Discussion Paper

A Greenhouse Gas Cap–and–Trade System

for Ontario

December 2008

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A Greenhouse Gas Cap–and–Trade System for Ontario

An Invitation to Comment

The Earth’s climate is changing. It has always done so, naturally, but human activity is accelerating the rate of change — in ways that are damaging ecosystems around the world. Plants and animals are being stressed. Human health and welfare are at risk everywhere on the planet. If we do not act now, and with determination, the problem will get worse. The world’s leading scientists have warned us about the devastating effects of increasing global greenhouse gas emissions.1 They have told us what we must do to anticipate and adapt to widespread ecological change.2 3 Leading economists, such as Sir Nicholas Stern,4 have warned that if we fail to act now, climate change will exact much greater penalties later on. But there is also great hope and opportunity in dealing with climate change. A responsible and progressive approach to reducing greenhouse gas emissions will result in cost savings through increased efficiency and lower fuel consumption. A cleaner environment and innovation will accelerate the transition to a greener economy. Real reductions in greenhouse gas emissions will become a new driver for economic prosperity. Ontario is committed to being part of the solution to climate change. To be effective, actions will be required by every group and individual in the province. Every person, family and business can help reduce Ontario`s carbon footprint, whether by walking or riding bicycles instead of over-using cars, washing clothes in cold water, using clotheslines, turning off lights and computers when not in use, installing more efficient (or solar-powered) water heaters, purchasing energy star computers and appliances, or eating local produce. These actions, and more, are under personal control. Collectively, they will contribute significantly to mitigating global climate change. They will become part of the new culture of living in a greenhouse gas constrained world. There are large sources of greenhouse gases that are not under direct individual control. These include electricity generators and companies in a range of industrial sectors. These sources must also be part of the solution. This Discussion Paper is directed towards such large emitters. In this regard, Ontario has a comprehensive strategy and is pursuing through partnerships such as the Western Climate Initiative the integration into a broad North American Cap-and-Trade system for greenhouse gases — one that will guarantee reductions in greenhouse gas emissions from these sources. The initial emphasis would be on the large emitters, but the trading system would broaden over time to cover more companies, to facilitate trading among companies at the regional, national and global levels. It is important to understand that doing nothing about large industrial emitters of greenhouse gases can harm both Ontario’s environment and its economy. Ontario has an open market economy. It operates in a global trading system. The solutions we implement must work in

1 Climate Change 2007: Fourth Assessment Report of the Intergovernmental Panel on Climate Change. 2 From Impacts to Adaptation: Canada in a Changing Climate 2007, Lemmen, D.S., Warren, F.J., Lacroix, J., and Bush, E, March 2008. 3 Human Health in a Changing Climate: A Canadian Assessment of Vulnerabilities and Adaptive Capacity, Health Canada, July 2008. 4 Report to the Prime Minister and the Chancellor of the Exchequer on The Economics of Climate Change, Sir Nicholas Stern, Office of Climate Change, United Kingdom, October 26, 2006.

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harmony not only with our Canadian and North American trading partners, but also with the global trading system. That is the broader context in which the design of a Cap-and-Trade system for reducing greenhouse gas emissions must be viewed. There are some basic points to keep in mind when reading and commenting on the Discussion Paper:

• Ontario’s Climate Change Action Plan5 is the framework within which Ontario’s greenhouse reduction measures will be implemented;

• Ontario will pursue integration into an emissions trading system based on a Cap-and-Trade model that will achieve reductions in emissions from industrial and electricity generating sources;

• Ontario is a member of the Western Climate Initiative6 and will seek to harmonize with this leading North American program when it comes into effect in 2012; and

• Ontario also signed a Memorandum of Understanding with Quebec on June 2, 2008, to establish a joint greenhouse gas emissions Cap-and-Trade regime that invites other provinces and territories to collaborate with Ontario and Quebec in implementing the regime as early as January 1, 2010.7

Ontario will take a pragmatic approach to Cap-and-Trade, focusing first on large emitters and later building on this system to expand the base of emitters and be consistent with the WCI trading system and eventually with other large regional and global systems. The challenge for stakeholders who comment on the Discussion Paper is to help the Government of Ontario develop a robust, but flexible, emissions trading system; one that can be adapted to new developments in rapidly evolving emissions trading markets. Finally, it will be critical to facilitate the transition by industry towards low carbon solutions. To that end, Ontario will explore complementary approaches to accelerate the development and adoption of newer, greener low carbon technologies. Delivery of these technologies will help ensure that Ontario industry maintains or grows a competitive advantage over industries in other jurisdictions. We believe the challenge of climate change can be met — in ways that will create new economic opportunities. Businesses that offer solutions will thrive. New jobs and wealth will be generated. Ontario plans to be at the forefront of this new economy. We will create clean green industries and jobs for many generations to come. We will leave healthy, resilient ecosystems as a legacy to our children. We will be responsible global citizens, finding solutions around the world. Ontario is taking the initiative. We’re moving forward; sensibly, progressively, and in full cooperation with leaders in North America and around the world. We invite you to share your insights and advice on how to support the development of a framework for a progressive and flexible Cap-and-Trade emissions trading system for Ontario that meets our environmental and economic objectives.

5 Go Green: Ontario’s Action Plan on Climate Change, Government of Ontario, August 2007. 6 Western Climate Initiative, Design Recommendations for the Regional Cap-and-Trade Program, September 23, 2008. 7 See www.premier.gov.on.ca/news/Product.asp?ProductID=2281.

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Table of Contents

1. Context 5 1.1 Climate Change Impacts: Why Ontario Must Act Now 5 1.2 Ontario’s Greenhouse Gas Reduction Goals 7

2. What is Cap-and-Trade? 11 3. Ontario’s Key Design Principles for Cap-and-Trade 14

3.1 Linking with the Western Climate Initiative 14 3.2 Emissions Caps 17 3.3 Scope and Point of Regulation 17 3.4 Electricity Sector 19 3.5 Distribution of Allowances 20 3.6 Offsets 21 3.7 Credit for Early Action 23 3.8 Banking and Borrowing 24 3.9 Compliance and Reporting 25 3.10 Economic and competitiveness analysis 27 3.11 Summary 27

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1. Context 1.1 Climate Change Impacts: Why Ontario Must Act Now The Earth’s climate is changing. The United Nations Intergovernmental Panel on Climate Change (IPCC) issued a report on November 17, 2007, confirming that climate change is occurring and impacting a range of natural and human systems.8 The IPCC has stated that most of the observed increase in global average temperatures is due to human activities. The following table shows the six greenhouse gas categories and their main sources from human activities. Greenhouse Gases9 Greenhouse Gas Global Warming Atmospheric Main Sources from Potential (CO2e) Lifetime (years) Human Activity Carbon dioxide 1 Variable Combustion of fossil fuels,

deforestation and industrial processes.

Methane 21 12 Cultivation of livestock,

natural gas delivery systems, landfills and coal mining.

Nitrous Oxide 310 120 Agricultural practices,

production and application of fertilizers, and the burning of fossil fuels.

Hydrofluorocarbons 1,350 12 Liquid coolants, such as CHCLF2 air conditioning and

refrigerators. CCL2F2 6,200–7,100 12 Liquid coolants and foams. Perfluorocarbons 6,500–9,200 50,000 Aluminum production and

semi-conductor industry applications.

Sulphur Hexafluoride 23,900 3,200 Dielectric fluid used in electrical equipment, such as transformers.

8 IPCC, 2007: Climate Change 2007: Synthesis Report. Contribution of Working Groups I, II and III to the

Fourth Assessment Report of the Intergovernmental Panel on Climate Change [Core Writing Team, Pachauri, R.K. and Reisinger, A. (eds.)]. IPCC, Geneva, Switzerland, 104 pp.[100 Year GWP]

9 Adapted from Emissions Trading Primer, Pollution Probe, November 2003.

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Two recently published studies have assembled research on the potential impacts on Canada of climate change during this Century.10 11 The following findings indicate what is already happening and what is at stake for Ontario:

• Since 1948, average temperatures in Ontario have increased by as much as 1.4 degrees C. Projections indicate that intense rainfall events, heat waves and smog episodes are likely to become more frequent.

• Heat-related mortality could more than double in southern and central Ontario by the 2050s, while air pollution mortality could increase by about 15 to 25% during the same interval.

• Remote and resource-based communities have been severely affected by drought, ice-jam flooding, forest fires and warmer winter temperatures, which have caused repeated evacuations, disrupted vital transportation links and stressed forestry-based economies.

• Wetlands have undergone dramatic declines in recent years, especially in southern Ontario. Lower water levels in the Great Lakes will further compromise the wetlands that maintain shoreline integrity, reduce erosion, filter contaminants, absorb excess storm water, and provide important habitat for fish and wildlife.

According to an authoritative report on climate change economics by Sir Nicholas Stern, “Climate change will affect the basic elements of life for people around the world — access to water, food production, health, and the environment. Hundreds of millions of people could suffer hunger, water shortages and coastal flooding as the world warms.” Stern went on to note that “Using the results from formal economic models, the Review estimates that if we don’t act, the overall costs and risks of climate change will be equivalent to losing at least 5% of global GDP each year, now and forever. If a wider range of risks and impacts is taken into account, the estimates of damage could rise to 20% of GDP or more. In contrast, the costs of action — reducing greenhouse gas emissions to avoid the worst impacts of climate change — can be limited to around 1% of global GDP each year. Costs could be even lower if there are major gains in efficiency, or if the strong co-benefits, for example from reduced air pollution, are measured. Costs will be higher if innovation in low-carbon technologies is slower than expected, or if policy-makers fail to make the most of economic instruments that allow emissions to be reduced whenever, wherever and however it is cheapest to do so.”12 The Stern Review reached several conclusions relevant to Ontario’s future economic prospects and the proposed provincial emissions trading system:

• “Action on climate change will also create significant business opportunities, as new markets are created in low-carbon energy technologies and other low-carbon goods and services. These markets could grow to be worth hundreds of billions of dollars each year, and employment in these sectors will expand accordingly.

10 From Impacts to Adaptation: Canada in a Changing Climate 2007, Lemmen, D.S., Warren, F.J., Lacroix, J., and Bush, E., March 2008. 11 Human Health in a Changing Climate: A Canadian Assessment of Vulnerabilities and Adaptive Capacity, Health Canada, July 2008. 12 Extracted from Summary of Conclusions, Report to the Prime Minister and the Chancellor of the

Exchequer on The Economics of Climate Change, Sir Nicholas Stern, Office of Climate Change, United Kingdom, October 26, 2006.

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• The world does not need to choose between averting climate change and promoting growth and development. Changes in energy technologies and in the structure of economies have created opportunities to decouple growth from greenhouse gas emissions. Indeed, ignoring climate change will eventually damage economic growth.

• Climate change is the greatest market failure the world has ever seen, and it interacts with other market imperfections. Three elements of policy are required for an effective global response. The first is the pricing of carbon, implemented through tax, trading or regulation. The second is policy to support innovation and the deployment of low-carbon technologies. And the third is action to remove barriers to energy efficiency, and to inform, educate and persuade individuals about what they can do to respond to climate change.

• Expanding and linking the growing number of emissions trading schemes around the world is a powerful way to promote cost-effective reductions in emissions and to bring forward action in developing countries; strong targets in rich countries could drive flows amounting to tens of billions of dollars each year to support the transition to low-carbon development paths.”13

1.2 Ontario’s Greenhouse Gas Reduction Goals Ontario has a comprehensive plan for moving on climate change. Ontario’s Climate Change Action Plan is Ontario’s “greenprint” for creating solutions.14 The Plan includes short, medium, and long-term targets for reducing greenhouse gas emissions. These targets are ambitious, but achievable:

• By 2014, we will reduce Ontario’s greenhouse gas emissions to 6 per cent below 1990 levels — a reduction of 61 megatonnes relative to business-as-usual.

• By 2020, we will reduce greenhouse gas emissions to 15 per cent below 1990 levels — a reduction of 99 megatonnes relative to business-as-usual.

• By 2050, we will reduce greenhouse gas emissions to 80 per cent below 1990 levels. Leading jurisdictions around the world are creating market-based systems that allow large industrial emitters to trade emissions allowances through a type of system referred to as Cap-and-Trade. Ontario believes that a Cap-and-Trade emissions trading system is a flexible, market-based mechanism that can facilitate lowest cost reductions in greenhouse gas emissions and provide opportunities for lowering the global cost of emissions reductions. By providing market-based incentives, it can support the transition to a low-carbon economy and encourage technological innovation, economic growth and job creation. A Cap-and-Trade system has therefore been included in the mix of policy instruments to be employed to achieve Ontario’s Climate Change Action Plan targets. Moreover, the Cap-and-Trade program would be designed to achieve real reductions based on the internationally accepted base year of 1990. In support of this policy initiative, Ontario has signed a Memorandum of Understanding with Quebec to develop and implement a Cap-and-Trade system as early as January 1, 2010.15 The proposed Ontario-Quebec trading system would enable electricity generators and designated industrial sectors in both provinces to gain experience in trading greenhouse gas emission allowances before broader trading regimes, such as the Western Climate Initiative (WCI), come into effect. This would better prepare Ontario to participate in and inform the development of the

13 Ibid. 14 Go Green: Ontario’s Action Plan on Climate Change, Government of Ontario, August 2007. 15 See www.premier.gov.on.ca/news/Product.asp?ProductID=2281.

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WCI and other regional trading systems that may be implemented, whether through the Mid-western Greenhouse Gas Reduction Accord and the Regional Greenhouse Gas Initiative, or through national (i.e., Canada, U.S.) and international trading systems (i.e., the European Union Emissions Trading Scheme). Linking emissions trading programs will create markets with larger numbers of participants and a greater diversity of emissions reduction costs, thus improving market liquidity and economic efficiency through decreased costs of compliance. To further enhance the ability to link greenhouse gas emissions trading systems, Ontario, Quebec and other provinces and territories have joined The Climate Registry — a non-profit partnership of North American member states, provinces and tribes that is developing an accurate, complete, consistent and transparent greenhouse gas measurement protocol that is capable of supporting policies for its Members and Reporters. The Climate Registry will provide a verified set of greenhouse gas emissions data from its Reporters, supported by a robust accounting and verification infrastructure (see www.theclimateregistry.org) Ontario will also work with the federal government to ensure that regulated sectors do not result in duplicative regulations and emissions trading systems. We will continue to emphasize the importance of a regulatory framework and related emissions trading system that achieves absolute emissions reductions and is compatible with other Cap-and-Trade systems developing in North America and around the world to facilitate broad access to trading and a level playing field for industry. Ontario GHG Emissions By Sector 2006

Source: Canada’s 1990 – 2006 National Inventory

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Where Emissions Reductions Will Have Been Achieved by 2014

Source: Ontario Greenhouse Gas Emissions Targets: A Technical Brief, June 2007

Where Emissions Reductions Will Have Been Achieved by 2020

Source: Ontario Greenhouse Gas Emissions Targets: A Technical Brief, June 2007

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Regional and International Greenhouse Gas Emissions Trading Initiatives

Western Climate Initiative (WCI) — WCI is a collaboration launched in February 2007 with the goal of identifying, evaluating and implementing collective and cooperative ways to reduce greenhouse gases. The number of partners in WCI has grown to include seven states and four provinces. Upon participating as an observer since August 2007, the province of Ontario became a member in July 2008. WCI jurisdictions are recommending a design for a broad Cap-and-Trade program as part of a comprehensive regional effort to achieve the goal of reducing greenhouse gas emissions 15% economy-wide by 2020 from the 2005 base year. WCI currently represents approximately 73% of Canada’s economy and 20% of the United States’ economy, making it the largest Cap-and-Trade program in North America.

Regional Greenhouse Gas Initiative (RGGI) — RGGI is a cooperative effort by ten Northeast and Mid-Atlantic states — to design a regional Cap-and-Trade program initially covering carbon dioxide emissions from power plants in the region. In September 2003, RGGI members endorsed an action plan to develop a core Cap-and-Trade program for power plants, with subsequent design phases to consider offset protocols. In the future, RGGI may also be extended to include other sources of greenhouse gas emissions and greenhouse gases other than CO2. RGGI allows for other states and jurisdictions to join the initiative. Ontario is currently participating as an observer to RGGI.

Mid-western Greenhouse Gas Reduction Accord (MGA) — MGA is an accord signed on November 16, 2007, that currently includes seven Mid-western members (i.e., six states and the province of Manitoba) and four observers (i.e., three states and the province of Ontario). The Accord covers an area in the U.S. that runs from Ohio to Kansas. Participants have signed various agreements designed to cut greenhouse gas emissions, promote energy conservation and fight global warming. For example, Illinois, Iowa, Kansas, Michigan, Minnesota and Wisconsin signed an agreement setting greenhouse gas reduction goals that allow companies to buy and sell pollution credits to meet member states’ targets. The Accord will establish greenhouse gas targets and timeframes, develop a market-based and multi-sector Cap-and-Trade mechanism to help achieve states’ reduction targets, establish a tracking system for reductions, and implement additional steps, as needed, to achieve the reduction targets, such as low-carbon fuel standards and regional incentives and funding mechanisms.

European Union Emissions Trading System (EU ETS) — The European Union has established the largest multi-national emissions trading system in the world. Initiated in January 2005, it covers more than 10,000 installations in the energy and industrial sectors that are collectively responsible for close to half of the EU’s emissions of CO2 and 40% of its total greenhouse gas emissions. The first EU ETS Trading Period expired in December 2007. The second Trading Period has been underway since January 2008 and will last until December 2012.

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2. What is Cap-and-Trade?16 The following section describes the key elements of a Cap-and-Trade system including potential design features for further consideration. “Emissions trading” is a mechanism by which companies that reduce their emissions below the levels required by regulation can sell “surplus reductions” to companies that still need to make reductions to meet compliance commitments. The process begins with a government regulator setting targets and timelines for the reduction of emissions of specific pollutants, in this case greenhouse gases. The regulator identifies the largest emitters and establishes an aggregated cap on the total amount of emissions that can be released to the atmosphere by these “capped emitters” in a given compliance period. The total emissions allowed under the cap are divided into units called “allowances,” with each allowance equal to one tonne of emissions (i.e., one tonne of Carbon Dioxide Equivalent, or CO2e). Each emitter is allocated a specific number of allowances by the regulator, which governs the amount of greenhouse gases the emitter is allowed to release into the atmosphere in a compliance period. Each capped emitter must monitor (or estimate using approved methodologies) its actual emissions in the compliance period. At the end of the compliance period, the capped emitter must report its total annual emissions to the regulator and surrender a number of allowances equal to its actual emissions. If the emitter’s actual emissions are equal to the number of allowances that were allocated by the regulator, the capped emitter has achieved compliance for that period. If the actual emissions are greater than the number of allowances allocated, the capped emitter must purchase allowances from another capped emitter (or from an offset credit provider, to be described later) or face penalties imposed by the regulator. If the actual emissions are less than the number of allowances that were allocated, the capped emitter has an excess number of allowances that it can sell to an over-emitting capped emitter, or it can “bank” the excess allowances and use them to meet its own emissions reduction requirements in future compliance periods. During emissions trading, the allowances acquire a monetary value through market activity and can be bought and sold as a commodity. The purchase and sale of allowances among capped emitters is the essence of emissions trading. There are two basic approaches to distributing allowances to capped emitters (although mixes of these approaches are often used). In either allocation methodology, allowances attain their value through market transactions.

• Auctioning: Companies bid against each other for allowances, which then go to the highest bidder. The revenues received by the government may be recycled back into the economy for a variety of purposes such as to provide compensation and/or adjustment assistance to companies that are adversely affected by the requirement to reduce emissions. Other revenue recycling/use options may also be pursued, including using auction funds to stimulate low-carbon technology development and innovation.

16 Information in this section has been copied or adapted from Emissions Trading Primer, Pollution

Probe, November 2003.

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• Gratis: Allowances may be issued free of charge by the regulator to each emitter. The allowances are either proportional to past emissions (i.e., grandfathered) or based on current emissions. They may also be based on production or other bases.

Ontario is considering a hybrid system using gratis and auctioning of allowances. The province is also considering a variation of the basic Cap-and-Trade model including the use of offset credits along with allowances. Open systems allow non-capped emitters to create emissions reduction credits and sell them to capped emitters. The term “offsets” is used to describe credits created by non-capped emitters. Whereas capped emitters are legally mandated to reduce their emissions by specific amounts, non-capped emitters are companies (or other greenhouse gas emission sources or carbon sinks) that take voluntary action to reduce emissions or sequester carbon in advance of, or along with, the development of emissions trading programs. Offsets

Under an offsets system, uncapped emitters can generate credits by undertaking projects to reduce their emissions. Credits can be sold to the capped sources that have compliance obligations under the emissions trading program.

Allowing capped emitters to use offset credits to demonstrate compliance can reduce the compliance costs for a trading program. The offset projects have to meet criteria specified by the regulatory authority.

In addition to energy conservation and other ways of reducing energy use, carbon credits could be created by various carbon sequestering activities, such as tree planting, managing farmlands and forested areas, or forest conservation, as long as other valued ecosystem services, such as conserving wildlife habitat and protecting watersheds, are assured. Ontario has established a working group of experts in emissions trading, the environmental community and relevant sectors to develop protocols for carbon offsets. Protocols

A protocol sets out a proposed plan for quantifying greenhouse gas emissions reductions for a specific project type. It provides guidance to project proponents on how to apply the quantification approach in their projects.

Given the key role that new, more efficient technologies will play in meeting the challenges of a carbon constrained world, Ontario is also consulting with stakeholders on a technology and innovation strategy that would complement the role that the Cap-and-Trade system will play in transitioning to a low-carbon economy. Discussions that will inform the development of a technology roadmap for Ontario will occur concurrently.

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An Emissions Trading Example17

Consider two companies, A and B, both producing 1,000 tonnes of greenhouse gas emissions per year. The government decides to regulate the emissions and reduce the combined emissions from 2,000 to 1,600 tonnes per year — a total reduction of 400 tonnes. Each company is allocated 800 emission allowances, for a total of 1,600 tonnes.

Company A has old equipment that needs replacing, so it decides to invest in new equipment that reduces emissions to 600 tonnes (i.e., 200 tonnes below what is required by regulation). Company B has relatively new equipment that has not been fully “written off,” It would lose a considerable sum of money if it replaced the equipment now. Thus, company B continues to use its existing equipment, but it will also continue to emit 1,000 tonnes of greenhouse gases per year.

With no emissions trading system, company B would be in violation of its greenhouse gas limit and would either face a penalty for non-compliance or would be forced to buy new equipment to reduce its emissions. Under emissions trading, company B could buy 200 tonnes of allowances from company A so that it can balance its actual emissions with the number of allowances it holds.

The new result is that the government’s target reduction of 400 tonnes of greenhouse gases has been achieved. Company A has received money from company B for its extra emissions reductions (which it might otherwise not have made), and company B is in compliance with its greenhouse gas reduction requirement.

The following sections of the Discussion Paper lay out design principles and details for public and stakeholder review and comment.

17 Adapted from Emissions Trading Primer, Pollution Probe, November 2003.

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3. Ontario’s Core Design Principles for Cap-and-Trade The following key principles will guide the design of Ontario’s greenhouse gas emissions trading system:

– Absolute reductions in emissions of greenhouse gases must occur; – Trading rules must be simple, consistent and transparent; – Program must be administratively efficient; – Equitable treatment must be assured among the capped sectors; – Credit for early action must be available to industry leaders; – Emissions measurement, monitoring and reporting must be accurate; – Development and deployment of clean technologies must be integrated into the trading

program; and – Trading opportunities must be facilitated with comparable regional and national trading

systems. Important decisions need to be made about what the Ontario Cap-and-Trade program would look like, including:

– Sectors that would be capped by the program (scope) and the companies that would be required to hold allowances equivalent to emissions (capped emitters);

– What level the emissions caps would be set at, now and in future (stringency); – How allowances would be distributed and how this would change over time (allocation); – How the Ontario program would be linked to other trading programs (linkages); – Flexibility provisions that would be included in the program (flexibility); – Recognition for early emissions reductions that would be included in the program (credit

for early action); – Mandatory reporting requirements (reporting); and – Consequences for non-compliance (compliance).

3.1 Linking with the Western Climate Initiative Ontario’s emission trading system would be designed to be compatible with other trading systems such as the Western Climate Initiative (WCI) or other North American and international systems. It would apply to many of the same major emitters that will be captured under WCI, and the allowances distribution, tracking, reporting and compliance systems will follow the approaches of other international systems. By starting earlier, Ontario would provide our industries with greater experience in all aspects of emission trading, including familiarity with the market approach and full range of compliance options. This would prepare Ontario’s industries for future Cap-and-Trade programs, such as WCI or other Cap-and-Trade systems that are implemented. The Ontario program would also allow government and industry to potentially reap benefits from early actions, improve the quality of the emissions data to support policy development, fine tune the approaches to distribution of allowances to minimize the effects on Ontario’s competitiveness, and streamline compliance requirement for industries and government.

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Aligning with the Western Climate Initiative

In the near term (i.e., 2012 and thereafter), in order to link with other trading systems, such as the Western Climate Initiative (WCI), the Ontario program may add more industry sectors and facilities. The initial emissions threshold for regulated facilities may drop to a lower level to be comparable to these trading systems (e.g., 25,000 tonnes per year). Also under the WCI, residential, commercial and industrial fuel combustion at facilities below the WCI threshold of 25,000 tonnes per year is proposed to be included at the start of the second compliance period in 2015, along with transportation fuel combustion from gasoline and diesel. However, WCI has acknowledged that individual jurisdictions may instead utilize comparable fiscal measures, such as British Columbia’s carbon tax, to address transportation fuels and fuel use by residential and commercial sources.

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For more details, see Western Climate Initiative, Design Recommendations for the WCI Regional Cap-and-Trade Program, September 23, 2008 at www.westernclimateinitiative.org.

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3.2 Emissions Caps Ontario proposes to set the initial greenhouse gas cap using current emissions data to assist in determining the emissions baseline from which targets will be determined, and against which reductions and success will be measured. An overall emissions cap would be set for regulated sectors that will apply during the first compliance period, which would start as early as in 2010. The initial cap would be tightened over time to meet targeted reductions. Ontario will explore ways to partner with industry to help meet the required reductions through complementary technology and innovation strategies. In setting the cap, the province will consider a number of different factors, including Ontario’s Climate Change Action Plan targets, requirements for federal equivalency, the need to be as stringent as emerging U.S. or European trading systems for linking purposes, the contribution of each industry sector to the overall provincial emissions reduction target, and the economic and technical feasibility of emissions reductions by various industry sectors. It is expected that the initial caps on the regulated sectors would be based on the most current emissions data available, adjusted for growth, if required, to realistically estimate emissions for the start of the first compliance period. An average of emissions over a three-year period may be used to set the initial cap for that emitter. The Ontario Cap-and-Trade system may be implemented as early as 2010. The initial cap may be reduced on a linear (i.e., through equal annual percent reductions) or stepped basis to achieve the province’s overall greenhouse gas reduction cap in 2020. Alternatively, the cap could be reduced in periods greater than one year, as long as the overall target is reached by 2020. Six greenhouse gases have been covered in climate change programs due to their inclusion in the Kyoto Protocol: carbon dioxide, methane, nitrous oxide, perfluorocarbons, hydrofluorocarbons, and sulphur hexafluoride. To be consistent with the Kyoto Protocol, all six greenhouse gases will be included in Ontario’s emissions trading program. 3.3 Scope and Point of Regulation The scope of program coverage is a central question in the design of a Cap-and-Trade system. The broader the system’s scope, the more opportunities there will be to achieve gains from emissions trading. The number of regulated emitters is important to the efficient functioning of the market. Too many sources will increase administrative complexity, while too few may allow some sources to dominate and hence reduce market efficiency. A single company or group of companies holding a large percentage of the total number of allowances may be able to influence the allowance price in order to improve their competitive standing. This would frustrate the goals of using a market mechanism to find cost-effective and least-cost ways to reduce greenhouse gas emissions and stimulate technological innovation. In deciding which sources or facilities to cover, a balance must be struck between covering as many emissions sources as possible and the task of efficiently managing the monitoring, verification and tracking of emissions (i.e., the administrative costs). Emissions covered by Cap-and-Trade programs generally include sources associated with the combustion of fossil fuels, and may also include “process emissions” that are released during the production and manufacturing process. In cement production, for example, process emissions are higher than combustion emissions.

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3.3.1 Proposed Approach Ontario’s proposed approach is to integrate with the WCI or broader trading systems for 2012 (and beyond) by phasing in as early as 2010 most sectors included in the federal framework (to ensure a single framework). It would include caps and scheduled emissions reductions for facilities that emit more than 100,000 tonnes per year of carbon dioxide equivalent (CO2e). This would allow both industry and regulators to gain experience with the program while there is a small number of participants. In the period 2010 and 2011, the Ontario trading program would include the electricity sector, large stationary combustion sources, fossil fuel production, and other industrial processes in which individual plants are significant sources of CO2e emissions. For Ontario, in addition to the electricity sector, this would include the following sectors: iron and steel, cement, petroleum refining, pulp and paper, lime, base metal smelting and chemicals. The “point of regulation” for capped emitters would be at the facility level for industrial firms. For electricity generators, the point of regulation would be at the generation plant for direct in-province generators or at the corporate level to be consistent with the federal framework. For electricity imported from generation sources located outside of Ontario, the point of regulation would typically be an “entity” (i.e., importer, market operator, or other enterprise) that is the first point at which electricity is delivered to the Ontario market. The threshold for regulated emitters may be lowered to 25,000 metric tons of CO2e to harmonize with other emissions trading systems in 2012. 3.3.2 Selected Issues for Discussion

• In setting the cap, the contribution of each sector to the overall provincial emissions reduction target would be determined, considering Ontario’s Climate Change Action Plan targets (for electricity, industrial emissions, research and innovation, etc.), requirements for federal equivalency, the need to be as stringent as other emerging U.S. or European trading systems for linking purposes, as well as the economic and technical feasibility of emissions reductions by the sectors.

• An initial threshold of 100,000 tonnes/year of CO2e for application in 2010/2011 is proposed.

• Ontario would use 2005-2007 actual emissions data adjusted for representative years to realistically represent emissions for the start of the first compliance period in 2010/11.

• Caps would be reduced on a linear basis, or they could be stepped down at predetermined years.

• Allowances would be allocated on a corporate or a facility basis. • Industrial sources would be regulated at the point of greenhouse gas emission. • Sectors in addition to electricity generation, with large stationary combustion sources and

other industrial processes, including iron and steel, cement, petroleum refining, pulp and paper, lime, base metal smelting and chemicals.

• Additional sectors may be phased into the Cap-and-Trade system over time starting in the 2012 period.

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3.4 Electricity Sector Ontario has a diverse mix of electricity sources. Electricity generated in the province includes nuclear, hydroelectric and fossil fuel-fired (coal and natural gas) sources, as well as a growing amount from wind energy and other renewable energy sources. The electricity sector is undergoing significant change within Ontario including transitioning to lower emitting energy sources such as natural gas and decreasing the use of coal. In addition, Ontario imports and exports electricity from other jurisdictions in North America. These are important considerations that will need to be recognized in the design of the Cap-and-Trade system. Large fossil fuel-fired generating plants in Ontario are major greenhouse gas emitters and would be included in the Cap-and-Trade program. Electricity is imported by many different types of firms that re-sell it to other customers in Ontario. In some Cap-and-Trade systems, two common points of regulation are the place of electricity generation and the point-of-sale. In Ontario, more than 90% of the electricity sector’s greenhouse gas emissions can be captured through generator-based regulation. Regulating greenhouse gas emissions at the point-of-sale of electricity is more complex, but it can capture virtually all electricity sector emissions. This broader approach to regulation and compliance is also compatible with the way electricity is traded in regional markets. Ontario buys and sells electricity in an interconnected North American market. Electricity entering the provincial grid can be regulated to cover related CO2e emissions (calculated based on the kilograms per megawatt-hour) using the “first seller” as the point of regulation. Emissions associated with electricity exports from Ontario would, in turn, ideally be regulated by the receiving jurisdiction, though this may not occur if the receiving jurisdiction has no emissions reduction obligations of its own. In this case, the emissions associated with exported power would be the responsibility of the exporting generator. Electricity that enters the provincial grid on its way to another jurisdiction would fall outside of the regulated system. In order to link to other emissions trading systems, such as the WCI, the design of the Cap-and-Trade system, including the threshold for the electricity system would have to be compatible. 3.4.1 Proposed Approach Ontario would establish a cap for greenhouse gas emissions from electricity generation. Generators that meet the 100,000 tonnes/year CO2e emissions threshold, for 2010-2011. The first year of regulation would cap each generating facility at, or close to, its current amount of emissions. In 2012, the threshold would be reduced to 25,000 tonnes CO2e to be consistent with WCI, and the amount of allowances under the cap would decline from 2012 to 2020 in accordance with provincial greenhouse gas reduction targets. Ontario would also propose to regulate emissions associated with imported electricity at the point of first sale in the province. Discussions will be needed with “first deliverers” to determine how the reporting of emissions should be done. Imported electricity would either have to be tracked in a verifiable way or assigned a “default” greenhouse gas emissions rate (in kg/MWh). Imported electricity will need to be adjusted for electricity that is passing through the provincial grid destined for another jurisdiction.

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3.4.2 Selected Issues for Discussion

• Point of regulation would be at the corporate or facility level. • Electricity imports regulated at the point-of-sale to the Ontario grid. • A threshold will be set for electricity imports. • Use of an emissions factor to calculate emissions associated with imported power. • Treatment of renewables, other non-fossil fuel electricity generation and energy efficiency

projects. 3.5 Distribution of Allowances The distribution of allowances in a Cap-and-Trade system is the central mechanism whereby individual firms receive their emissions allowances for a compliance period. The key questions are whether allowances would be distributed free (i.e., gratis), sold via auction, or allocated using a combination of the two approaches. When allowances are provided gratis, the regulator specifies who will receive the allowances and on what basis. If allowances are auctioned, questions arise as to what type of auction process should be used and how the funds generated by the auction would be deployed. If a combined approach is selected — with some allowances distributed gratis and the rest auctioned — decisions must be made on the gratis/auction split. A combined approach is proposed to be used initially, with the transition towards higher levels of auctioning in the future. Of the total annual allowance budget, not all of the allowances would be distributed through gratis allocation or auction. Some may be retained by the government for a variety of policy reasons, such as accommodating new market entrants, and providing for set-asides. The province would retain sufficient flexibility to issue and hold allowances for appropriate purposes. 3.5.1 Proposed Approach Ontario would establish a total allowance cap that would be used as a basis for the distribution of allowances to regulated emitters. The program would be developed so that the first compliance period could begin on January 1, 2010. The number of allowances allocated to the regulated industry and electricity sectors for this and subsequent periods would be aligned with Ontario’s Climate Change Action Plan targets and timelines. Ontario is considering a range of options on whether the distribution of allowances for the regulated sectors would be done on a gratis or auction basis, or would use a combination of the two approaches. There is some advantage to commencing the program with a combined gratis/auction allocation process, with a higher proportion of the allowances being gratis initially. This would give the province more flexibility to issue gratis allowances as credit for early action or for process-related emissions (where fewer short-term opportunities exist for low-cost emissions reductions). The percentage of auctioned allowances would increase over time. An important policy issue to consider if auctioning is used is how the revenue would be used. There are many options available. For example, among others WCI is considering using the revenues to further reduce greenhouse gas emissions through programs that target emissions reductions in sectors not covered by the Cap-and-Trade system and funding investments in energy efficiency, research, development and demonstration of new technologies that will reduce

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emissions over the longer term. These options, and others, will need to be assessed in terms of their economic and environmental advantages and disadvantages. The allowance cap and its allocation among sectors would also be adjusted, as necessary, to facilitate linking with other trading systems. Such linkages would require a similar level of rigour and stringency among the systems. For allowances and offsets to be valid for trading in other jurisdictions, Ontario would have to demonstrate compatibility in its allocation and offsets. Ontario allowances would have an equivalent value to those in other trading systems. The WCI is proposing that a minimum of 10% initially in 2012, rising to 25% by 2020 (potentially rising to 100%) be auctioned. When similar industries operate in more than one jurisdiction, linked trading systems may have to treat those industries similarly, perhaps even identically to ensure a level competitive playing field is maintained. If gratis allocations are given in some jurisdictions, benchmarks may have to be developed to harmonize allocations. Thus, Ontario’s initial emissions trading system would have to be designed flexibly to be able to adapt to changing circumstances as regional, national and international trading systems evolve. Over the longer term, the Ontario caps and allowances distribution system will be designed to be consistent with the broader WCI approach. The overall design will need to be administratively simple, transparent, minimize costs to Ontario industries and foster market liquidity to provide flexibility for the regulated entities. 3.5.2 Selected Issues for Discussion

• The allowances would be distributed initially through both auctioning and gratis. • The auction would be based on a percentage of total allowances. • Auction revenues may be used in a variety of ways. • Determination of gratis allocations.

3.6 Offsets In a Cap-and-Trade system, offsets are created through emissions reduction projects undertaken at sources outside of the capped sectors or through the removal of CO2 from the atmosphere through biological or geological sequestration. The offset provision allows capped entities access to an additional compliance option through purchasing offsets generated by voluntary emissions reduction projects. Offsets reduce the overall cost of the Cap-and-Trade program by bringing in lower-cost emissions reduction opportunities generated outside of the cap. Offsets offer financial incentives, as they allow revenues to flow to the owners of offset projects, making those projects more financially attractive/viable. Offset projects promote investment and innovation in uncapped sectors of the economy. They also promote secondary social, environmental and economic goals through the promotion of emissions-reducing practices and technologies. Examples of offset projects include landfill methane capture, renewable energy generation, energy efficiency gains, and appropriate agricultural practices and afforestation.

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3.6.1 Proposed Approach The Ontario Cap-and-Trade system may include provision for the use of offsets. Offsets would need to meet the criteria of being real, surplus, verifiable, permanent, and enforceable. The offsets would have to follow the best verification practices. The offset projects would have to demonstrate that they offer environmental benefits that would not have occurred in the absence of the project. Efforts will be made to link to the Canadian and WCI offsets programs as they develop. Ontario will support the development of these offsets systems that recognize emissions-reducing projects by facilitating the creation of offsets protocols. The WCI Partners have recommended limiting the use of all offsets, and allowances from other GHG emission trading systems that are recognized by the WCI Partner jurisdictions, to no more than 49% of the total emission reductions from 2012-2020 in order to ensure that a majority of emission reductions occur at WCI covered entities and facilities. Each WCI Partner jurisdiction will have the discretion to set a lower percentage limit. The WCI Partners have identified the following project types as priorities for investigation and development to facilitate their participation in the offset system.

– Agriculture (soil sequestration and manure management); – Forestry (afforestation/reforestation, forest management, forest preservation/conservation,

forest products); and, – Waste management (landfill gas and wastewater management).

3.6.2 Selected Issues for Discussion

• Lower limit of 49% of the total emission reductions from 2012-2020 that are eligible to be met through offsets and allowances from other GHG emission trading systems.

• Offset creation criteria include real, surplus, verifiable, permanent, and enforceable. • Determination of “surplus to business as usual” • International emissions credits (i.e., CDM). • Use of existing protocols adapted for Ontario (e.g., Alberta, CDM). • Number of years a project should be allowed to create offsets

Clean Development Mechanism

The Clean Development mechanism (CDM) is a Kyoto Protocol mechanism that allows emissions reduction and afforestation/reforestation projects with sustainable development benefits to be implemented in developing countries that have ratified the Kyoto Protocol.

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3.7 Credit for Early Action Credit for early action is a way to recognize and reward greenhouse gas emissions reductions undertaken prior to the beginning of a regulated Cap-and-Trade system. The proposed federal framework provides for a number of ways to comply with its proposed emissions reduction targets. One way for a facility to meet all or part of its reduction target is to use credits received from the Credit for Early Action (CEA) Program. The CEA Program will allocate credits totalling 15 megatonnes of carbon dioxide equivalent, with a maximum of five megatonnes allocated for use in each of 2010, 2011 and 2012. If eligible reductions exceed 15 megatonnes, credits will be distributed on a pro rata basis. The application process is made up of three Phases, culminating with the allocation of early action credits in July 2009. Since 1990, Ontario industry has undertaken early actions well beyond the 15 megatonne limit proposed under the federal framework. It is important to consider ways to recognize these actions. 3.7.1 Proposed Approach In Ontario, early action that has been taken to reduce emissions would be subject to carefully defined criteria. At a minimum, regulated emitters owning or controlling covered facilities or sources would have an established and credible public record of emissions reductions at those facilities or sources for which credit for early action is requested. Reductions that were a result of a plant slow-down or shut-down (unless for the purpose of reducing emissions by increasing lower emitting production), actions outside of the facility’s boundaries, the movement of production off-site (with some exceptions), the capturing or sequestering of greenhouse gases, energy efficiency improvements at another facility, or the reduction of fugitive emissions would be ineligible for early action credits. Under the WCI, Early Reduction Allowances would be issued for certain emissions reductions at covered entities and facilities within its jurisdiction that are achieved after January 1, 2008 and before January 1, 2012. The WCI Partner jurisdictions will jointly establish criteria to determine which early reductions will be eligible for Early Reduction Allowances. The criteria will ensure that the reductions are voluntary, additional, real, verifiable, permanent and enforceable. Each WCI Partner jurisdiction would have discretion to recognize early actions other than those that would be eligible for Early Reduction allowances (i.e. such as those that occur prior to January 1, 2008) within their respective allowance budgets. Recognition of these very early actions by Ontario will be considered. 3.7.2 Selected Issues for Discussion

• While a limit may be set on the amount of early action credits that are made available, consideration of action taken by Ontario industry beyond the 15Mt limit under the federal framework

• Basis to recognize early actions in Ontario • Recognition of early actions prior to the January 1, 2008, start date for Early Reduction

allowances under the WCI.

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3.8 Banking and Borrowing Banking and Borrowing

Allowances and/or credits can be used immediately to meet current regulatory requirements, or they can be banked for future use. If they are banked, they can be used to:

• Meet future reduction requirements; for example, as the emissions limits (and hence the number of available allowances) are gradually decreased over time by the regulator; or

• Create revenue by being sold at an opportune time. In general, as the end of the compliance period approaches, the demand for tradable units increases, and therefore the price also increases.

3.8.1 Proposed Approach To reduce the cost of the Cap-and-Trade program and to give more flexibility to regulated emitters, banking of allowances will be considered. This means that emitters that reduce their emissions more than required by law would have surplus allowances (i.e., they will hold more allowances than they need to submit to the government in a given compliance period). These emitters would be permitted to bank the surplus allowances and use them in a future compliance period to the extent agreed upon with linked systems in 2012. Banking provides emitters with greater flexibility to manage their business needs and plan for future investments. It also encourages earlier action to reduce emissions, as well as encourages over-compliance. Both of these outcomes are good for the environment. “Borrowing” of allowances from later periods is not being considered as this could result in an unacceptable deferral of total emissions reductions. This is consistent with other emissions trading systems with which Ontario may link, including WCI, in which regulated emitters are expected to be permitted to bank allowances. 3.8.2 Selected Issues for Discussion

• Banking of allowances.

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3.9 Compliance and Reporting All programs that regulate emissions of greenhouse gases have mandatory reporting by the regulated sectors, firms, facilities or sources. Tracking of emissions is necessary for several reasons:

– To facilitate compliance, so that each regulated emitter can retire sufficient numbers of allowances to match its regulated emissions cap;

– To track emissions and emissions reductions among the regulated emitters; – To ensure that the emissions market is functioning effectively and efficiently; – To provide accurate and transparent data to market participants and the public; – To allow regulators to distribute allowances properly; and, – To enable regulators to confirm whether or not compliance has been achieved.

Currently, Statistics Canada collects emissions data in Canada. Several U.S. states and some Canadian provinces participate in The Climate Registry, a joint initiative to measure and collect greenhouse gas emission data on a voluntary basis using a common standard and a unified emissions reporting system. A number of states that are members of regional Cap-and-Trade systems, such as the Western Climate Initiative and the Mid-western Greenhouse Gas Reduction Accord, are enacting mandatory reporting programs to ensure that all facilities covered by their systems report to state agencies. All regulated emitters under Ontario’s Cap-and-Trade program, including emitters that apply for offsets, would be required to report emissions. The compliance period chosen for a Cap-and-Trade program may be on an annual or multi-annual basis. Longer compliance periods offer regulated entities more flexibility in planning for (or responding to) large and unexpected changes in the allowance markets, large fluctuations in prices, or anomalies in temperature (hotter summers/colder winters). The WCI has established three-year compliance periods (i.e., 2012-2014, 2015-2017, and 2018-2020). 3.9.1 Proposed Approach With Ontario’s initial Cap-and-Trade program beginning as early as 2010, the first compliance period would be from 2010 to 2011. After that, compliance periods would be brought into line with linked trading systems, such as WCI, in which each compliance period would be three years long, starting in 2012. Emitters under the Cap-and-Trade system would be required to report annually and to verify at the end of the compliance period that their allowances and reported emissions match. Under WCI, mandatory reporting for all six greenhouse gases would commence in January 2010 for all entities and facilities that will be subject to reporting. Submission of 2010 emissions reports would begin in early 2011. The entities and facilities subject to reporting are those with annual emissions equal to or greater than 10,000 tonnes/year of CO2e. However, in some limited instances, the threshold may be based on other parameters, such as throughput or capacity, as long as these thresholds represent the equivalent of, or are lower than the 10,000-metric-ton threshold.

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The reporting threshold of 10,000 tonnes is lower than WCI’s proposed threshold of 25,000 tonnes for facilities and entities to be covered under the Cap-and-Trade system in 2012. Ontario and other WCI partners will be using the reported data to develop the 2012 caps for the Cap-and-Trade system, and future targets. As well, WCI partners may require third-party verification or government audit programs for facilities and entities that are covered by the Cap-and-Trade regulation. To support the Ontario Cap-and-Trade compliance system in the period leading up to 2012, all regulated emitters would be required to report emissions annually and to retire the appropriate number of allowances (and/or offsets) to meet their regulatory obligations. Facilities (with emission greater than 100,000 tonnes of CO2e emissions) in the following sectors would be covered by the Cap-and-Trade system in 2010:

– Fossil fuel-fired electricity generators – Industries, including all stationary combustion sources and process emissions in the

following sectors: - Base metal (nickel/copper) smelting and refining - Cement - Chemical - Iron and steel - Lime - Petroleum refining - Pulp and Paper

Beyond 2012, in order to align with other trading systems, the Cap-and-Trade system and compliance reporting requirement may be extended, in accordance with the scope of the system, to include other sectors with facilities that are emitting greater than 25,000 tonnes CO2e. The reporting units would include regulated emitters for specified industrial sectors and the generating plant and first seller (or deliverer) in the electricity sector. All six greenhouse gases would be reported. To the extent possible, Ontario intends to harmonize its reporting requirements with other provinces and jurisdictions to support the establishment of formal linkages with their trading systems. The primary issue for linking emissions trading programs is whether one program will accept allowances/offsets from another program as valid units of compliance for meeting the emissions limits of participants in its program. Achieving linked trading systems would require institutional compatibility to establish the equivalence of allowances/credits and to allow them to move from one trading system to another. Ontario is committed to avoiding onerous reporting requirements for emitters in the province. Accordingly, Ontario will work closely with the federal government, as well as representatives of The Climate Registry and the WCI, to avoid multiple reporting and to develop agreements to facilitate the sharing of reported information among jurisdictions. 3.9.2 Selected Issues for Discussion

• Reported emissions must be verified by an independent third party or subject to government audit.

• Emissions reporting in Ontario will ensure consistency with internationally accepted methods.

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3.10 Economic and Competitiveness Analysis Economic and competitiveness analysis will need to inform the design of a Cap-and-Trade system for Ontario. Ontario is undertaking economic modelling of the implementation of Cap-and-Trade in Ontario. Stakeholders can assist in addressing competitiveness issues by providing any existing analysis and input on the competitive and economic situation of Ontario industries. Better information on internal abatement opportunities for industry will also help to inform the economic impact analysis of Cap-and-Trade. 3.11 Summary Over the coming months, the proposed design features and details outlined above will require further discussion to inform the development of an Ontario Cap-and-Trade program that can be integrated with other trading systems. As the province moves forward, we invite you to share your comments on Ontario’s approach to Cap-and-Trade. Please submit your comments on the Discussion Paper in writing or by email to: Heather Pearson Air Policy Instruments and Program Design Branch Ministry of the Environment 135 St. Clair Avenue West, 4th Floor Toronto, Ontario M4V 1P5 heather.e.pearson@ontario.ca