Clean Energy Canada | A Cap and Trade Primer: The Mechanics and Impacts of Quebec’s Cap and Trade System
April 16, 2015
On January 1, 2013, Quebec took a bold step toward fighting climate change by launching a cap and trade system under the Western Climate Initiative’s (WCI) carbon market. A year later, when Quebec linked its system with California’s, it created North America’s largest carbon market.
While it is too early to draw conclusions on Quebec’s long term economic performance under the cap and trade system, a great deal remains to be learned from how the system came together. Quebec is the first subnational jurisdiction in Canada to develop a cap and trade system, and the first in Canada to do so under the Western Climate Initiative. Thus far, the system has also survived two changes in government.
What is cap and trade?
Cap and trade is a form of market regulation applied to greenhouse gas (GHG) emissions.
The “cap” puts a limit on the maximum amount of GHGs that can be emitted, which is then translated into a number of allowances. Allowances can be distributed free to some or all covered entities or auctioned to highest bidders within a competitive bidding process; each emission unit usually represents one tonne of GHG.4 Companies must match their emissions to their allowances. Over time, the overall cap is lowered, leading to reductions in GHGs.
The “trade” creates a market for emission or carbon allowances. A company that is part of a capped sector must report its total emissions. If its emissions are equal to its allowances, then the emitter is compliant. At the end of the compliance period (in Quebec, three years), the emitter must return its allowances to the regulator.
If total emissions come in below the allocated allowances, the company has unused allowances — a surplus — which it can then choose to bank, surrender (for compliance during the current compliance period) or trade with other companies/entities that are part of the market. If the emissions are greater than the allowances allocated, then the company must purchase allowances from those who have them for sale, at auction, or acquire offsets (see below). If the company does not have enough allowances or offsets to cover their emissions, the regulator will impose penalties.
Surplus allowances are traded and priced according to supply and demand. As the regulator gradually lowers the cap on emissions, fewer allowances are available. This creates a demand for allowances, which increases their value or price. Over time, industries that use carbon-intensive technology will find it more economical to upgrade to lower- carbon technology to reduce their need for allowances.
What is an offset?
Offsets are initiatives undertaken by non-regulated industries that reduce or remove greenhouse gas emissions, and which can be sold to emitters to help meet their compliance obligations. To be eligible as an offset, the regulatory authority must validate projects. In Quebec and California, offsets are limited to eight percent of the compliance obligation.
How does it work?
- In Quebec’s system, sectors perceived as trade-vulnerable receive emission allowances free of charge. These sectors include: aluminum, lime, cement, chemical and petro- chemical industry, metallurgy, mining and pelletizing, pulp and paper, and petroleum refining, among others.
- Emission units not allocated free of charge are auctioned off, at most up to four times a year. Since January 2014, Quebec and California have held these auctions jointly.
- The higher of Quebec or California’s minimum prices, at the predominant exchange rate, sets the price floor at auction. The final sale price of each emission unit is the lowest price bid for which the last emissions unit is awarded.
- In Quebec’s cap and trade system, trading period is referred to as the “compliance period”. Allowances are allocated and auctioned within this period.
- Compliance periods last three calendar years each as of January 2015 (2015-2017, 2018-2020, and so on). Rules pertaining to the free allocation of allowances are only set by regulation until 2020. All allowances have to be surrendered by the first of November following the end of the compliance period.
What does the system cover?
- The system covers persons or municipalities operating a facility with annual GHG emissions greater than or equal to 25,000 tonnes of equivalent carbon dioxide a year.
- It covers close to 85 percent of Quebec’s GHG emissions. At its outset in 2013, this included the industrial, manufacturing, and electricity-generating sectors. In 2015, coverage expanded to include GHG emissions related to the use and combustion of fossil fuels that are sold or distributed.
- In addition, the cap and trade system is open to individuals or entities that would like to participate in the carbon market, even when there is no regulatory obligation for them to do so.
How are Emission Units Distributed?
- For 2013/2014, industrial emitters exposed to foreign competition received most of the emission units they needed free of charge so as to prevent “carbon leak- age” — that is, the movement of companies to jurisdictions without a cap and trade system.
- Beginning in 2015, in order to encourage GHG reductions, the number of free units decreases at a rate of one to two percent per year.
- Electricity and fossil fuel distributors don’t receive free allocations.
All proceeds of the auction of units go into Quebec’s “Green Fund” to finance various initiatives outlined in the province’s 2013 – 2020 Climate Change Action Plan. These include public transit, research and innovation, green energy, and dealing with residual municipal solid waste.
The above originally appeared in Inside North America’s Largest Carbon Market: Ten Lessons From the Front Lines of Quebec’s Fight Against Carbon Pollution. For references, please see the original document.