Canada: Carbon Offsets In The Western Climate Initiative: Emerging Business Opportunities

The state and provincial regulatory systems that ultimately emerge from the western climate initiative (WCI) and other regional initiatives will be designed to substantially reduce greenhouse gas (GHG) emissions through market-based regulation. Each will likely entail a declining cap on the amount of GHG emissions that regulated entities can emit, but will give them flexibility as to how to meet this cap.

The emergence of regional cap and trade systems, such as WCI, in conjunction with the prospect of national systems in Canada and the U.S., will likely create significant economic opportunities for those engaged in developing projects that remove or reduce GHG emissions in non-regulated sectors. This bulletin provides an overview of some of these opportunities.

Compliance Options

Under the WCI, regulated entities will have three basic compliance options:

1. Do it yourself": Regulated entities may reduce or remove their own GHG emissions through process improvements, investments in energy-efficient equipment or technological innovation;
   
   
2. Allowances and Allowance Trading": Regulated entities may use their own allowances or purchase allowances previously issued to other regulated entities; and
   
   
3. Carbon Offsets": Regulated entities may use recognized credits generated by projects (either their own projects or those of others) that reduce or remove GHG emissions not covered by the cap and trade system ("carbon offsets").
   
   

The WCI has recommended including offsets in its cap and trade system, but many details have yet to be settled. The WCI's design recommendations will determine the economic viability of carbon offset projects within the WCI system by addressing three key sources of uncertainty facing carbon offset project developers: project approval risk, quantification uncertainty, and volatility in the market price of carbon.

Carbon Offset Project Approval Process

To ensure offsets represent real emission reductions or removals, a separate regulatory system will be required to address the offset project process, from initiation to the issue of tradable carbon offsets that can be used by regulated entities for compliance. A key issue facing carbon offset project developers is likely to be the cost and complexity of the project approval process.

Few regulated carbon offset programs exist today. One such program is the Clean Development Mechanism (CDM), one of three so-called flexible mechanisms under the Kyoto Protocol. A brief review of the CDM program will provide insights as to how the WCI carbon offsets program may work.

Sponsors of a CDM project develop and implement projects at sites in developing countries that will result in measurable reductions in GHG emissions in excess of any regulatory requirement to reduce emissions. Carbon offsets that are certified under the Kyoto Protocol's CDM program are known as Certified Emissions Reductions or CERs. A CER represents the reduction, avoidance or sequestration of one metric ton of CO₂ equivalent. CERs command top value in the marketplace because, unlike carbon offsets generated for voluntary markets, CERs may be used by parties to meet mandatory reduction requirements under the Kyoto Protocol.

Numerous activities qualify as "projects," from efforts to replace obsolete industrial processes to reduce GHG emissions, to efforts aimed at capturing methane gas from landfills. All offset projects must be "additional" (i.e., not required by law or regulation) and not the result of "business as usual." Typically, this means that offset projects must rely - to some degree - on the economic value of the reduced emissions to justify project economics. The CDM Executive Board, which certifies the CERs that are generated from these projects, is quite vigilant on this issue and has disqualified some projects.

Like the CDM program, we expect that any offset program sanctioned under WCI would designate official bodies to review submitted projects and would most likely delegate the authority to approve offset projects and issue carbon offsets to each member jurisdiction according to the following procedures:

1. The project developer identifies a candidate project and analyzes its potential GHG benefits pursuant to an existing or proposed methodology (see discussion on protocols and methodologies below).
   
   
2. The project developer prepares a Project Design Documentation and submits it to a WCI- designated official body for validation. Current WCI draft design recommendations suggest that carbon offset projects that take place within the WCI jurisdiction will be preferred, but carbon offsets derived from extra-territorial projects may also be eligible. If an extra-territorial project is certified by a jurisdiction with a carbon regulatory program similarly stringent to that of the WCI, no further review may be necessary; if not, the WCI may require that the project be re-validated for the WCI.
   
   
3. Once approved, the designated official body formally registers the project and the project can begin.
   
   
4. Thereafter during operations, the project developer would confirm through a third party verifier (likely accredited by WCI or the WCI-designated official body) the performance of the project and its resulting GHG benefits. The verification report would be submitted to WCI or the WCI-designated official body.
   
   
5. If the verification report is accepted, WCI or the jurisdictional member would issue certified carbon offsets directly to the project developer, or into the authorized trading system on the developer's behalf.
   
   

A barometer for the scale of the opportunities within the WCI can be found in the number and types of projects that qualify as offset projects under CDM. In 2007, private sponsors funded 785 CDM projects. Of these projects, 29 percent were associated with renewable power, 23 percent reduced hydro fluorocarbons and nitrogen oxides, 20 percent captured energy inefficiencies, 10 percent captured fugitive emissions, 10 percent were associated with conversion of waste materials, and the remaining 8 percent were unclassified. These CDM and other projects avoided more than 800 million tons of CO₂ equivalent (CO2e) GHG emissions with a transactional value of approximately $15 billion. By 2013, the carbon market analyst, Point Carbon, estimates that accumulated reductions from CDM projects will exceed 3 billion tons of CO2e.¹

Carbon Offset Credits: Protocols and Quantification

One of the critical elements of the regulatory system for carbon offsets will address quantification – the measurement of emission reductions or removals from a particular project. A single methodology cannot be used for all project types since the emission source, reduction or removal activity and a variety of other factors differ from project to project.

While a wide array of projects may be eligible for purposes of the offset system, offset project developers must consider which of those projects have the benefit of an approved quantification protocol. Obtaining approval of a new quantification protocol for an offset project type that does not yet have an approved protocol can be costly and result in delay.

Though the WCI has not yet published detailed rules concerning the proper quantification protocols, it may look to other offset programs for guidance. By adopting those already approved in other regulatory systems, with or without variation, WCI may be able to fast-track its offset system and avoid replicating efforts. Some of the other offset programs WCI may look to for guidance are:

• CDM – The CDM Executive Board has approved 100 project-specific methodologies for various offset project types, including: incineration of HFC23 waste streams, steam system efficiency improvements, waste heat recovery at cement plants, fuel switching, grid connection of isolated electricity systems, manure management systems, landfill gas recovery, and introduction of low-emission vehicles to commercial vehicle fleets. Review the comprehensive list at http://cdm.unfccc.int/methodologies/PAmethodologies/approved.html?searchon=1&searchmode=advanced
  
  
• Alberta – Alberta has approved offset quantification protocols for the following offset project types: afforestation, beef feeding; beef lifecycle, biofuel, biogas, biomass, compost, energy efficiency, enhanced oil recovery, landfill gas, pork, tillage, waste heat recovery, and wind-powered electricity systems. For full details, visit http://www.environment.alberta.ca/1238.html
  
  
• California – The California Climate Action Registry has a number of offset quantification protocols for the following offset project types: reforestation, forest management and forest conservation, manure management, and landfill gas recovery. For full details see http://www.climateregistry.org/tools/protocols/project-protocols.html
  
  

What Will the Price of Carbon Be?

Expectations with respect to the market price of carbon will be the most important factor determining the viability of carbon offset projects. But estimating the future price of carbon within the WCI is complex. Demand will depend on how WCI-partner jurisdictions allocate emission allowances and the relative cost-effectiveness of internal reductions. The supply of carbon offsets will depend on a number of design decisions, as well as the ongoing efficiency and predictability of the project approval process.

Currently, there are two very different kinds of carbon markets in existence. In some markets, the credits or allowances that are traded may be used to meet the regulatory obligations of purchasers. In others, credits from offset projects (e.g., CERs and Voluntary Emission Reductions, or VERs) are bought by businesses outside a cap and trade system in order to meet GHG emission reduction goals that have been adopted voluntarily.

These two markets yield very different prices for carbon. In early June, the 2008 European Union Allowances (EUAs), which are bought and sold to meet regulatory requirements under the European Union Emissions Trading System (EUETS)² were traded at a price of approximately US$41.00 per metric ton of CO₂ on the European Climate Exchange (ECX). At the same time, the 2008 carbon financial instruments ("CFIs"), which are bought and sold to meet voluntary carbon reduction goals on the Chicago Climate Exchange ("CCX")³ traded at a price of approximately US$7.00 per metric ton of CO₂ .

As discussed above, the closest equivalent to carbon offsets under the WCI may be CERs issued under the CDM. There are few publicly disclosed spot transactions for fully issued CERs. One transaction that was reported in 2007 cleared at €16.40 per issued CER, whereas a transaction reported in January 2008 settled through an exchange at €16.50. A reasonable estimate for the value of a fully-issued CER today is around US$30.00.

We think the price of offset credits will not be uniform and in all cases will be less than the price of allowances to be traded within the WCI. The price that regulated entities will be willing to pay for credits generated from offset projects will be driven by a number of factors, including: WCI policy choices (e.g., whether a regulated entity may cover all or only part of its emissions through obtaining offset credits), the type of project (e.g., some offsets yield less certain emission reductions and hence are not valued as highly), the identity of the project developer (e.g., credits generated by developers with a proven track record will command a premium), where credits are generated (e.g., which body verified and issued them), and the timing of issuance.

It is worth noting that a trade under the Regional Greenhouse Gas Initiative ("RGGI") occurred in February 2008 for a price announced between US$5.00 and US$10.00, and another trade one month later at US$7.00. Note that RGGI allowances represent the price of one short ton of CO2 versus one metric ton for EUAs and CFIs. The RGGI members announced that they have set a minimum bid price of US$1.86 for allowances during the first regional auction expected to occur on September 10, 2008.

Economic opportunities in carbon offset markets will increase if, as we anticipate, governments increase restrictions on GHG emissions and market liquidity and price transparency for carbon offsets and allowances improves. Increasing financial sophistication and innovation within carbon markets, such as the "bundling" of carbon offsets to reduce risk, will also lead to firmer pricing. Furthermore, we anticipate that as carbon markets in different jurisdictions become more integrated over time, the price of carbon will increase significantly.

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