On October 5, 2007, the Montréal Exchange Inc. ("MX") announced that it had filed for regulatory approval of market rules designed to govern the trading of Montréal Climate Exchange ("MceX") environmental products on its electronic trading platform, SOLA®, namely futures contracts on Canadian carbon dioxide equivalent units ("CE2e"). The rules were filed with Québec's regulator of financial markets the Autorité des marchés financiers (Québec) (the "AMF")1. The regulatory process provides for an initial 30-day period of public consultation (now expired) and will be followed by the standard approval procedure of the MX.

The new market rules are introduced by way of additions to or amendments to existing rules. The object of these changes is to permit the listing and trading of futures contracts in CO2e on the MceX. The MceX will initially focus on greenhouse gas ("GHG") emissions and the implementation of a trading system to meet the needs of GHG emitters for reductions in GHGs, which the federal government is expected to impose eventually.

If and when these mandatory reductions targets are imposed, the MceX will provide:

  • A price discovery process that can generate the price signal;
  • Price risk management facilities through futures contracts;
  • A known and respected environment, which is likely to attract liquidity.

The system proposed by the federal government is described as a "baseline and credit system" and is based on the allocation of units to a company for exceeding its intensity based reductions target (1 credit = right to emit one tonne of CO2e). At the end of each compliance year, the emissions of the regulated emitters will be verified. Each regulated emitter must then offset its actual emissions against its established target. Where it has failed to meet its target, the deficit may be offset by, among other things, the purchase of credits on the domestic market.

As part of the federal government's plan published in April 20072, key industrial emitters will be able to choose from one of the three following ways of complying with their GHG emissions reductions obligations in Canada:

  1. Buying one of two kinds of units on the domestic market:
    • Regulated Emitter's Credits, which are credits that will be issued by government authorities at the end of a compliance year to regulated emitters that reach or exceed their GHG emissions reductions targets. These credits can be sold or kept and used to ensure compliance in subsequent years
    • Offset Credits, which are credits that will be attributed to companies that are not regulated emitters but that are involved in voluntary projects to reduce their GHG emissions.
  1. Contributing to a technology fund up to a percentage of the emitter's compliance requirements (70% to begin, and reducing after 2011 until abolition in 2018);
  2. Buying international units, such as certified emission reductions ("CER") under the Kyoto Protocol's Clean Development Mechanism ("CDM") (limited to 10% of the regulated emitter's target).

Although the suggested regulatory framework is viewed by the MX as being less than ideal, it has indicated its intention to proceed with the launch of the carbon market in early 2008.

Detailed Analysis

GHG intensity reductions

According to the federal government's plan, regulated emitters' existing facilities will be subject to an annual mandatory reduction of 6% of the intensity of their GHG emissions from 2007 to 2010, compared to 2006 levels, and an annual decrease of 2% from 2011 to 2020.

New facilities (2004 and after) will not be required to show a reduction for the first three years of operations, but will have to show an annual reduction after that of 2% per annum until 2020 (intensity based).

Two sources of domestic credits

Domestic (Canadian) credits will stem from 2 sources: regulated emitter's credits and offset credits. The federal government anticipates perfect fungibility between these two types of credits, which will form a unique trading and delivery currency and the CO2e futures contracts that the MX intends to list will be based on this unit. Other items to note are that:

  • It is also anticipated that CO2e will be transferable from year to year;
  • Offset credits will be generated from the moment a project provides verified GHG emissions reductions; and
  • Kyoto credits will not be part of the domestic market and will have a separate currency and price.

National Registry

The federal government has announced its intention to set up a national registry (the "Registry") to account for delivered, held, transferred and cancelled units. This Registry will only electronically process cash transactions and will not recognise futures transactions. As a result, although a futures contract could be traded prior to the establishment of the Registry, it must be in place at contract maturity to facilitate physical delivery.

Futures contracts

The two types of futures contracts envisioned are:

  1. Futures contracts with physical settlement; and,
  2. Futures contracts with cash settlement.

Common to both these contracts is the carbon dioxide equivalent CO2e, which will be treated by the MX as a commodity. The size of both contracts will be 100 units. Some other characteristics of the contracts are identified below:

  1. Futures contracts with physical settlement:
  • Will allow regulated emitters to physically obtain units for complying with the Canadian regulatory framework;
  • Expiry of contracts will coincide with the compliance period imposed by the Canadian regulatory framework;
  • A national registry must be set up to allow for the transfer of units from the seller to the buyer via a clearing corporation;
  • Exchange for Physical transactions ("EFP"), Exchange for Risk transactions ("EFR"), Substitution of OTC derivative instruments for futures contracts transactions (Substitution), block trades, pre-arranged transactions and cross transactions will be permitted.
  • An alternative delivery procedure will be established in CDCC's rules;
  • A position limit as well as a minimum position reporting threshold will be set by the MX;
  • CDCC will establish rules in the event of unit shortage;
  • A special cash settlement based on a final settlement price to be determined by the MX in the event the federal regulatory project is abandoned (Force Majeure);
  1. Futures contracts with cash settlement
  • Adapted to the needs of financial stakeholders interested in participation in the carbon market without physical delivery of the underlying unit;
  • Coordination of the expiry of the contracts so as to give flexibility (daily, monthly, quarterly and annually);
  • Upon expiry, all open positions will be settled in cash at a final settlement price based on a method reflecting the market price of the CO2e cash instrument;
  • Exchange for Physical transactions ("EFP"), Exchange for Risk transactions ("EFR"), Substitution of OTC derivative instruments for Futures Contracts transactions (Substitution), block trades, pre-arranged transactions and cross transactions will be permitted;
  • Same force majeure procedure applies as for the futures contracts with physical settlement.

Proposed Regulatory Changes

The proposed rules changes (some of which have already been submitted to the AMF for approval) include:

  • The addition of Rule 6815B regarding the substitution of OTC derivative instruments for futures contracts;
  • The amendment of the list of permissible OTC financial instruments with respect to Article 6815A;
  • The procedure for the execution and reporting of exchange for physical transactions and exchange for risk transactions;
  • The exchange for physical and exchange for risk reporting form;
  • The procedures for the execution of block trades;
  • The procedures applicable to the execution of cross transactions and the execution of prearranged transactions;
  • The procedure for alternative delivery of a CO2e futures contract with physical settlement;
  • The procedure to determine the daily settlement price;
  • The procedure for position limit reporting (any total position exceeding 250 CO2e futures contracts (for a contract of 100 t) or above any other lesser reporting threshold that will be determined by the MX from time to time)

It should also be noted that margins will be subject to the same practices as the ones applicable to all other futures contracts. The MX also wants the Rule regarding position limits to be worded in such a way as to allow it the flexibility to adjust the limits according to the size of the underlying markets.