Will weak cap-and-trade auctions threaten Ontario’s climate plan?

By Brian Platt, Special to TVO.org - Published on May 31, 2016
Cap-and-trade will set overall limits on greenhouse gas emissions and fund electric cars, building retrofits and other environmental projects.

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Something went wrong in the most recent cap-and-trade auction held by California and Quebec. Only 11 per cent of the total allowances were sold on May 18, leaving the two governments hundreds of millions of dollars short from what they were expecting.

Cap-and-trade auctions deal in greenhouse gas emissions allowances, a limited number of which are issued by the government. Every firm needs to buy enough allowances to cover its emissions, though for a transitional period the government gives some away for free to large polluters and trade-exposed industries. The allowances can then be traded among firms, with heavier polluters buying extra allowances from lighter polluters.

The recent California and Quebec auction result could bode ill for Ontario’s entry into the cap-and-trade market. The system that's starting up in Ontario next year is more than just a mechanism for setting an overall limit on greenhouse gas emissions. It's also the source of funding for billions of dollars the province plans to spend over the next few years on electric car incentives, energy retrofits for buildings, and many other environmental initiatives that are crucial to achieving Ontario's emissions reduction targets.

While experts caution that the auction’s underselling was just one instance, repeated poor performance would leave Ontario scrambling to find money for its climate change action plan. Ontario's partners in the program, California and Quebec, have been holding joint auctions since the fall of 2014. Each one is big money: California brings in about C$780 million for state coffers from every auction, while Quebec brings in about C$200 million.

There were signs the market was starting to weaken this spring. After five joint auctions that sold out completely, the sixth one held in February sold 95 per cent of the allowances on offer. But nobody expected the May auction to sell just 11 per cent of allowances. As a result, important publicly-funded projects — such as California’s high speed rail plans — are facing a serious funding crunch.

It raises a troubling question: What happens if Ontario commits to huge new spending programs based entirely on cap-and-trade proceeds, but then the money disappears?

Joining California and Quebec to create one large carbon trading market comes with benefits such as added flexibility in the market, which puts much less cost on Ontario businesses than if the province had tried to go it alone. But it also makes the system enormously complex, and the most worrying thing about the recent auction is nobody knows for sure why it failed — or whether it might happen again.

The main theory among economists and other close observers of the cap-and-trade system is that two factors have combined to weaken the market for allowances. First, California has over-supplied its market (which is about double the size of Ontario's and more than triple the size of Quebec's) with allowances, in part to ensure prices don't sky-rocket unexpectedly and impose heavy costs on industry. Secondly, ongoing lawsuits and political uncertainty in California have businesses worried about stockpiling too many allowances, just in case cap-and-trade doesn't stick around for the long term.

"There's a lot of allocations in the system, and then a bit of uncertainty kicking around," said Dave Sawyer, whose firm EnviroEconomics has done cap-and-trade analysis for Ontario's environment ministry.

He said businesses have likely bought the allowances they need for the current compliance period, but are cautious about buying up more for the next one.

"Compliance periods are three years, so businesses have time to basically sit back and let a couple of these auctions slide, and see how things move."

Duncan Rotherham, a vice president at ICF International who has worked on cap-and-trade modelling for Ontario energy firms, agreed the market is over-allocated — but also said the most recent auction result was a surprise.

"We did expect (the auctions) to be more and more under-subscribed, but not this much this quick," he said. "And it's completely unclear whether the Ontario government's factored that into their decision-making vis-à-vis how they're going to deploy the proceeds and what's going to be funded."

Ontario's climate change action plan has been the source of controversy, since a leaked version of the $7-billion spending plan appeared in the Globe and Mail two weeks ago. Premier Kathleen Wynne has since been putting out political fires over whether the province is phasing out natural gas heating. The final version of the plan is expected in early June.

But the province has already been making big announcements that rely on funding from cap-and-trade auctions, including a $900 million program to retrofit social housing apartments. Earlier announcements worth $325 million were characterized as a "down payment" on cap-and-trade proceeds.

Environment Minister Glen Murray said he's not particularly worried about the money for those programs vanishing in stagnant auctions.

"This was one auction. That's like saying we had a thunderstorm yesterday and lightning hit my building, and what would happen if that happened every day?" he said.

"There is a cycle to carbon markets relative to the compliance period ... If this happens several times, yes, obviously we'd be concerned. We don't expect it to happen several times."

Ontario will be sheltered during the first year of its cap-and-trade system, when the auctions are isolated within the province and every company subject to the cap will need to fill up on allowances. But in 2018, Ontario will start holding joint auctions with California and Quebec. That's when a weak market could start seriously harming government revenues.

The next California-Quebec joint auction is scheduled for August. If that one performs poorly again, policymakers will start scrambling to find a fix.

But for now, Murray is preaching calm.

"Nothing that's happened so far is unexpected or outside the series of events that we thought might happen," he said. "We know in the earlier years, until the market is mature, you'll see more dramatic swings."

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