How to avoid creating incentives for provinces and territories to weaken rather than strengthen output-based pricing system

Implementing Carbon Contracts for Difference (for credit prices): Part 3.

The first two blogs in this series have shown how carbon contracts for difference (CCfD) can be used to reduce uncertainty in carbon credit prices, and why a CCfD system that relies on direct federal government purchases of credits is the best design option.

This final blog in the series takes on a specific design challenge for credit price CCfDs relating to federalism. Done poorly, credit price CCfDs could exacerbate tensions between federal and provincial / territorial governments around carbon pricing.

The challenge: Moral hazard for provincial and territorial governments

Federal CCfDs on credit prices run by provincial governments risk creating incentives for those provinces to weaken their carbon pricing systems, rather than strengthen them. Weaker provincial / territorial systems would appeal to provincial and territorial governments. It would lower carbon costs for emissions-intensive firms (diluting their incentive to reduce emissions). But it would also increase the flow of federal dollars into the provinces through credit price CCfDs to support low-carbon projects.

That equilibrium is a recipe for entrenching federal and provincial disagreements on climate policy. Yes, if provinces weaken their systems in a way that violates federal equivalency standards, the federal government has the authority to replace any provincial system with the federal version. But the federal government is likely to want to use that measure only as a last resort.  

Two additional tweaks in policy design can help. We note important tradeoffs for each.

A discounted strike price

Contracts for sales of credits can be structured in a way that creates local constituencies that will strongly support robust carbon credit markets for output-based pricing. In particular, setting a strike price (the carbon price defined in the contracts at which governments are committing to purchase credits) that is lower than the benchmark carbon price (i.e., $170 per tonne in 2030) can help.

If the strike price for CCfDs for credit sales were (for example) $150 per tonne in 2030, holders of credits would prefer that CCfDs not be exercised. They would rather sell those credits for just under $170 per tonne (the scheduled headline price). The wider the gap between the benchmark price and the strike price, the stronger incentive market participants have to exceed the strike price—and to lobby provincial governments (or even a future federal government) to continue to strengthen the pricing system. But such a policy will need to be counterbalanced against the fact that lower strike prices provide less economic certainty and could mean some projects don’t move forward.

Incentives for joint federal-provincial CCfDs

Federal CCfDs for provincial/territorial systems creates a fundamental disconnect. The federal government takes on risk that is strongly affected by provincial / territorial policy decisions. Discounted strike prices could help solve this problem. But the federal government may want to go further, and introduce joint federal-provincial CCfDs to address this problem. If provinces and territories were also to take on the risk of fiscal costs in the event of oversupplied credit markets, they would not have incentive to weaken their carbon pricing systems. 

Federal policy design could create incentives for provincial / territorial participation. Federal CCfDs would establish an eligibility precondition such that CCfDs would only be offered in jurisdictions that have agreed to contribute to any payouts triggered by the contract. For example, the federal government might require provinces and territories to shoulder 10 per cent of the cost of pay-out events.

The tradeoff here is that preconditions could slow down the roll-out of the program or even result in CCfDs not materializing in key provinces like Alberta, where 55 per cent of the country’s industrial emissions—and many important decarbonization projects—are located.

Transparency will be key

Credit price CCfDs have huge potential. And, yet, they’re also complex, requiring market participants and federal and provincial governments to make sophisticated choices while accounting for a wide range of dynamics (stringency rules, volume of contracts signed in a given jurisdiction, expected supply of credits and offsets, and more). All this complexity creates a need for transparency. In particular, the federal government, as the chief architect of the program, should insist that information about credit values is regularly published for each pricing program, and that the details of CCfDs are publicly accessible.

More certainty and lower risk — for emitters and for government

Any credit price CCfD design will come with challenges and risks. But, in this series of blogs, we’ve argued that good policy design can mitigate the most important risks. Furthermore, we believe CCfDs, even if imperfect, should be adopted. Without them, industrial carbon pricing systems will fail to incentivize the needed emissions reductions and low-carbon investments to accelerate Canada’s clean energy transition.