On June 16th, the Oil Sands Advisory Group (OSAG) publicly released its report providing advice to the Alberta Government on implementing the oilsands emissions limit.
Part of Alberta’s Climate Leadership Plan, the oilsands emission limit restricts greenhouse gas (GHG) emissions from the oilsands sector to 100 megatonnes (MT). The report’s recommendations can be grouped broadly into two categories – (1) things to do to avoid reaching the cap and (2) things to do if the cap is reached. The hope is that with technological advances and other innovations, oilsands production will continue to increase without ever hitting the emissions limit. There is good reason to believe this could happen, but smart policy should be in place just in case. This post focuses on the OSAG report’s recommendations for enforcing the emissions limit if and when the cap is reached.
OSAG’s recommendations for enforcing the oilsands emissions limit
Once the emissions limit is reached, the report recommends that scarce cap space be distributed based on whether the facility has commenced construction and/or the relative greenhouse gas intensity of the project. Specifically, the report proposes two tools the government may wield to ensure the cap is not breached. First, the regulator may restrict the construction of approved projects that have not yet commenced construction until there is enough room under the cap to allow new construction. Second, the regulator may require emission reductions from certain low-performing (from a GHG perspective) oilsands facilities. Specifically, the worst quartile of projects in terms of GHG intensity will be required to reduce emissions by two-thirds of the projected cap overage, while the second worst quartile of projects will be required to reduce emissions by one-third of the projected cap overage.
At first look, this method of allocating scarce cap space to oilsands projects seems reasonable. Once the cap is reached, emissions reductions will have to come from somewhere and targeting unbuilt and low-performing facilities could make sense. The large upfront capital costs of oilsands facilities means that it would likely be more efficient for already built projects to continue to utilize cap space. If reductions are needed from already operating facilities, ones with higher GHG intensities may have more potential to reduce that intensity. If intensity reductions are not possible and production reductions are necessary, high-intensity facilities would be forced to reduce output less than low-intensity facilities since each barrel reduction is associated with a larger amount of emissions.
However, while these factors may correlate with the most efficient oilsands emission reductions – the real world can be a lot more complicated. Ramping down production of currently operating facilities could end up increasing the GHG intensity of the operation. Facilities yet to commence construction may be so much more efficient and productive than current operations that, even with the high upfront capital costs, it may make sense to shutter older facilities to make room for new ones. The truth is that the best way to allocate emission authorizations once the cap is reached is unknown by any one entity – especially the regulator. But by mandating emission reductions from specific facilities, the proposed system almost guarantees that inefficient and expensive emission reductions will be sought in lieu of efficient and cost-effective reductions.
Further, the proposed system misses an opportunity to provide robust incremental incentives for emission reductions once the cap is reached. By only penalizing facilities in the bottom two quartiles based on a GHG intensity or facilities yet to be built, the proposed mechanism only provides incremental incentive to reduce emissions to these facilities specifically. Facilities that are in the top half will not face any additional incentive to reduce emissions since they will already receive 100 per cent of their requested emissions authorizations. Additionally, the incremental incentive may even be dampened because of the penalty cutoffs. Facilities on the cusp of a more favourable quartile will only face incentive to improve just enough to move up. Facilities yet to commence construction will only face incentive to achieve GHG intensities low enough to let them fit under the cap and be within the top half of all facilities. While these incentives are better than nothing, they miss a significant opportunity to harvest emission reductions elsewhere – ones that may be cheaper and easier to obtain.
Finally, the proposed system injects additional regulatory uncertainty into the oilsands development process since the regulator would have the discretion to delay or cancel already approved projects or mandate emission cutbacks from currently operating facilities. While steps can be taken to increase the transparency and lead-time of these decisions, the uncertainty will always remain.
Market-based mechanisms to enforce the emissions limit
A market-based mechanism to allocate cap space once the cap is reached would address these issues. Such a mechanism would allow authorized emissions to flow to facilities where they are most valuable and induce emission reductions where they are most cost-effective. As it happens, there is a name for emission caps enforced using market mechanisms – cap-and-trade.
At a fundamental level, a cap-and-trade system for the oilsands would require emitting facilities to acquire a commensurate amount of emission allowances to cover their emissions. Only a finite amount of allowances, i.e., 100 MT, would be made available. These allowances would be tradable between entities so that facilities that value the ability to emit the most would be able to purchase them.
A cap-and-trade system would harvest the most cost-effective emission reductions to achieve the desired cap level. Facilities that value the ability to emit less, such as facilities that can reduce emissions relatively more efficiently and cheaply, would be able to sell them or avoid the need to purchase more. In effect, the magic of the market would cause the finite amount of emissions under the cap would flow to the facilities that can use them the most efficiently. This would occur because every facility would experience an incremental incentive to reduce emissions once the cap is reached – no matter whether they are built or where they are on the GHG intensity scale.
If designed well, a cap-and-trade system would also provide more certainty to oilsands developers and investors compared to the system proposed in the OSAG report. While there may be uncertainty regarding allowance value, oilsands companies are very experienced in financial and commodity markets. There are tried and true ways to manage risk in these markets. Managing the risk of a regulator’s whims is another story.
Implementing a cap-and-trade system is not simple. There are many different design factors that would need to be decided to ensure a fair and efficient system. For example, the relatively small number of companies operating in the oilsands means a particular focus would need to be placed on ensuring market power issues are not an issue. Additionally, the system would need to be designed to minimize impacts on oilsands competitiveness.
But these are not insurmountable hurdles. There is ample market monitoring experience for cap and trade systems now that such systems have been operating for decades. A cap and trade system could also be designed to auction all allowances but return all proceeds on an output basis. This would make the system operate similar to the output-based allocation carbon levy, the system envisioned for large emitters under Alberta’s Climate Leadership Plan by incentivizing emission reductions without encouraging production cutbacks.
As the government evaluates OSAG’s recommendations, it should think carefully about implementing a clunky system that mandates emission reductions from specific facilities. As it has shown in its choices to implement a carbon levy and output-based allocation system, the government recognizes the benefits of market-based solutions to reducing carbon emissions. It should continue to seek these benefits when implementing the oilsands emissions limit.
– Nick Martin is a policy analyst at the Canada West Foundation