U.S. House passes American Clean Energy and Security Act

While Canadian market participants are understandably focused on our own emerging climate-change regulatory framework, it is important to keep up to date on U.S. developments and their potential implications for our markets and industries. This short article provides a high-level overview of key features of current U.S. federal legislative initiatives and their possible effects north of the border.

Key features of ACES

On June 26, 2009, the American Clean Energy and Security Act (H.R. 2454, the Bill or ACES) was narrowly passed by the U.S. House of Representatives. The passage of the Bill is the first major step in the U.S. towards the institution of federal climate change and greenhouse gas (GHG) reduction legislation. ACES' key policy objectives are set out in its four main titles:

  1. Clean Energy. Establishes a national renewable energy standard and promotes renewable energy, carbon capture and sequestration, and smart grid technology;
  2. Energy Efficiency. Increases energy-efficiency standards in household appliances and various industries and public institutions;
  3. Reducing Global Warming Pollution. Establishes a nationwide cap-and-trade program to reduce GHG emissions; and
  4. Transitioning to a Clean Energy Economy. Supports the transition to a low-carbon, energy-efficient economy for both industry and consumers.

Several features are worth particular mention. The Bill amends the U.S. Clean Air Act to bring GHG emissions from regulated sources to 97% of 2005 levels by 2012, 83% by 2020, 58% by 2030, and 17% by 2050. In connection with its framework for a carbon market, it provides for the trading, banking and borrowing, auctioning, holding and retiring of emissions allowances. The Bill also gives the Commodity Futures Trading Commission jurisdiction over the establishment, operations, and oversight of markets for regulated allowance derivatives.

In order to gain the support needed to pass the Bill in the House, several notable amendments were made:

Credit allocations. The cap-and-trade proposal in the Obama budget called for 100% of emission allowances to be auctioned. ACES falls well short of that target by initially allowing only 15% of allowances to be auctioned, while the other 85% are to be allocated for free to emitters. Refineries secured a larger allocation than was originally intended under the version of the Bill first introduced in the House. These changes are viewed as a necessary compromise designed to gain the support of congressional representatives of industrial and coal-burning states.

Agriculture and forestry. In last-minute negotiations during the drafting of final amendments to ACES, major concessions were secured by the agriculture and forestry lobby. The final version of the Bill effectively excluded these industries from the definition of "capped sectors," while leaving responsibility for developing a program for the generation of offsets in these sectors to the United States Department of Agriculture (USDA) rather than the Environmental Protection Agency (EPA). These changes are significant because it was originally intended that all sectors of the economy would be covered by the cap-and-trade regime, and many suspect that the USDA will be more permissive than the EPA in developing an offset program for agriculture and forestry.

Senate response to the bill

Democratic Party leaders had set an end-of-summer deadline for bringing a climate-change bill to the floor for a vote, but because the Senate has been preoccupied with health care and other initiatives, that deadline has now been pushed back. According to a spokesman, Senate Majority Leader Harry Reid "fully expects the Senate to have ample time to consider this comprehensive clean energy and climate legislation before the end of the year." Passage by the end of 2009 would be symbolically significant, as the United Nations is scheduled to hold a global summit in Copenhagen in December on the topic of the next steps on controlling GHG emissions after Kyoto expires in 2012.

Speculation is rampant as to whether the Democratic Party leadership in the Senate can muster the sixty votes needed to avoid a Republican-backed filibuster. With some moderate Democrats joining many Republicans in opposition to the current bill, Senate Environment and Public Works Committee Chairman Barbara Boxer and Senate Foreign Relations Committee Chairman John Kerry have indicated they need time to work out mutually acceptable language. Among the concerns expressed by some senators who are considered swing votes is the prospect of price instability as experienced following the implementation of the European Union Emission Trading System. Senator Boxer is considering a price collar on emission allowance prices to provide greater cost certainty. Arkansas Democrat Blanche Lincoln has described ACES as "deeply flawed," citing its adverse impacts on smaller oil refineries such as those in her state. Ten other Democrats, representing states with significant manufacturing industries, wrote to President Obama to communicate support for inclusion of a "longer-term border adjustment" in climate legislation to ensure that energy-intensive jobs and industries do not leave the U.S. for non-carbon-constrained countries.1 The fact that many of the undecided senators come from coal and manufacturing states (or from Sunbelt states that would experience the sharpest increases in energy costs under the proposed legislation) is an indication of the difficulties that ACES may be facing.

Canadian business under ACES

Canadian businesses will be affected by a U.S. climate-change regulatory regime, no matter what form it eventually takes. Until the Senate passes its own version of the Bill, the nature of its impact will not be understood with any certainty. However, based on the current form of the Bill, it is clear that Canadian businesses will be forced to consider the following issues:

Trade

As mentioned above, many senators are insisting that climate-change legislation include a broad carbon tariff that goes beyond ACES' more limited tariff on "carbon-intensive" goods. A carbon tariff would prevent the occurrence of "carbon leakage" as U.S. industries lose competitiveness to jurisdictions that do not price carbon to the same standard. Similarly, the inclusion of subsidies in ACES to offset the cost increases associated with pricing carbon borne by U.S. companies may distort the dynamic of cross-border competition. Canadian businesses, many of which are reliant on cross-border trade with the U.S., could stand to win or lose - depending on how the Senate crafts its final version of the Bill and how Canadian authorities choose to respond to its impact on trade.

If the Senate passes a version of ACES that does incorporate tariffs, subsidies or other trade barriers, those barriers would certainly be challenged in an international forum such as the World Trade Organization (WTO), the General Agreement on Tariffs and Trade (GATT) or the North American Free Trade Agreement (NAFTA). However, the U.S. could potentially assert a right to implement a tariff or subsidy through an exception under GATT or NAFTA. For example, pursuant to Article XX of GATT, WTO members are authorized to adopt measures that are (i) necessary to protect human, animal or plant life or health, (ii) relate to the conservation of exhaustible natural resources, or (iii) secure compliance with national law, so long as such measures are made effective in conjunction with restrictions on domestic production or consumption. These exceptions are subject to the requirement that such measures are not applied in a manner that would constitute a means of arbitrary or unjustifiable discrimination between countries where the same conditions prevail, or a disguised restriction on international trade. NAFTA also contains similar provisions that can potentially be used to justify a carbon tariff.

A possible response to an import tariff under U.S. federal cap-and-trade legislation by the Canadian government, apart from a WTO/NAFTA challenge in the short term, would be to implement its own equivalent regime to address climate change. In this event, the Canadian government would become the recipient of the tariff revenue (or equivalent) that would otherwise flow to the U.S. government.

Oil sands

Canada has the second-largest proven oil reserves in the world. Many view the viability of the Alberta oil sands as a major determinant of overall Canadian prosperity. However, the extraction and refining of tar sands is an energy-intensive process that produces substantial amounts of GHGs, and any attempt to curb GHG production will inevitably have a dampening effect on the overall economic activity in the oil sands and Alberta as a whole.

Earlier versions of ACES threatened Alberta oil directly, reflecting sentiments expressed publicly by President Obama that the U.S. would seek to avoid fuels with large associated environmental impacts. Early drafts of ACES provided for a low-carbon fuel standard, similar to that created by Governor Schwarzenegger in California, requiring that annual average lifecycle GHG emissions from transportation fuel not exceed the annual average lifecycle GHG emissions from transportation fuel in 2005. While this proposal would have significantly reduced the viability of Alberta oil as a marketable fuel source in the U.S., it has since been dropped - although a less-targeted carbon tariff on Alberta oil could still emerge in the Senate bill.

Agriculture and forestry

As GHG emissions in the U.S. agriculture and forestry sectors would not be regulated under ACES, there is obviously no significant concern that trade barriers would be erected by the U.S. to compensate for an ACES-related reduction in U.S. competitiveness. It also seems likely that any cap-and-trade regime instituted in Canada would follow the U.S. lead by not regulating these sectors. However, in the event that Canadian officials were to implement a cap-and-trade or other GHG reduction regime that did include agriculture and forestry, concerns over competitiveness would be felt domestically. This could lead Canada to impose its own version of an import tariff designed to prevent carbon leakage from Canada to the U.S. Such a move would undoubtedly subject Canada to attack through the WTO, NAFTA etc., as discussed above, and could create grounds for the imposition of countervailing measures by Canada's trading partners. Canada's regulatory approach on this matter will therefore be critical to the prospects of the domestic agricultural and forestry sectors.

International offsets

ACES would permit capped entities to hold an international emission allowance in lieu of a domestic emission allowance, subject to certain conditions. Were Canada to create a cap-and-trade regime, therefore, Canadian entities would be able to sell or transfer their unused allowances to U.S. entities, including their U.S. subsidiaries and parents. The transferability of allowances provided for in ACES would make Canada/U.S. carbon regulation a cross-border exercise.

The Senate version of the Bill currently provides for the differential treatment of international offsets as compared to offsets generated within the U.S. Each entity subject to an emissions cap may satisfy a percentage of the number of allowances required to be held by holding 1 domestic offset credit or 1.25 international offset credits in lieu of an emission allowance. This differential treatment takes effect in 2018. Until then, domestic and international offsets will be accepted at par.

Whether this is a step to protect the integrity of the cap-and-trade regime from non-compliant offsets or whether it is designed to protect and foster a domestic offset project market in the U.S. is not clear. In either case it is a key regulation that will materially affect the growth of the Canadian offset market. All else being equal, if passed by the Senate such a provision will make it likely that only short-term Canadian projects (i.e. five years or less) that can take advantage of the at-par treatment between 2012 and 2017 will be competitive with U.S. projects, if the offsets generated by them are to be marketed in the U.S.

Conclusion

What should be apparent from the foregoing is that the climate change initiatives in the U.S. need to be carefully followed by the Canadian marketplace, as it is highly likely that U.S. legislation would have significant consequences for Canada.