Setting the Stage

This week, all eyes are on Paris as world leaders converged on the French capital in a multi-national effort to forge a new global climate change agreement. As negotiators now turn their focus on transforming the climate rhetoric into legal text, climate change is back in the global spotlight.  Over the years, climate change policy has experienced its ebbs and flows. Climate change arrived on the international stage at the Rio Earth Summit in 1992, where 154 countries signed the United Nations Framework Convention on Climate Change (UNFCCC) to stabilize atmospheric concentrations of greenhouse gas (GHG) emissions at a level to prevent “dangerous anthropogenic interference with the climate system”. The UNFCCC entered into force on March 21, 1994 and 195 countries have ratified the UNFCCC to date. Subsequent international negotiations led to the Kyoto Protocol, an international treaty which extends the UNFCCC and commits its signatories to reduce GHG emissions. The Kyoto Protocol was adopted in December 1997 and came into force on February 16, 2005. There are currently 192 signatories to the Kyoto Protocol. While Canada withdrew from the Kyoto Protocol effective December 2012, a newly elected federal government has indicated its willingness to re-engage in international talks to reach a new global climate change treaty for the post-Kyoto era.

Following the anticlimactic outcome of the 15th session of the Conference of the Parties to the UNFCCC (COP 15) which produced the non-legally binding Copenhagen Accord in 2009, there is cautious expectation of a legally binding successor agreement – or an agreement that contains certain legally binding components – to the Kyoto Protocol as countries gather for the next round of international climate change talks to be held in Paris from November 30 to December 11, 2015 (COP 21). So what has changed since the Copenhagen climate talks? There are four key international drivers:

  1. Pressure from sub-national and local governments around the world, many of which have undertaken their own initiatives to implement policies and programs to reduce GHG emissions and are now calling for more coordinated national strategies to address climate change. From energy efficiency standards and green building codes, to investments in clean energy and infrastructure, Canadian provinces, territories and municipalities have been leading the way on climate change action.
  2. Calls from industry leaders and investors around the world for governments to put a price on carbon, aimed not only at reducing GHG emissions, but also at facilitating business planning, an “even playing field”, and risk management. The 2014 Global Investor Statement on Climate Change, signed by 385 investors with more than $24 trillion in assets, sets out steps institutional investors (both asset owners and asset managers) can take to address climate change, and calls on governments to support a new global agreement on climate change in 2015. In addition, many companies already operate in countries that have carbon pricing systems in place, so they are incorporating a real or internal carbon price into business planning and investment decisions. According to the CDP (formerly the Carbon Disclosure Project), in 2015, 437 companies are using an internal carbon price ranging from US $6 to US $89 per tonne of carbon dioxide equivalent (CO2e); an additional 583 companies have indicated they will start carbon pricing within 2 years.
  3. The world’s two biggest emitters – China and the United States – have recently made significant commitments to reducing their GHG emissions. In November 2014, the two countries issued a Joint Announcement on Climate Change, pursuant to which the US set an economy-wide emissions reduction target of 26%-28% below 2005 levels in 2025 and committed to make best efforts to reduce its emissions by 28%, while China will achieve peak emissions around 2030 and will make best efforts to peak early. China will also increase its share of non-fossil fuels in primary energy consumption to around 20% by 2030. In August 2015, the US finalized its Clean Power Plan, which will reduce emissions from the power sector to 32% below 2005 levels by 2030. In addition, China plans to a introduce national cap-and-trade program between 2018 and 2020 (covering major industrial sectors) and has committed US $3.1 billion to help developing countries adapt to climate change
  4. Limiting the rise in global temperatures to no more than two degrees Celsius (2°C) has become the de facto target for global climate change policy, which is the level scientists of the Intergovernmental Panel on Climate Change (IPCC) say is needed to avoid the potentially adverse consequences of climate change. The concept of the two degree threshold first emerged in the 1970s, when Professor William Nordhaus suggested that warming of more than two degrees would push the climate beyond the limits that humans were familiar with. The two degree limit was formally enshrined into international climate policy in the 2010 Cancun Agreements, which commits governments to “hold the increase in global average temperature below 2°C above pre-industrial levels”. As the British Met Office reports that global temperatures for 2015 are on track to be 1.02 Celsius above the 1850-1900 average, there is a sense that the window is quickly closing for collective action on climate change.

Together, these factors are pushing climate action to the top of the policy agenda and boosting the anticipation for a meaningful international agreement on climate change.

Role of the Intergovernmental Panel on Climate Change (IPCC)

The IPCC is an inter-governmental scientific body that operates under the auspices of the United Nations. It is the leading international body for the assessment of climate change. Established in 1988 by the United Nations Environment Programme (UNEP) and the World Meteorological Organization (WMO), the IPCC’s mandate is to provide its members with a clear scientific view on the current state of knowledge in climate change and its potential environmental and socio-economic impacts. While the IPCC reviews and assesses the most recent scientific, technical and socio-economic information produced worldwide as it relates to climate change, it does not conduct any research nor does it monitor climate related data or parameters.

Understanding the Concepts (1) – What is an INDC?

Countries participating in the UNFCCC process to create a new international climate agreement have been asked to publicly outline what post-2020 climate actions they intend to take under a new international agreement. These actions are known as their Intended Nationally Determined Contributions or INDCs. In May 2015, Canada submitted its INDC to the UNFCCC Secretariat, pledging a 30% reduction from 2005 levels – approximately 523 Mt – by 2030.  In its Sixth National Report on Climate Change, Environment Canada projected Canada’s emissions to be 815 Mt CO2e, or 11% above 2005 levels, with current measures in place. Given the overall increase in Canada’s emissions over the past two decades and continuing upwards trajectory, achieving Canada’s INDC will require ambitious federal and provincial policies. The new federal Liberal government is expected to update Canada’s INDC following COP 21 and further consultation with the provinces and territories, which was confirmed by Canada’s Environment Minister in November 2015 who said that the current INDC will be considered a floor for future action. As a result, it is widely expected that a new federal climate change strategy will call for more stringent targets and actions.

Understanding the Concepts (2) – What is the Global Carbon Budget?

One of the recent contributions of the IPCC to the climate lexicon is the concept of a global “carbon budget”. The concept of a carbon budget was first articulated in the IPCC’s 2013 Fifth Assessment Report, which addressed the physical basis of climate change. Essentially, the carbon budget represents the amount of carbon dioxide emissions the world can emit while still having a likely chance of limiting global temperature rise to 2 degrees Celsius above pre-industrial levels. According to the IPCC, we have already used 65% of our carbon budget (from 1870 to 2011: we used 1,900 gigatonnes of carbon dioxide (GtCO2), from a total carbon budget of 2,900 GtCO2). If emissions continue unabated, the IPCC estimates we will exceed our budget before the end of 2045.

Understanding the Concepts (3) – What is the Social Cost of Carbon?

For policymakers, the “social cost of carbon” (SCC) is emerging as an important new instrument for pricing carbon. The EPA describes the SCC (which has its origins in US policy processes where new regulations are required to undergo a cost-benefit analysis) as an estimate of the economic damages associated with a small increase in CO2 emissions (usually one tonne) in a given year. The dollar figure then represents the monetized damages associated with an incremental increase in carbon emissions in a given year, which could take various forms including decreased agricultural yields, harm to human health and lower worker productivity –  all related to climate change. The purpose of the SCC is to allow government agencies to incorporate the social benefits of reducing CO2 emissions into cost-benefit analyses of regulatory actions that impact cumulative emissions. While the SCC is meant to be a comprehensive estimate of climate change damages and includes changes in net agricultural productivity, human health, property damages from increased flood risk, and changes in energy system costs, current modeling and data limitations mean that the SCC does not include all important damages. Notwithstanding these limitations, the SCC is a useful measure to assess the benefits of CO2 reductions. The EPA pegs the current dollar value of SCC at US $37 per tonne of CO2  emitted, however researchers at Stanford University have estimated that at US $220 per tonne, the SCC could actually be six times higher than the value that the United States now uses to guide current policy decisions.

Why is Carbon Pricing Important?

Carbon pricing is increasingly seen as the key mechanism by which meaningful GHG emission reductions can be achieved. As a result, there has been growing pressure on governments to account for the societal costs of climate change and put a price on carbon. A price on carbon looks to capture what are referred to as the external costs of carbon emissions, i.e. costs that the public pays for indirectly, such as damage to crops and damage to property as a result of flooding. By placing a monetary value on carbon, governments, business and individuals will have an incentive to change their behaviour to less carbon intensive alternatives.

Market instruments are perceived as providing more cost efficient and flexible compliance mechanisms, so governments are now looking to the market for solutions. There are two main types of carbon pricing mechanisms available to policymakers:

  • Emissions trading systems (ETS) – ETS is a market-based approach used to manage GHG emissions by providing economic incentives for participants to reduce emissions. While emissions trading systems tend to be complex, the economic concept behind it is straightforward – since climate change is a shared global burden and the environmental impacts of reducing emissions is the same wherever the reductions take place, it makes economic sense to reduce emissions where the cost is lowest. Under an ETS, an annual limit or cap is set on the amount of GHG emissions that can be emitted by certain industries. Regulated entities are then required to hold a number of emissions allowances equivalent to their emissions. Regulated entities that reduce their GHG emissions below their target will require fewer allowances and can sell any surplus allowances to generate revenue. Regulated entities that are unable to reduce their emissions can purchase allowances to comply with their target. By creating demand and supply for emissions allowances, an ETS establishes a market price for GHG emissions. In order to achieve absolute reductions in GHG emissions, the limit or cap is gradually lowered over time.
  • Carbon taxes – A carbon tax puts a price on each tonne of GHG emissions generated from the combustion of fossil fuels. The idea is that over time, the carbon price will elicit a market response from all sectors of the economy, thus resulting in reduced emissions. The design and implementation of carbon taxes varies widely across jurisdictions. Design aspects such as the scope of coverage, point of application, and tax rate will depend on the jurisdiction’s energy mix, composition of its economy, existing tax burdens, existence of complementary environmental policies, and political considerations. With respect to scope, some jurisdictions have focused on a narrow category of energy users and large emitters, while others such as British Columbia have adopted a broader scope where the carbon tax covers GHG emissions from the combustion of all fossil fuels. According to the Institute for European Environmental Policy, there are currently no schemes that cover all GHG emissions in a given jurisdiction.

The key differences between the mechanisms are that with an ETS, the quantity of emission reductions is known, but the price is uncertain.  With a carbon tax, the price is known, however the quantity of emissions reductions is uncertain. A tax requires decisions on the scope and rate of the tax, while within a trading system, a firm can acquire or bank emission allowances over multiple years depending on the program – emissions trading offers a broader range of compliance options, thus increasing flexibility for participants and potentially lowering compliance costs.  Both carbon pricing mechanisms can generate revenue that can be used to lower other taxes or invest in “green” initiatives. Both mechanisms also have related monitoring, reporting, verification and compliance obligations, and both need special provisions to minimize the effects on certain energy intensive, trade exposed industries. The choice of the instrument will depend on each jurisdiction’s national and economic circumstances. There are also more indirect carbon pricing tools, such as fuel taxes, the elimination of fossil fuel subsidies, and regulations that incorporate a social cost of carbon.

In its report, State and Trends in Carbon Pricing 2015, the World Bank and Ecofys estimate that almost 40 countries and more than 20 cities, states and provinces currently use carbon pricing mechanisms or are planning to implement them. These jurisdictions are responsible for more than 22% of global emissions. Others are developing or considering systems that will put a price on carbon in the future. Altogether, these actions will encompass almost half of global CO2 emissions.  While climate policy in jurisdictions around the world tended to lag early on, recent developments have signaled a general move towards cap-and-trade as the preferred market tool for addressing climate change. In North America, both Québec and California launched cap-and-trade systems in January 2013 and linked their programs one year later, creating North America’s largest carbon market. Ontario’s cap-and-trade program is expected to come online in 2017, which will link to the existing programs in Québec and California. In January 2009, the Regional Greenhouse Gas Initiative (RGGI, comprising nine states in the US Northeast) began operating the first market-based regulatory program in the United States to cap and reduce CO2 emissions from the power sector.

At the international level, the European Union ETS has been in operation since 2005 and represents the first, and still the largest, global system for trading emission permits. Together with Québec and California’s system, and the launch of a cap-and-trade system in South Korea, the World Bank estimates that as of April 1, 2015, the value of global emissions trading systems was approximately US $34 billion, while carbon taxes were valued at about US $14 billion.  China is also moving towards cap-and-trade and recent bilateral discussions between China and the United States could eventually lead California to link its cap-and-trade market with China’s regional cap-and-trade markets, which are currently in their pilot phase.

The following provides a snapshot of current carbon pricing initiatives around the world:

  • Québec and California launched emissions trading systems in 2013 as part of the Western Climate Initiative (WCI), which were formally linked in 2014. Ontario, also a member of the WCI, has announced that it will implement a cap-and-trade program, which will likely start trading on January 1, 2017. The WCI was formed in 2007 by a group of US states and Canadian provinces (including BC, Manitoba, Ontario and Québec) that decided to adopt a common approach for addressing climate change, in particular by designing and implementing a North American system for capping and trading GHG emission rights. The WCI has since been succeeded by the Western Climate Initiative, Inc., a non-profit corporation established to provide administrative and technical services to support the implementation of state and provincial GHG emissions trading programs.
  • BC has implemented a broad based, revenue neutral carbon tax of CAD $30 per tonne of CO2 Virtually all emissions from fuel combustion in BC are subject to the carbon tax and all carbon tax revenue is recycled through tax reductions.
  • China launched pilot emissions trading systems in seven cities and provinces (including Beijing, Tianjin, Shanghai, Chongqing, Hubei, Guangdong, and Shenzhen) in 2013 and 2014 and plans to launch a national system between 2018 and 2020. A voluntary emissions trading market has also been active in China since 2008. In 2009, the “Panda Standard” (a voluntary carbon standard) was issued. China’s has set a target of reducing CO2 emissions intensity by 40-45% below 2005 levels by 2020, and 60-65% below 2005 levels by 2030.
  • South Korea’s cap-and-trade system started on January 1, 2015 and forms part of the country’s efforts to meet its GHG emissions reduction target of 30% below business-as-usual by 2020. Approximately 525 companies are subject to the South Korean cap-and-trade program, which covers about 68% of the country’s total GHG emissions.
  • The European Union (EU) ETS, launched in 2005, has the distinction of being the world’s first emissions trading system. The system covers more than 11,000 power stations and industrial facilities, along with airlines, in the 28 EU member states plus Iceland, Liechtenstein and Norway. In total, around 45% of total EU emissions are subject to the EU ETS. The system remains the world’s largest emissions trading market, accounting for more than three-quarters of international carbon trading. As many as 40 million allowances have been traded per day. In 2012, 7.9 billion allowances were traded with a total value of €56 billion. Reforms are being considered for the EU ETS, which has struggled with low prices and an excess number of allowances in the past.
  • Mexico introduced a carbon tax in 2014 with an initial price of US $3.5 per tonne of CO2e that applies to the use of fossil fuels (natural gas is exempt from the tax). Mexico also has a voluntary carbon market and has implemented climate change legislation, the General Climate Change Law, which seeks to reduce GHG emissions by 30% below a business-as-usual scenario by 2020.
  • Chile will become the first South American country to implement a carbon tax in when large power generators operating thermal plants (with installed capacity equal or greater than 50 megawatts (MW)) will be required to pay US $5.00 per tonne of CO2 starting in 2018 (thermal plants fueled by biomass and smaller installations will be exempt). Chile has set a voluntary target of cutting GHG emissions 20% from 2007 levels by 2020.

Industry Leads the Way

In recent years, companies have been working hard to reduce their carbon footprints and signal corporate support for the transition to a lower carbon economy. In particular, an increasing number of companies are setting emission reduction targets and taking action to address climate change impacts in both their own operations and their supply chain. Since many companies operate in jurisdictions where GHG emissions are subject to mandatory emission reduction program or carbon taxes, they are well attuned to carbon pricing issues as a response to the regulatory environments in which they operate. However, given the diversity in scope and timing of climate policies, companies are faced with having to consider multiple carbon compliance costs in their business decisions. As a result, there have been increasing calls from the private sector on governments to establish clear pricing and regulatory certainty to support climate-related investments and climate risk assessment efforts. In the meantime, companies have been managing their emissions, assessing risk and developing business plans based on a real or internal carbon price that is incorporated into their planning and investment decisions. This means that companies worldwide are already advanced in their use of carbon pricing and in planning for climate change risks, costs and opportunities.

As climate negotiators break the issues down for discussion, compromise will be crucial to overcome the wedge issues of binding emission reduction commitments, climate finance and transparency in reporting and monitoring. Stay tuned for further developments.