Canada: Focus on Climate Change, May 2005

Originally published in May 2005

Introduction

The Kyoto Protocol to the United Nations Framework Convention on Climate Change (the "Protocol Protocol") entered into force on February 16, 2005 and committed thirty industrialized countries to reduce or limit their greenhouse gas ("GHG GHG") emissions for the period between 2008 and 2012. Under this new treaty, Canada has committed to a reduction of 6% below 1990 levels – a reduction which translates into a so-called "Kyoto Gap Gap" of 270,000,000 tonnes of carbon dioxide equivalent ("tCO 2e")1 or 270 Mt per year. In response, the federal government has been active in 2005 regarding climate change and has released the following in rapid succession:

• the 2005 Federal Budget ("Budget 2005 2005") was announced on February 23, 2005;

• Bill C-43, the Budget Implementation Act, 2005 ("Bill C-43 43"), was tabled in Parliament on March 24, 2005; and

• Project Green: Moving Forward on Climate Change – A Plan for Honouring our Kyoto Commitment (the "2005 Plan Plan") was released on April 13, 2005 to explain the federal government’s plan to comply with the Protocol.

These initiatives are subject to the passage of both Budget 2005 and Bill C-43 through Parliament. While uncertainty surrounds the longevity of the current federal government, extensive impacts would occur across Canada if these initiatives are indeed implemented. These proposals are summarized below. FMC continues to monitor these initiatives and will provide further information when available.

The total cost between 2005 and 2012 for these initiatives can be estimated as approaching $15 billion (each further discussed below): new federal funding ($7.8 billion); existing federal funding ($2.8 billion); provincial funding under the Partnership Fund ($1.0 billion); maximum cost to Large Final Emitters ($3.4 billion).

These initiatives can be divided into four main categories: (1) Action by Large Final Emitters; (2) Incentives for Developers; (3) International Linkages; and (4) the Trading System under CEPA.

Action by industry is targeted towards the Large Final Emitters ("LFEs LFEs") which comprise the LFE Group (a creation of Natural Resources Canada) that includes large industrial emitters in such sectors as upstream and downstream oil and gas, electricity generation, mining and selected manufacturing, such as cement plants and iron and steel mills. The LFE Group consists of about 700 companies and collectively represented approximately 46% of Canada’s GHG emissions in 2000. A key component of the 2005 Plan is that LFEs will be required to collectively reduce GHG emissions by 45 Mt. The federal government plans to provide GHG emission permits to LFEs on the basis of emissions intensity (emissions per unit of production) at a target lower than the current emissions intensity. This will force GHG emission reductions. LFEs will be required to reconcile, at each year end, actual emissions with an equivalent number of permits (actual emissions = permits = production * intensity target). The same intensity target will apply across an industry sector. Fossil fuel combustion-based emissions will require an emissions intensity decrease of 15% (85% of current intensity) and chemical processbased emissions, so-called "fixed process emissions emissions", will require no net increase of emissions intensity (100% of current intensity). However, the maximum reduction in emission intensity for any specific industry sector will be 12% (88% of current intensity). As a result, a company with high emissions intensity will need to implement greater reductions to reach the sector target than a competitor with a low emissions intensity.

LFEs will have the following options for compliance:

1. in-house GHG reductions;
2. purchase of permits from an LFE with a surplus;
3. purchase of credits from a non-LFE which implements a project that reduces domestic emissions;
4. purchase of qualifying international Kyoto credits;
5. purchase of permits from the federal government at $15 per tCO2e – this is the "Price Assurance Mechanism Mechanism" and these permits can be referred to as "PAM AM Units Units"; and
6. investment into the newly announced Greenhouse Gas Technology Investment Fund whereby investments into technologies that can reduce GHG emissions will entitle LFEs to permits at the same rate of $15 per tCO2e (total participation of the LFE Group will be limited to 9 Mt of permits).

While under development, it appears that the Price Assurance Mechanism will offer PAM Units under annual forward contracts whereby LFEs will need to commit at the beginning of the year to purchase a specific amount for delivery when the LFEs annual compliance is being finalized. Also, it appears likely that PAM Units will not be tradeable or bankable as this increases the financial risk to the government if the market price for permits exceeds $15.

The availability of PAM Units allows the estimation of the LFE Group’s maximum cost of compliance:

It is important to note that the 2005 Plan contemplates implementation of the foregoing under the Canadian Environmental Protection Act, 1999 ("CEP CEPA") while making maximum use of equivalency agreements with each province to establish such a system. There are significant jurisdictional issues of both a legislative and constitutional nature regarding the federal government’s power to implement the LFE program under CEPA.

While LFEs are a key component of the 2005 Plan, it is important to highlight that Budget 2005 provides initiatives for both LFE and non- LFE alike:

• initial funding of $1 billion for a "Climate Fund Fund" (with funding to increase to a total of $4-5 billion between 2008-2012) whereby the Canada Emissions Reduction Incentives Agency ("CERIA CERIA") will purchase domestic and international credits on behalf of the federal government and retire these credits in conjunction with Canada’s commitment to the Protocol;

• $200 million over 5 years and $920 million over 15 years for the Wind Power Production Incentive ("WPPI WPPI") to quadruple the current target of wind power generation from 1000 MW to 4000 MW – the WPPI incentive provides financial support of $0.01 per kWh for the first 10 operational years of eligible wind-power projects commissioned before April 1, 2010;

• $97 million over 5 years and $886 million over 15 years for the Renewable Power Production Incentive ("RPPI RPPI") to encourage the development of 1500 MW of other types of renewable energy - the RPPI incentive will provide financial support of $0.01 per kWh for the first 10 operational years of eligible projects commissioned between April 1, 2006 and March 31, 2011;

• $300 million for tax incentives by accelerating the capital cost allowance (from 30% to 50%) for investments in highly-efficient cogeneration and renewable energy generation equipment; and

• $250 million Partnership Fund to support federal-provincial projects such as the expansion of the east-west transmission grid, carbon storage and clean coal technology (with the possibility that federal funding could total $1.5 billion and provincial funding could total $1.0 billion).

The Climate Fund, WPPI and RPPI are widely expected to encourage the business community to develop projects to reduce GHG emissions. As mentioned above, a further incentive for non-LFE developers is that the Federal Government will issue credits to projects that create real and verifiable reductions for purchase by LFEs for domestic compliance. This will be an additional funding opportunity for developers to implement projects.

The 2005 Plan contemplates the recognition of credits issued under two of the flexibility mechanisms of the Protocol: the Clean Development Mechanism ("CDM CDM") and Joint Implementation ("JI JI"). Canadian linkage with these mechanisms can occur in two ways:

1. LFE purchase of credits to assist with LFE compliance domestically; and

2. Climate Fund purchase of credits to assist with Canada’s compliance with the Protocol.

LFEs can obtain credits by (1) implementing CDM or JI projects or (2) purchasing such credits from project developers. Only the international credits obtained by LFEs which are "real and verified emission reductions" will be recognized. The Climate Fund will utilize similar criteria for investment decisions, but will also consider additional factors including whether the project applies Canadian technology or expands Canada’s trade.

The domestic permit trading system to be developed under CEPA will likely include the following key points:

• an LFE with a surplus of permits can transfer excess permits to an LFE with a shortfall of permits;

• the federal government will manage a registry that will be the official record of the issuance, holding and transfer of permits for LFEs (each LFE will maintain a compliance account);

• the registry will not be a trading platform, the process by which buyers and sellers identify each other and settle financially will be carried out elsewhere;

• permits can only be transferred from one account to another;

• the federal government will hold a "LFE Remittance Remittance" into which LFEs will remit a sufficient number of permits to demonstrate compliance;

• non-LFEs who wish to participate in the permit trading system will be required to maintain a trading account; and

• procedures will be required to link the CDM and JI credits obtained by LFEs with such a registry.

This newsletter highlights the key climate change-related developments which have the potential to affect your business.