Carbon markets trends and their influence on decarbonization

Tom Heintzman: Welcome to The Sustainability Agenda, a podcast series focusing on the evolving complexities of the sustainability landscape. I’m your host, Tom Heintzman. Please join me as we explore today’s most pressing issues with special guests that will give you some new perspectives and help you make sense of what really matters.

Duncan Rotherham: The key thing that I would say before one looks external or exogenous for offsets or renewable energy credits, regardless of being a compliance calibre or voluntary calibre participant, is understand your own emissions and your own marginal abatement cost curve, and I think companies are getting better there.

Tom Heintzman: Welcome to our multi-part series, Profiling the Carbon Markets. The purpose of this series is to examine some of the most significant issues facing our clients in both the voluntary and compliance markets. On today’s episode, we’ll be discussing the key trends in the carbon markets, how these are influencing the velocity of decarbonisation and transition efforts, and what this means for companies over the short and long term. I’m super excited today to welcome our guest, Duncan Rotherham, a Partner in Infrastructure and Capital Projects at Deloitte, Canada. Duncan is a senior leader with over 20 years of experience in the decarbonisation and energy transition markets. He’s provided advice to a broad range of clients on decarbonisation since Kyoto days. Duncan has worked with utilities, municipalities, financial service companies and heavy emitters, including in Alberta’s tier system and with Ontario’s independent electricity system operator. I’ve known Duncan for many years now, and I’m delighted to have him on the show.

Duncan Rotherham: Thank you very, very much, Tom. Looking forward to talking through the topic.

Tom Heintzman: Fantastic. Well, let’s start at the highest level. Carbon pricing is widely regarded as one of the most important tools for decarbonisation. How is carbon pricing affecting the current practices and investment decisions of your clients?

Duncan Rotherham: Great question. I’d say it depends. You know, in its simplest form, carbon price imposes the external costs of the physical impacts of climate change on the source of emissions, and typically, as we see it manifest in one of two ways as a tax or as a market based outcome, when the carbon price is imposed as a tax, we get the luxury of price certainty, but not necessarily an abatement outcome that we’re looking for. We’re hoping that industry and the broader economy responds to price. Where it’s imposed through a market based mechanism, we allow price to solve based on an environmental constraint. So we’re solving for emissions, and in theory, price solves where it may. So why I say it depends is I think price manifests differently depending on the mechanism. For example, in Canada right now we have more of a tax based system, so there’s not actually a constraint on emissions on any commercial or residential or industrial emitter. There’s simply an imposed price with good price transparency. So what I’m seeing as our clients are responding to this is that price is being accounted for in their decisions. It improves the cost effectiveness of a lot of the sort of opportunities that they’re looking at with regard to what their abatement plans are and when they carry it out. I think between the industrial emitters and the commercial energy end users, we’re seeing a difference in how entities are responding broadly. So the heavy emitters, the industrials are accommodated through a bit of a different vehicle. Their price is diluted a little bit through an output based pricing mechanism. However, they’re responding with better context form of a marginal abatement cost curves and things like that. While the commercial entities are, for the most part, looking at it as sort of a voluntary commitment, they look at it as an incremental price that they pay per unit of energy. However, even they’re driven by their decarbonisation targets, voluntary for the most part there. We’re also seeing that price be accommodated in their decision making. So I think I’d go back and sort of say, you know, it depends. In Canada, as a result of the tax system, there’s some nuance.

Tom Heintzman: Great. That’s super helpful. I want to pick up on carbon price in Canada. Canada has imposed a carbon tax, the United States has not. I’m wondering whether you’re seeing any broad results, ways that you can compare the two countries and the impacts that that’s having?

Duncan Rotherham: Definitely, especially with the emissions intensive or energy intensive industrials. Essentially the US approach through the Inflation Reduction Act as well as several other mechanisms is expecting activity in the form of abatement through incentives, for the most part, tax incentives and financial incentives. In Canada, we’ve got a bit of a combination of both where we’ve got a tax which imposes a price, which imposes cost, which drives action, and we’ve got a variety of incentives. So I think right now we’re definitely seeing our Canadian clients with operations north and south of the border. Look to see sort of where can they optimise to reduce their compliance obligation while at the same time sort of maximising the incentive opportunities, sort of these limited time cash offers that that seem to be available right now to incent technological deployment. Broadly, I would suggest that the US approach is predominantly carrots. Canadian system is a combination of carrots and sticks and right now the Canadian system is adopting just because of the scale of the economy compared to the US trying to sort of accommodate and keep up with the incentives that we see offered in the States. So while there is a price and there is an obligation here, I think there’s also a proliferation of incentives targeted at the industry.

Tom Heintzman: Is it too early to draw conclusions about which one is the most effective in terms of changing behaviour? Or are there already indications that having a tax or not having a tax is more effective?

Duncan Rotherham: I think it’s probably a little too early to tell. The US Inflation Reduction Act is very generous, I would suggest, in certain areas and really sort of became a game changer quickly for things like hydrogen. Europe had to respond to that as well as Canada is responding to that in a variety of ways. I would suggest it’s impossible for an economy the size of Canada to keep up with the scale of incentive that’s offered by the US. And so I do think that right now you’ll likely see a proliferation of investment in the US versus Canada and on a per unit of GDP basis, simply because of the opportunity and the limited nature, the opportunity in the States. It’s almost you know, you have to make these investments in a timely manner or else otherwise someone else will and take money that otherwise could have been dedicated to your facility. So it is an effective mechanism definitely to to spur urgent or quick action.

Tom Heintzman: Got it. Okay. So let’s turn now to the heavy emitters who in Canada, in certain jurisdictions in the United States have caps placed upon their emission, and that’s generally referred to as the compliance market, and it tends to be several hundred times larger globally than the voluntary markets, where people are voluntarily either capping their own emissions or buying offsets. What do you see as the top trends and challenges in the compliance markets?

Duncan Rotherham: Right. So maybe I’ll stick to a bit of a Canadian focus at first here, given my precedent in the market that I operate in, but I can opine a little more globally as well. If we imagine the Canadian economy emits about 700 million tonnes a year, the industrial emitters are maybe 250 to 300 million tonnes of those 700 million tonnes. So if we imagine the market, and I’ll use that term a little loosely at this stage, the market for industrial emitters from an emissions perspective is call it 250 million tonnes. The way that price is imposed or the compliance obligation is imposed on industry. It’s through an output based performance standard, and the provinces for the most part have taken up and developed their own systems to impose an intensity based target on industry. So unlike a residential or a commercial customer, the industrials aren’t paying price per tonne on every one of their tonnes of emissions. They have an intensity based target that’s set typically at sort of around 90% to 95% of their total emissions, and that that target will tighten. But if you sort of look at it right now, that that market is only if the average industrial is reduced by 5 or 10%, their emissions multiply that by the 250 million tonnes, you get sort of a market in Canada of potentially 25 to 30 million tonnes of emission reductions that actually need to be achieved. I’d say the other challenge in Canada with the market is it’s very segmented at the provincial level, so there’s very little, for example, trading between BC system and in Alberta system or an Alberta system in an Ontario system. So right now you have sort of parallel provincial markets as opposed to a national market. So I think in Canada right now I’d describe the market as relatively modest and ineffective from a global perspective, mostly as a result of the European emissions trading system and California. The compliance market is, as it’s in my opinion, as it should be, significantly greater than the voluntary market. However, you can run scenarios where that changes quickly, especially as more voluntary commitments that are typically set around 2030 and sync with the Paris Accord get closer to their due date, and then the expectation is that there’ll be incremental demand for voluntary credits in order to meet those voluntary commitments.

Tom Heintzman: So just to double click on one of the points you made, we’ve got a fragmented system here in Canada, largely provincial, which is the way in many things in Canada. Is there any prospect of harmonising across provinces or is that not something you see even in the 5 to 10 year time frame?

Duncan Rotherham: If we look at the fundamentals and the logic of a market based mechanism, the larger the market, the more fungible the credits within that market, the more effective that market can be. So with sort of the purity of a carbon market in mind, I hope that we would see more of an integrated national market with units trading between provinces. I would say at this stage, you know, the likelihood of that happening in the short term is not as great as I would like it to be because of just the inter-provincial complexities. And not every province yet is in a position where they’re covering industrial emitters in the same way. For example, even British Columbia, which has long had a price on carbon, is just now starting to compliance year 2024 going to be implementing an output based performance standard on their industrial emitters, while Alberta in theory has had one in some shape or form for well over a decade. So I think we still need to see these provincial systems evolve a little bit, and I think the hope would be that there would be an intermingling. And then an obvious challenge to that would be Quebec, which is already integrated into the broader sort of California market, let’s call it. So I think Quebec as a distinct market because of its ties into the California market, may stay distinct perpetuity, but one would hope that maybe the western Canadian provinces or prairies could come together on something in a reasonable, logical format.

Tom Heintzman: And I think I’m right in saying that Quebec has had much lower compliance as a result of being part of the California market, so it might make sense to merge some of these markets. Is that a fair statement?

Duncan Rotherham: It is a fair statement, and what we’re seeing with Quebec and California is, it’s solving lower because of the mostly because of the design of the California system, but in effect, in certain constraints because there are price caps and price floors and price ceilings, it’ll solve to achieve the environmental outcome, which is the emissions outcome of those combined markets. While the rest of Canada is wed to the Greenhouse Gas Pollution Pricing Act, and the price within that, that sort of escalates to $170 from where it’s at now by 2030. So again, we sort of a tax based system where we’ve got that price certainty but not an emission certainty, and Quebec and California, which are essentially sort of right now solving for an emissions outcome.

Tom Heintzman: Now let’s turn to the voluntary market. So all those companies out there that are not heavy emitters but are voluntarily taking it upon themselves to reduce their emissions, and also, once they’ve done that, to buy renewable energy credits or offsets, the voluntary carbon market has seen quite a bit of public scrutiny over the last year or two. What, in your view, are its biggest challenges and how are these being addressed?

Duncan Rotherham: I think first of all, I’d say there’s some nuance here. So we’re talking about you mentioned sort of offsets and recs or renewable energy credits, and I think that’s an important nuance as opposed to a carbon market. So the voluntary carbon market, I’ll use that term a little loosely, is really an offsets or renewable energy credits market. The demand is set by the companies, by definition, the voluntary market, it’s not a compliance calibre regulated outcome, so there’s no allowance. So it’s not solving for a macro price, it’s not a tax, there’s no imposed implicit price. You know, it’s predominantly an offset market, although RECs are also a useful instrument in order to achieve conformance with a voluntary target. So I would say the scrutiny that we’re seeing on this market right now, some of it’s fair and some of it’s less so. You know, if you’re a long time offset producer, there’s a lot of whining or consternation about the scrutiny, but I think it’s a good thing. It’s a good sign. We should want a strong and robust system. We should want that system to be transparent and survive. But broadly, I think really to proliferate. We’re hoping for instead of sort of a proliferation of standards, which is what we’re seeing now, the market needs to come together a little bit more. There’s a logic to a variety of different offset types from a variety of different locations and vintages, even with a variety of different characteristics, because different people define sort of the charisma around an offset in different ways. But I do think that out of necessity, the market needs to come together more here in a pretty quick fashion. I think really most of these obligations in the voluntary system are set for around 2030 and building up to that. So I think the market has a couple of years to really ensure that it’s relevant or it risks the scrutiny snowballing and it becoming neutered in its ability to be an effective remedy for voluntary emitters to meet their targets.

Tom Heintzman: So both the voluntary and the compliance markets are having an impact on the speed and scale and the capital deployed in the energy transition. How successful would you say they’ve been to date and are there any recommendations you would make to increase the extent to which they’re influencing the transition?

Duncan Rotherham: You know, I think just because we call something a carbon tax doesn’t necessarily mean it’s going to have the outcome that we hope. So the example that I’ll give is the taxes that we’ve been paying on refined petroleum product or our transportation fuels for a long, long time now. We’ve been taxing these fuels with the goal not of actually driving demand destruction in these fuels. Basically, we’re imposing a tax on something to pay for our roads, public infrastructure, even funding some hospitals and other public costs. And so we’ve been imposing a tax on fuels for a long, long time and haven’t really seen a tremendous amount of demand destruction. So simply turning around and saying we’re going to impose a new tax this time, we’re going to call it a carbon tax, and it’s intended to reduce demand and have people fuel switch and acquire electric vehicles or smaller vehicles, be more fuel efficient vehicles, I think is a little ambitious. I do think a mechanism like a carbon tax, especially for commercial enterprises like building owner operators, so not large final emitters, not industrials and residential customers, We’re going to need a carbon tax coupled with programs and incentives. And I think that’s what we’ve seen for a long time, for example, in what it’s required to incent energy efficiency incentives and delivered potentially through utility programs or by programs, for example, like we’re seeing from Enercon or even the independent electricity system operator here in Ontario. So I think a simple tax I think is not proving particularly effective in those segments. And then for industry, there’s some nuance as well. I mean, I think a lot of people would look and say, hey, industry is facing an incremental price of carbon that’s going to land at $170 circa 2030. They should be developing abatement plans in synchronicity with that forward price. But even industry looks at the forward price and says there’s policy and political uncertainty associated with that forward price. So it will likely have a federal election in 2025, provincial elections predictably. So there’s a fair amount of policy uncertainty that essentially discounts that forward price of carbon so that many companies aren’t looking at this right now and simply saying, you know, it seems like a foregone conclusion that price will solve at $170 by 2030. I should do everything below my marginal rate that solves below that of my marginal abatement cost curve. So I think there’s more work to be done for the price of carbon, whether it’s tax or a market based mechanism to have its intended outcome.

Tom Heintzman: That’s very interesting and helpful. Duncan, I have one more question before I let you go. Even though we’ve been covering the topic at a very high level, it’s clear to me and I’m sure to the listeners, that these are complicated subjects for an executive listening who’s seeking to move their company forward and reduce their emissions, what advice would you give clients seeking to build a carbon management strategy and use carbon offsets? What do they need to know about the carbon markets over the short, medium and longer term in order to make the best decisions for their company?

Duncan Rotherham: You know, my advice is very similar to somebody who’s participating in the voluntary market, let’s say a commercial or a large building owner operator, as it would be for a large industrial. And that I think the first thing that needs to be done is most companies now have a reasonable appreciation of their emissions profile. Most, although not all of those that actually quantify their emissions, have an appreciation of what emissions they have control over and what sort of emissions they’re a taker of. For example, if I use electric energy, I’m a taker of the emissions intensity of the electricity from the grid. And so your ability to control that is really, hey, can I potentially enter into a power purchase agreement with a renewable producer or something like that to acquire recs or offsets? But I think the key thing that I would say before one looks external or exogenous for offsets or renewable energy credits, regardless of being a compliance calibre or voluntary calibre participant, is understand your own emissions and your own marginal abatement cost curve. And I think companies are getting better there. But I think that would be the first tip, is know what it would cost you internally where technologically viable to meet for example a 2030 target or to reduce your emissions by 30% by 2030. And then what’s economic versus the price of carbon or what’s economic versus a shadow price if you don’t have a carbon price imposed on you? So it’s sort of the fundamental financial analysis layered on top of the emissions accounting that I think every company should be focussed on first and then after that have an appreciation of the external abatement options, which would be offsets and renewable energy credits and the like. These offsets can become addictive quickly. They can look cheap now, but they may not be a close to a free option in perpetuity to meet your voluntary or compliance calibre obligation by design. They’re intended as a temporary mechanism. As companies abate and reduce their own emissions. So I would say first to look internally carefully and then entertain the exogenous opportunities to meet your compliance and voluntary obligations.

Tom Heintzman: Well thank you, Duncan, for taking the time to join the show today. You’ve been at it for a long time. I’m always impressed by the breadth of your knowledge and your ability to articulate these difficult concepts. So thank you for taking the time to join us, and thank you listeners for tuning in.

Duncan Rotherham: Appreciate the opportunity. Thank you Tom.

Tom Heintzman: If you’d like to learn more about how your business can navigate the carbon markets, join us for CBC’s Carbon Summit on October 26th, 2023, in Toronto. The summit will bring together experts in carbon market structure, project development and policy. To register, please contact your CIBC Relationship manager. Please join us next time as we tackle some of Sustainability’s biggest questions, providing you different perspectives to help you move forward. I’m your host, Tom Heintzman, and this is The Sustainability Agenda.

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