c. Banking of Emissions Allowances

The Framework states:

Facilities would be able to bank allowances for up to two compliance periods (six years). This would be permitted for all allowances, whether allocated to a facility free of charge or purchased from another covered facility. Consideration is being given to including a limit on the total number of allowances that can be banked. [90]

With an emissions cap that decreases over time, it will get harder and harder for companies to meet the required emission reductions. Some banking of emissions allowances is probably necessary to avoid perverse incentives for companies to delay the costs of implementing emission reductions. For example, if a company is able to reduce their emissions by more than they are required to do in a given year, we need them to do so rather than wait until a future year when their emissions limit is stricter. 

However, it is important that allowances not be allowed to be banked forever. One of the stated principles of the Framework is that GHG emissions decline over time. [91] We don’t want a system where companies could wait to develop their oil and gas (for example, if they expect the price of oil to be higher in the future, as it may), then develop and sell it all, dropping a large carbon “bomb” on the world. We also don’t want companies to be able to bank so many credits that Canada’s emissions reduction targets in future years could be in jeopardy.

There is a real risk of creating a glut of emissions allowances.  In other systems used to date this has occurred when, for different reasons, there has been an over-allocation of emissions allowances in early years that firms did not need at the time.  The over-allocation could occur because the regulator estimated poorly and distributed too many.  This is perhaps less of a risk for the Framework, because ECCC has stated – quite rightly – that this cap-and-trade system will be limited to only the oil and gas industry.  When many industries are covered by a single cap-and-trade system, as with California’s, it is difficult for the regulators to get the allocation of allowances right over all the industries, which are then allowed to trade amongst themselves.  

However, there could also be an over-allocation in years such as those that were most impacted by the Covid pandemic, when the world simply could not use or need the regular amount of oil and gas, and so it was not produced.  The temporary decrease in consumption, and therefore production, was an odd side-benefit from Covid.  An event like the Great Recession of 2008-2009 can have the same effect of decreased oil and gas consumption, demand, and production.  It would be perverse to let firms bank their unneeded and unused allocated credits caused by events such these to use long into the future.

Whether from poor estimating by the regulator or by a “black swan” event such as Covid, the result of permitting nearly unlimited banking is, over time, a glut of credits.

This is bad for two reasons:  As discussed above, it sets the stage for a future “carbon bomb”.  Beyond that, though, a glut (in a classic economics 101 example of oversupply) will cause a reduction in price for credits.  The cost of emitting one tonne of carbon could become vanishingly small. Firms will be incentivized to buy extremely cheap credits rather than reduce their emissions, especially given the potential overrun in costs to implement any given emission reduction technology. If it would cost a firm $60 per tonne to retrofit its facility to reduce emissions, but it can buy allowances for $20 per tonne, it will not retrofit its facility.  This would not be a problem if the cap is always set to allow only an emissions level which leads to the targeted reduction and there is no non-compliance (i.e., firms emitting notwithstanding they are over the cap and have not purchased enough credits); but no regulator is capable of perfect foresight and enforcement. There needs to be a mechanism which can quickly reduce a glut when it starts to form and to adjust the cap as needed. 

Experts are warning that this is exactly what is happening in California’s cap and trade system [72], where regulated companies have banked, “a glut of credits that could allow businesses to keep polluting past state limits in later years, after the overall cap becomes more restrictive.” [93] The California Legislative Analyst’s Office has warned that because of excess allowances, actual emissions could be as much as 30% over the statewide target by 2030. [94]

The 2021 Annual Report of the Independent Emissions Market Advisory Committee to the California State Senate Standing Committee on Budget and Fiscal Review explained the scope of California’s problem with overallocation and credit banking:

The market’s third compliance period (2018-2020) resulted in 100 percent compliance. This good news was also accompanied by noteworthy data that indicate a substantial number of allowances were held (or “banked”) in private accounts, raising questions about the program’s ability to contain emissions from sources covered by the emissions cap to adequately support the economy-wide greenhouse gas limit in the years ahead. All told, some 321 million allowances were banked into the market’s post-2020 period, equal to more than the emissions reductions expected from the program over the coming decade. An additional reserve supply of allowances totaling 274 million tons resides in public accounts and could also enter the market, depending on future prices… Whatever the explanatory factors, the number of allowances held in private and public accounts casts uncertainty over the state’s ability to hit its 2030 emissions limit. [95]

“One analyst likened the problem to a game of musical chairs that starts with too many chairs and allows participants to save seats for later.” [96]

The issue has also been a problem for the European Union’s carbon-trading system and for the Regional Greenhouse Gas Initiative, a system among nine [at the time the article was written, but now 11 – see Footnote 84] Eastern American states that deals with credits for the electricity sector. [97]

Learning from the California experience, and given how late the emissions cap will be implemented with respect to 2030 emission reduction targets,  facilities should only be able to bank allowances for a single compliance period (three years), rather than the six years the Framework proposes.

It is troubling that a limit on the total number of allowances that can be banked is described only as being under consideration [98] rather than a definite element of the Framework. Unlimited banking of allowances should be a non-starter if the oil and gas emissions cap is to be effective. The Framework does not propose what the limit on banking allowances could be, leaving that to the draft regulations expected to be released in 2024.  It also does not propose what the emissions allowances will be for each of the years before 2030.  Taken together, we cannot determine the risk of an emissions credit glut being created in even the first few years.  ECCC should have included information both on the credit allowances in the first few years and the limit on credit banking in the Framework.  Since they have not, they should provide it immediately, or at least shortly after the close of this online public consultation, so that people can comment on both issues.  In any event,  ECCC must include a clear limit in the draft regulations, with the percentage set at a low level that takes into account the declining emissions cap in future years. 

Furthermore, the flexibility to bank allowances should be phased out over time, and be completely eliminated well before the Canadian economy reaches net-zero in 2050. This phase-out should have been discussed in the Framework.  Since it was not, ECCC should announce it as soon as possible rather than planning to amend the regulations later, so companies can plan ahead and concerned citizens can hold companies and the government accountable.

Together, these recommendations would reduce loopholes and help ensure the oil and gas cap’s GHG emissions reductions are actually achieved. 

In terms of preventing and/or fixing the problem of a glut of emissions allowances, the European Union has developed an effective solution for its cap-and-trade system known as the EU ETS.  The solution is called the “Market Stability Reserve”:

It works as follows.  The European Commission measures the number of surplus allowances in circulation based on an objective formula.  If that number is less than 400 million, the Market Stability Reserve injects an additional 100 million allowances into circulation.  If the number exceeds 833 million, the Market Stability Reserve absorbs up to 24% of the total by deducting this amount from future years’ auction budgets.  IF the number is between 400 and 833 million, no action is taken.

The practical effect of the Market Stability Reserve is to clear a significant excess buildup of allowances in the EU ETS.  When the EU began its reporting, the number of surplus allowances in the program has hovered in the range of 1.6 to 1.7 billion, close to a full year’s worth of covered emissions…As of the 2019 program year – the most recent available as of this writing – an additional 994 million allowances have been transferred or scheduled for transfer to the Reserve on top of the original 900 million removed under the initial “backloading” initiative [which was an earlier attempted solution that was found to be much less effective].  More will soon follow.

In essence, the Market Stability Reserve provides a kind of central banking function that aims to stabilize prices by altering the supply of money – a Goldilocks strategy for managing allowance supplies.  If the EU market has too many allowances, prices will fall to unacceptably low levels; to prevent that outcome, the Reserve absorbs excess allowances to nudge prices back up.  If the market is too tight, then prices could rise to unacceptable levels; in this case, the Reserve injects new allowance supplies to moderate prices.  If the market’s supply-demand balance remains within a desired range, then all is well and the market is left alone to do its work. [99]

The ECCC should either include a system similar to the Market Stability System in the draft regulations or should include a provision permitting them to do so as they may deem fit. 

Recommendations:

Tell the federal government (using references to the papers we cite here, as you may wish):

• To ensure emissions are reduced as fast as possible and the 2030 target is met, banking of allowances should be limited to a single three-year compliance period, rather than six years. 

• To prevent the accumulation of a glut of emissions credits in the industry, unlimited banking of allowances should not be allowed. A clear limit on the total quantity of credits that can be banked must be included in the regulations, with the percentage set at a low level that accounts for the declining emissions cap in future years.

• To ensure the increasingly strict emissions cap in future years can be met, the regulations should phase out the ability to bank allowances, and completely eliminate it well before Canada reaches net-zero in 2050.

• To help prevent a glut of emissions allowances, the government should ensure this cap-and-trade system continues to cover only the O&G sector going forward. Expanding the cap-and-trade system to cover more industries could lead to an over-allocation of emissions allowances.

• To regulate the quantity of credit allowances on an ongoing basis, in order to prevent either a deficit or a glut, the draft regulations must either include a market regulatory mechanism similar to the EU ETS Market Stability Reserve or a provision that the government may implement such a system without further consultation if it sees fit to do so.