meanwhile, the California market has come under fire after an auction last month generated just 10 per cent of the revenue the state had anticipated. Critics say California has put too many emission allowances into the market, although there were also a number of temporary factors that added a great deal of uncertainty to the market.