What are contracts for difference?

Three types of carbon contracts for difference—and how they work

Here in climate policy wonk-world—and especially in the lead up to the 2023 federal budget — there’s lots of talk of “carbon contracts for difference” or CCfDs. And rightfully so: CCfDs can drive investment in clean growth projects but can also do so at lower costs for governments than straight-up subsidies. 

But here’s the thing: there are multiple versions of contracts for differences being considered and discussed. Let me walk through three that each have different strengths and weaknesses. Indeed, they each solve a different problem. 

Version 1: Contracts for Difference on the benchmark federal carbon price   

This is the simplest version of a CCfD, and it was the focus of the proposal that Blake Shaffer and I first made way back in 2021. It’s designed to tackle “stroke of the pen” risk—namely, that the scheduled price for carbon pricing won’t increase to $170 per tonne by 2030 as planned because future governments will change course on carbon pricing.  

Expectations of future carbon prices play a big role in determining the economic viability of various low-carbon projects—whether carbon capture and storage, green hydrogen, or clean electricity. But the risk of future governments moving away from that carbon pricing pathway dilutes policy certainty—and thus the incentive to invest in clean growth projects. 

So back to CCfDs. The basic idea here is this: an arms-length government body enters into contracts with emissions-reducing projects (we originally proposed the Canada Infrastructure Bank; the 2022 fall economic statement proposes the Canada Growth Fund). If the carbon price in 2030 does not rise to the $170 per tonne benchmark as planned, the government pays out to the proponent. 

Essentially, the CCfD provides insurance against policy shifts: it lets projects move forward as if the future price of carbon is guaranteed. And the federal government is particularly well-suited to taking on this risk because it controls the factors that determine risk, namely the decision to adjust that price trajectory or not.  

Notably, CCfDs need not only be for large projects. Financial institutions or investors could easily bundle multiple, smaller projects—say heat pumps for buildings, electric cars for fleets of vehicles—and aggregate those low-carbon investments together to be collectively eligible for a CCfD. That’s important, because the policy risk on the carbon price for small emitters is likely greater than for the output-based pricing that applies to large emitters. 

For this kind of CCfD, more is better. Making it broadly accessible to projects and writing as many contracts as possible makes carbon pricing work better. It could also very well end up costing the federal government nothing—if the price of carbon in 2030 is indeed $170 per tonne, they don’t pay out. The government could even come out ahead: firms might well be willing to pay for this insurance. It could set the “strike price” (i.e., the price at which governments would be on the hook) at something like $150 per tonne. If the actual carbon price is higher than the strike price, then contracts could be designed for the project proponent to pay out.  

Version 2: Contracts for Difference on the credit price in provincial and territorial carbon markets 

Carbon pricing helps large emissions-reducing projects get off the ground—again, for example a carbon capture project—in part because it allows them to generate emissions reductions credits which can be sold for cash. If carbon pricing doesn’t exist in the future, those credits are valueless. 

But those credits might well be worth less than $170 per tonne in 2030 for other reasons. “Output-based carbon pricing” systems for larger industrial emitters across the country have tended to be overly generous. Many carbon pricing systems have made it too easy for firms to generate additional credits. As a result, there’s a real risk of a glut in credit markets. And as a result, credits trade at prices much lower than $170. That’s a problem for firms, projects, and investors banking on the value of avoided emissions. 

CCfDs could also present a solution to this problem, though with different tradeoffs. Strike prices could be based on credit prices rather than the benchmark carbon price. Essentially that means they’d be insuring against risk in carbon credit markets, rather than policy uncertainty alone. 

For this version of CCfDs, the stakes—both upsides and downsides—are higher.  

Providing more certainty about credit values would be more powerful in mobilizing investment into low-carbon projects. Especially for leading low- or zero-carbon projects, the price of credits could matter more for clean growth project cash flows than the benchmark price of carbon, given the volume of credits likely to be bought and sold, especially as the energy transition accelerates. 

That also, of course, requires the government to take on more risk. Higher contingent liability (that is, potential payouts) for government or arms-length funding bodies isn’t necessarily a bad thing: it can create more stability for carbon pricing. 

But the likelihood of the federal government having to pay out depends on whether provinces and territories tighten their output-based pricing systems, increasing demand for credits and decreasing supply. The federal government has some influence on this outcome: it establishes the criteria for provincial and territorial systems being accepted (or not, in which case the federal system applies). 

Yet federal CCfDs on credit price might instead create incentives for provinces to weaken their carbon pricing systems, rather than strengthen them: the result would be lower carbon costs and more federal dollars flowing provincial projects. If these incentives make tightening of industrial carbon pricing less likely, CCfDs on credit prices become more like straight up subsidies than sharing risk. 

That makes this kind of CCfD a trickier proposition. Clean Prosperity and the Transition Accelerator have argued that the benefits are worth the risks. It’s also argued that CCfDs on credits might also come with “strings” attached, such as requirements on transparency for credit market prices. Still, the downsides mean that a broad program for this type of CCfD would require careful thought. 

Version 3: Contracts for difference on other commodity prices (not on carbon dioxide emissions)

Maybe it’s not just policy uncertainty holding a project back. Some projects might still be uneconomic at a carbon price of $170 per tonne, but might have other benefits for society that justify public investment: they might drive innovation or claim first-mover advantage in global markets.  

Contracts for differences can also a play a role in overcoming these investment hurdles — but they might not be carbon contracts for difference. Instead, contracts for difference with strike prices based on commodity prices can overcome risk regarding future demand for clean products, such as clean electricity, low-carbon steel, cement, or hydrogen.  

UK contracts for differences, for example, provide a minimum price for delivery of clean electricity, de-risking the possibility that future demand might be lower. Alberta took a similar approach. Both policies provided guarantees based around electricity prices, and used “reverse auctions” to let market forces discover the strike price needed to de-risk investment in electricity. 

For the federal government, the new Canada Growth Fund could provide these kinds of contracts for difference as well, though likely for sectors such as cement or steel, given provincial jurisdiction over electricity. But they are best considered narrowly on a project-by-project basis: details of deals that offer value both for projects and for society will vary project to project and require project-specific tailoring. Moreover, in some cases, this kind of contract for difference might well provide public support worth more than the equivalent of $170 per tonne of greenhouse gas emissions (i.e., Versions 1 and 2). First-of-their-kind projects that offer innovation and learning benefits are most likely to merit this additional support and de-risking. 

Multiple tools to solve multiple problems

Ultimately, the transition to net zero will require huge mobilization of private dollars to build clean growth projects. Contracts for difference are an extremely useful tool for governments looking to mobilize that capital. They share risk rather than socializing it, crowding private dollars in and lowering fiscal costs for governments.

But when we consider how the federal government moves contracts for differences forward in the 2023 Budget, we should consider different types of CCfDs separately. They can and should be wielded in different ways, according to their strengths and weaknesses.