May 01, 2018

For richer, for poorer: the California, Ontario, and Québec carbon market

Kevin Poloncarz

On February 21, 2018, the state of California and the Canadian provinces of Ontario and Québec held their first joint auction of allowances issued under their respective cap-and-trade programs, which have now been “linked” with one another, creating the largest and only economywide carbon market in North America. Whether the linkage will survive the vicissitudes of changing political winds remains unclear. What is clear is that, despite the Trump administration’s views, “subnational” jurisdictions such as California and the two Canadian provinces will continue their efforts to demonstrate that cooperation is possible and progress can be made to reduce carbon emissions.

What linkage means

By linking their programs, the most populous U.S. state and Canada’s two largest provinces have essentially blended their respective caps on greenhouse gas emissions, allowing their emitters to comply by purchasing and surrendering compliance instruments (denominated in metric tons carbon dioxide equivalent) issued by any of them. The linkage is memorialized by a harmonization agreement, which reads more like an exchange of wedding vows than a prenuptial; it pays more attention to how the union will work than what happens if it does not.

Betting against political winds

Since 2014, California and Québec have held quarterly joint auctions, which were largely uneventful, although demand was suppressed due to uncertainty about the California program’s future and a lawsuit challenging it as an unlawful tax. That lawsuit was finally resolved last year, and the auctions have picked up some steam since then.

In this first auction with Ontario in February 2018, all the current vintage allowances offered for sale were sold at a settlement price of US$14.61 per metric ton, slightly above the “floor” price. A smaller pool of allowances that cannot be used until 2021 did not sell out, perhaps due to political uncertainty in Ontario. The Progressive Conservative party candidate has said that, if elected as the premier of Ontario in the Ontario general election on June 7, he would end Ontario’s cap-and-trade program and fight against the imposition of a federal carbon tax, alongside the western province of Saskatchewan.

Under Canada’s federal benchmark on pricing carbon pollution, each province must elect to implement an explicit carbon price—a tax like British Columbia’s—that rises to at least C$50 by 2022 or a cap-and-trade program like those of Ontario and Québec. If a province fails to do so, the Canadian federal government will implement a “backstop” consisting of a levy on fossil fuels and an output-based pricing system on industrial facilities. If a province’s program does not meet the carbon price benchmark, the federal backstop will supplement or “top-up” the provincial system. Therefore, Ontario could not simply suspend its program, terminate the linkage with California and Québec, and avoid carbon pricing.

The February auction results suggest that while entities may be confident that cap-and-trade will remain in the near term, they are not so bullish about the future.

Why does this matter?

In both scale and scope, the linked program represents an unprecedented degree of cooperation among jurisdictions to cut carbon emissions in North America.

The Obama administration’s Clean Power Plan was similarly designed to allow states to cooperate with one another, either by submitting a multistate plan for compliance with a blended target or by electing to trade with one another. The latter option was added at the request of states wary of marrying their respective targets, but, nevertheless, wanting to take advantage of the economies of scale offered by a broader market.

Now, in the absence of the Clean Power Plan’s implementation, the three linkage partners are attempting to demonstrate that an even more ambitious form of cooperation—one covering roughly 85 percent of their total emissions—is possible among subnational jurisdictions that do not share a common border, currency or, in the case of Québec, language.

Climate diplomacy in the Trump era

One of the main arguments made to members of the California legislature for continuing with the cap-and-trade program was the need to forge ahead with this model of climate diplomacy in the wake of the Trump administration’s announcement of its intention to withdraw from the Paris Agreement. Would the political will have been strong enough to reauthorize the program through 2030—as the legislature did this past summer by a bipartisan supermajority vote—if it were not for Trump’s election?

Regardless, the imperative to resist reversal of the last eight years’ federal leadership on climate change certainly helped lift the bill over the finish line.

But the bill requires several significant changes that could cause friction in the linked market. Chief among these changes is the requirement that the California Air Resources Board set a hard ceiling on the price of allowances.

All three jurisdictions’ programs already feature a “soft” price ceiling; each has set aside a pool of allowances that would be sold at relatively high, fixed prices to emitters if demand is high. A hard price ceiling, in contrast, would essentially allow emitters to pay to comply; once the set-aside pools are exhausted, emissions could exceed the caps, and the state must invest the revenue in achieving additional reductions, probably from outside the capped sectors.

If California’s ceiling is ever reached, that would likely act as a cap on prices throughout the linked market. Some, therefore, think the ceiling should be at least as high as the Canadian price (C$50) to assure that Ontario’s and Québec’s programs continue to meet the federal benchmark. The factors the California Air Resources Board must consider in setting the state’s ceiling suggest it could be substantially higher.

The California Air Resources Board will no doubt want to work closely with Ontario and Québec as it decides where the hard ceiling should be set. The harmonization agreement commits the three jurisdictions to work together to determine whether program differences need to be harmonized and, where they must, to consult one another on how to accomplish that. It also requires 12 months’ notice before any jurisdiction can withdraw.

If Ontario should choose to end its cap-and-trade program, extricating it from the linked market will not be easy. Successful bidders in auctions do not even know which jurisdictions’ allowances they have purchased. Thus, withdrawal by any jurisdiction could be as messy as separating assets in a community-property state.

A withdrawal by Ontario, moreover, would mark a significant setback for those seeing the partnership of California, Ontario, and Québec as a model for engagement on climate change in the Trump era. For that reason, the eyes of many will be watching to see whether the newly minted linkage can outlast its honeymoon phase.


Kevin Poloncarz

Kevin Poloncarz practices environmental and energy law at Paul Hastings, LLP, in San Francisco.