Until recently, few people in Ontario paid much attention to the "Federal Backstop," the federal carbon pricing system for provinces without a carbon tax or cap and trade program. However, when the provincial government ended Ontario's cap and trade program by repealing the cap and trade regulation effective July 3, 2018, Ontario was suddenly left open to the application of the Federal Backstop.

While the Ontario government is currently challenging the constitutional authority of the federal government to impose the Federal Backstop on Ontario, many Ontario corporations are preparing to comply with the federal regime.

End of Cap and Trade in Ontario

On July 3, 2018, Ontario revoked the Cap and Trade Regulation (Ontario Regulation 144/16: The Cap and Trade Regulation) and all the other regulations under the Climate Change Mitigation and Low-carbon Economy Act, 2016, effectively ending the short-lived cap and trade program in Ontario. The revocation regulation, Ontario Regulation 386/18: Prohibition against the Purchase, Sale and Other Dealings with Emission Allowances and Credits, as its name suggests, also prohibits registered participants in the former cap and trade program from purchasing, selling, trading or otherwise dealing with emission allowances and credits.

Shortly afterwards, on July 25, 2018, the Ontario government introduced proposed legislation to repeal the Climate Change Mitigation and Low-carbon Economy Act, 2016 and wind down the cap and trade program: Bill 4: Cap and Trade Cancellation Act, 2018. The proposed legislation includes provisions regarding:

  1. retiring and cancelling allowances and credits;
  2. government compensation for credits to be paid to participants, subject to a number of limitations (the amount of compensation will be determined in accordance with the regulations, which have not yet been released);
  3. preventing any cause of action from arising against the government as a result of various matters, including the repeal of the Climate Change Mitigation and Low-carbon Economy Act, 2016; and
  4. both extinguishing any existing proceedings and preventing any future proceedings against the government as a result of other specified matters.

Potential compensation for carbon credits

Until proposed regulations under Bill 4 are released, it is still not clear how compensation for carbon credits will play out nor to what extent corporations may experience losses due to past participation in the obsolete cap and trade program.

Based on initial government statements and Bill 4 itself, compensation appears especially uncertain for those who purchased credits in the last auction, those who purchased credits for future compliance periods and voluntary (as opposed to mandatory) market participants. Electricity importers, natural gas distributors and petroleum product suppliers are also currently excluded from compensation. Then again, Bill 4 leaves open the possibility that this exclusion could be modified through the regulations.

Furthermore, there are also uncertainties about how much money is available to reimburse cap and trade participants. The May 2018 Ontario Post-Joint Auction Public Proceeds Report1 states that, cumulatively, the Ontario cap and trade program resulted in over $2.87 billion Canadian of Ontario auction proceeds, which were deposited into the Ontario Greenhouse Gas Reduction Account (renamed the "Cap and Trade Wind Down Account" under Bill 4). The Ontario government has not yet advised how much of these auction proceeds has already been spent and how much remains to potentially reimburse cap and trade participants.

Proceedings against the government regarding the cancellation of Ontario's cap and trade program

Bill 4 includes provisions designed to prevent actions and proceedings against the government by those who oppose the cancellation of the cap and trade program. In particular, the proposed bill makes it clear that no cause of action arises against the government for the retirement and cancellation of allowances and credits, and nothing done under Bill 4 will be considered an expropriation.

That being said, there have already been court challenges regarding validity of Bill 4 itself. On September 11, 2018, Greenpeace Canada brought an application for judicial review against the government for failing to hold public consultations on Bill 4.2 Under the Environmental Bill of Rights, 1993, S.O. 1993, c. 28, the government is required to provide public notice and receive public comment prior to making any environmentally significant decision, including passing Acts or regulations.

On the same day, the government posted a notice of consultation on the Environmental Bill of Rights website and invited the public to comment on Bill 4 until October 11, 2018.3

Ongoing GHG Reporting Obligations for Ontario Businesses

Although the cap and trade program has been cancelled, many emitters will still have an obligation to report on their greenhouse gas (GHG) emissions to the Ontario government. The new reporting regulation (Ontario Regulation 390/18 under the Environmental Protection Act), includes the same regulatory requirements as the repealed Ontario Regulation 143/16, and incorporates the same Guideline for calculating emissions. It applies to iron and steel producers, natural gas distributors, and other entities that were considered "capped participants" under the prior Cap and Trade Regulation.

The main change is the introduction of an additional reporting period for 2018. Mandatory participants are required to submit a report on their GHG emissions from January 1 to July 3, 2018 by October 1, 2018 and have the report verified by an accredited third party by December 1, 2018.

Federal Backstop

Without a cap and trade system or carbon tax in place that meets the minimum federal requirements, Ontario is expected to be subject to the federal carbon pricing legislation, the Greenhouse Gas Pollution Pricing Act,4 also called the "Federal Backstop", which received Royal Assent in June 2018.

The Federal Backstop is expected to be effective on January 1, 2019. The Ontario government is challenging the constitutional authority of the federal government to impose the Federal Backstop on Ontario by joining Saskatchewan's court challenge5 and by bringing its own reference6 to the Ontario Court of Appeal. On October 3, 2018, Manitoba also announced it would no longer impose a carbon tax and would focus on other efforts to reduce GHG emissions as set out in the Made-in-Manitoba Climate and Green Plan.7

The federal government has only released one draft regulation under the Greenhouse Gas Pollution Pricing Act, the Draft Fuel Charge Regulations.8

The Federal Backstop has two mechanisms for pricing carbon:

  1. a charge on fossil fuels for fuel producers, distributors and importers; and
  2. an output-based pricing system for industrial facilities.

Both mechanisms will be discussed in greater detail below.

1. Charge on fossil fuels for fuel producers, distributors and importers

The first mechanism will impact fuel producers, distributors and importers by effectively putting a tax on fossil fuels. The types of fuels subject to the charge include gasoline, aviation gasoline, natural gas, coal, and combustible waste, among others.

Charge rates are set out in Schedule 2 to the draft Act. The charge rates are set for each fuel such that they are equivalent to $10 per tonne of carbon dioxide equivalent (CO2e) in 2018, rising by $10 per year to $50 per tonne CO2e in 2022.

Those subject to the fuel charge must register the day on which the person first produces, distributes or imports marketable fuels. Once registered, a registered entity must file returns with the Canada Revenue Agency and pay its net charge monthly to the Receiver General of Canada.

In general, a Registered Distributor will have to pay the charge when it uses fuel or delivers fuel to a person that is not a Registered Distributor. Registered importers will generally pay the charge when it is brought into the backstop jurisdiction, but a Registered Importer will not pay where they deliver the fuel to a Registered Distributor. 9

Consumers will not pay the fuel charge directly to the federal government. However, the fuel charge may be embedded in the ultimate price paid by consumers if subject fuel producers, distributors and importers pass the costs of compliance onto consumers.

Meanwhile, industrial facilities registered under the Output-Based Pricing System will not pay the charge on the fuels that they purchase. Instead, registered industrial facilities will be subject to a separate carbon pricing regime, as discussed in the subsection that follows.

2. Output-Based Pricing System for industrial facilities

An emissions intensity standard for large industrial emitters

The Output-Based Pricing System (OBPS) Regulations are still undergoing stakeholder consultation. However, based on the current regulatory framework10 and the July 2018 technical backgrounder, "Update on the output based pricing system",11 industrial facilities that emit over 50 kilotonnes (kt) of CO2e annually, are in a Federal Backstop jurisdiction, and engage in an activity with a prescribed output-based standard, will be required to register under the OBPS.12 Facilities that emit between 10 and 50 kt of CO2e annually are expected to be able to opt-in voluntarily to the OBPS by 2020.

The federal government will establish an output-based standard (i.e., a GHG emissions intensity standard) for each regulated industrial sector. This means that facilities participating in the OBPS will be subject to a carbon price on the portion of their emissions that are above a limit, which are determined on the basis of emissions per unit of output. In this way, the OBPS differs from cap and trade systems, such as the former Ontario cap and trade program, that impose a hard cap on total allowable GHG emissions.

OBPS facilities that emit at a lower intensity than the GHG emissions intensity standard for their industry can generate surplus credits that they can use in the future, or sell to another OBPS facility. Therefore, much like cap and trade programs, industrial facilities can stand to make a profit by reducing their GHG emissions.

OBPS facilities that exceed the GHG emissions limit for their industrial sector may cover additional GHG emissions by:

  1. Paying an emissions charge to the federal government (with the amount set by the federal carbon price: $20 per tonne starting in 2019 and rising by $10 each year to $50 per tonne in 2022);
  2. Using OBPS surplus credits issued by the federal government;
  3. Using eligible offset credits; or
  4. Using a combination of any of the above compliance options.13

Ongoing consultation with industry on the output-based standards that will apply

Environment and Climate Change Canada (ECCC) initially proposed setting output-based standards at 70% of an industrial sector's average GHG emissions intensity. However, since its initial proposal, ECCC has been undertaking a more nuanced three phase competitiveness impact analysis that takes into account the effect of carbon pricing on each industrial sector.

ECCC has completed Phase 1 and 2 of its analysis for the following sectors: cement production, iron and steel manufacturing, petroleum refining, food processing, bitumen and heavy oil upgrading, base metal smelting and refining, upstream oil and gas production, oil sands and heavy oil production, natural gas pipelines, lime production, pulp and paper production, nitrogen fertilizer production, ethanol production, potash mining and production, iron ore pelletizing, and all mining.

Based on its analysis, ECCC has made adjustments to the proposed output-based standards. The following four sectors were found to be at risk of decreased competitiveness due to the application of the Federal Backstop. As a result, their applicable output-based standard will be adjusted to 90% of the sector's average GHG intensity:

  1. Iron and steel manufacturing;
  2. Cement production;
  3. Nitrogen fertilizer production; and
  4. Lime production.

In addition, based on the ECCC's current regulatory framework, the starting point for all remaining industrial sectors will be 80% of the sector's average GHG emissions intensity, rather than 70% as initially proposed.14 ECCC is currently working on Phase 3 of its competitiveness impact analysis. Stakeholders have been invited to submit additional information on competitiveness to supplement the results of Phases 1 and 2. Additional industrial sectors may see adjustments to their output-based standards based on the Phase 3 analysis.

After Phase 3 of the analysis is complete sometime this fall, the government is expected to release a detailed document outlining the content of the draft OBPS regulations for comment.

ECCC has advised that the draft OBPS regulations are expected to be released November 1, 2018 and that registration in the OBPS will also begin at that time. Mandatory participants will have to register with both the ECCC and the CRA. The ECCC and the Canadian Revenue Agency have been running joint webinars on the OBPS. You can find their presentation on the OPBS here, ECCC registration here and CRA registration here.

Trade in surplus credits

Under the OBPS, surplus credits can either be banked for future use or sold to other participants in the OBPS program. ECCC is currently developing a system to track the issuance and use of surplus credits.

At this point, only Federal OBPS surplus credits will be accepted to comply with the OBPS. That means that a participant will not be able to submit credits or allowances generated in provinces or jurisdictions that are not subject to the Federal OBPS.

Further, it is uncertain whether OBPS participants will able to sell their OBPS surplus credits for use in other GHG emissions reduction programs in Canada and elsewhere. The credits may not be compatible with cap and trade based systems like the Western Climate Initiative, which impose a hard cap on emissions. However, other jurisdictions with intensity-based GHG emissions trading systems may accept them. The eligibility of surplus credits in other jurisdictions will be an important consideration that may affect the liquidity and, consequently, the value of the credits.

Offset credits

The federal government contemplates OBPS facilities being given the option to use eligible offset credits to cover GHG emissions above the intensity limit for their industrial sector. Offset credits are voluntary activities that avoid, reduce or remove GHGs.15

Credits will be generated through voluntary activities that are not legally required or supported by government funds. Offset credits will also have to be verified by an accredited third-party verification body. The initial focus will be on certifying domestic offset credits. However, international offset credits may be accepted in the future.

Initial consultations suggest a focus on agriculture, land use and waste offsets as they are activities that take place across Canada and are not otherwise covered by the Federal Backstop or provincial carbon pricing systems. Further, if Ontario's former cap and trade system is any indication, there were regulations and protocols in place to manage offset credits for the voluntary capture of landfill gas, mine methane and ozone depleting substances. Corporations, municipalities and other organizations interested in these and other GHG-reduction activities are keen to see what types of projects will be eligible for carbon offsets under the OBPS.

Potential Implications of the OBPS

ECCC notes that the OBPS emissions intensity standard, as a type of emissions intensity standard, is designed to ensure there is a price incentive for companies to reduce their GHG emissions and promote innovation while maintaining competitiveness and protecting against carbon leakage (i.e. the risk that economic activity is displace to another jurisdiction with a lower or no price on carbon pollution or less stringent GHG regulations). Thus, the Federal OBPS may be more favourable to industry than Ontario's former cap and trade system. That being said, the OBPS may be somewhat less effective at achieving the goal of reducing total GHG emissions than cap and trade systems, which impose a hard cap on total allowable GHG emissions.16

Ontario Businesses Can Mitigate Risk During the Regulatory Waiting Game

Currently, Ontario awaits the release of the relevant federal and provincial regulations as well the outcome of the court challenges to the Federal Backstop. The final impact to regulated GHG emitters remains to be seen.

Regardless, however, under Ontario Regulation 390/18, emitters will continue to have report their GHG emissions, even if there are no cost consequences to the amount of GHGs they emit.

Future-ready businesses would also be wise to consider whether they can comply with the Federal Backstop should the federal government succeed in imposing it on Ontario.

Large industrial emitters will have even less certainty about the specifics of the Federal Backstop until the OBPS Regulations are finalized. However, they should be aware that the Federal government will likely impose intensity limits on their GHG emissions, above which emitters will have to pay a price. Much like the former Ontario cap and trade program, the Federal OBPS scheme presents challenges for corporations that rely on carbon-intensive activities, but may also open up potential profit opportunities in the form of saleable carbon credits and, potentially, carbon offsets.

It is a regulatory waiting game, but Ontario businesses may be able to proactively mitigate regulatory risks by ensuring that they can comply with the Federal Backstop.