California ARB to Link Carbon Market with Quebec

April 22, 2013

On Friday, April 19, 2013, the California Air Resources Board (ARB) voted unanimously to formally link its carbon market with a similar greenhouse gas (GHG) cap-and-trade market program established by the Canadian province of Quebec. Linkage of the two markets will commence Jan. 1, 2014. The integrated North America system will become the largest cross-border carbon trading market established since 2005 when the European Union Emissions Trading Scheme became operational. ARB and the Quebec Ministry of Environment have stated an intention to test, between now and Jan. 1, their market auction platforms and trading systems to ensure they’re “fully compatible.”

Linkage generally means that each market will recognize the legal compliance instruments of the other, i.e., the GHG emission allowances and offsets. Although there are some differences between the two programs regarding types of offsets that will be allowed for compliance in the respective jurisdictions, ARB has previously concluded that “Quebec’s program is equivalent to California’s, and in some ways more stringent.” The degree of difference between the two programs was not extreme, because the governments have been closely coordinating with each other in program design for the past several years. This intentionally close coordination of market development and design between California and Quebec therefore may limit the lessons that can be learned for other carbon markets as they emerge around the world. Other newly emerging carbon markets in Mexico, Australia and South Korea, as well as China’s seven “pilot’” markets, will likely experience greater challenge and effort as they seek to link or integrate with each other — particularly on transparency, enforcement and commodity trading/fungibility issues.

On a theoretical basis, linking two carbon markets tends to benefit both by creating a broader range of emission reduction opportunities, enhancing market liquidity and reducing volatility caused by temporal events such as extreme weather or economic downturns or upticks, some of the reasons cited by ARB in support of linkage. Linkage creates winners and losers (although it may be hard to predict who), because it is essentially like any other trade agreement that grants evenhanded access to other markets. Economists and other policy-makers generally tend to support linkage (as well as trade agreements in general) because it produces more efficient markets. However, at the end of the day, one system’s emissions allowances are going to cost more than the other, and while this may change over time, one system’s prices will be higher than they otherwise would have been absent linkage.

While market price assessments are still being made in this regard for the joint California-Quebec market, there undoubtedly will be shared benefits. Over time Quebec’s allowance prices might be expected to be higher than California’s for two reasons: Quebec’s cap is much tougher than California’s and Quebec gets a very large percentage of its power from nonemitting hydro sources. Quebec’s cap seeks to reduce GHG emissions 20 percent below 1990 levels by 2020, while California seeks to reduce its GHG emissions to 1990 levels by 2020. Logic suggests that as the Quebec cap bites deeper in the run-up to 2020, emission reduction options in Quebec will become more expensive, and the amount of reduction obligations that can be fulfilled by offsets will shrink. Thus, one would expect the price of offsets or allowances in Quebec to be, over time, higher than California’s. In addition, Quebec has few opportunities to obtain reductions from the power sector through, for example, energy efficiency or switching to lower- or no-carbon fuels, and will have to forgo whatever cost-effective opportunities might be available from that sector and instead focus on emission reductions from transportation and industrial sectors. Although these two factors suggest that linking will generate some increase in California prices, the overall impact on California will be quite modest since the Quebec market is so much smaller than California’s. At full rollout, Quebec’s cap (allowance budget) will total 63.6 million metric tons CO2e in 2015, while California’s will be 394.5 million metric tons. Thus, Quebec’s market is less than 20 percent of California’s and therefore its absolute price impacts will be relatively small.

In turn, California is keenly interested in the success of Quebec’s cap-and-trade system as a public policy matter, and would not like to see the Quebec effort fail due to excessive costs, small market size or other reasons. Moreover, linkage of California’s market with Quebec is expected to expand investments in low-carbon technologies, many of which are being incubated and developed in California, by stimulating demand for such technologies and associated products.

Administratively, ARB’s carbon market includes trading program parameters and restrictions that many believe are inefficient, or unnecessary, while in many instances Quebec’s market design is less onerous. ARB places the responsibility for failed offset projects (e.g., if project offsets reverse or did not produce as many offsets as was expected), for example, strictly on the offset buyer, which requires the buyer to replace any invalidated offsets and thus increases the risk for the offset purchases. In contrast, Quebec uses a self-insurance approach where each offset developer places 3 percent of the offsets into a buffer account, which becomes available to replace invalidated offsets. Quebec’s approach lowers the risk of offset purchases, to the benefit of California, and is expected to result in Quebec offsets selling for a premium. Over time, as experience and market data are obtained for each approach, ARB may be persuaded to change its approach. Similarly, Quebec recognizes different types of offsets, such as small landfill gas projects (which ARB has by default proposed to accept, unless it changes its approach), and experience with different offsets may help persuade ARB to expand its allowance offsets.