On May 30, 2024, McCarthy Tétrault hosted Cross Country Carbon Market Overviewas part of the firm's "Navigating the ESG & Sustainability Landscape" seminar series. The seminar's presenters included:
- Thomas McInerney, Partner (Calgary), Energy Group
- Cindy Vaillancourt, Partner (Montréal and Québec City), Environmental Group
- Selina Lee-Andersen, Partner (Vancouver), Environmental, Regulatory and Aboriginal Group
This blog presents the four key takeaways from the seminar. Please contact Thomas McInerney, Cindy Vaillancourt, Selina-Lee Andersen or any other member of our energy transition team if you would like additional information about the topics discussed during the seminar, or other Environmental, Social and Governance (ESG) best practices for your business.
1. An Overview of the Regulatory Landscape in Canada: Emission Offsets
The carbon emission offset regime in Canada operates as a combination of both federal and provincial legislation.
The key legislation at the federal level is the Greenhouse Gas Pollution Pricing Act (GGPPA) and Canadian Greenhouse Gas Offset Credit System Regulations (OCSR) thereunder, as well as the Clean Fuel Regulations (CFR) enacted under the Canadian Environmental Protection Act.
The GGPPA requires each province to implement a carbon emission pricing regime that is at least as stringent as the measures prescribed by the GGPPA. To the extent that a province does not implement such legislation, the GGPPA will apply – making it commonly referred to as the "Federal Backstop."
With respect to emission offset creation and requirements, the GGPPA establishes an output-based pricing system (OBPS) for greenhouse gas emissions stemming from large industrial emitters. "Covered Facilities" that are unable to achieve their emission-reduction obligations under the OBPS through physical abatement may acquire compliance units, which can take one of three forms:
- Surplus Credits: to the extent a Covered Facility reduces its emissions further than what is required by the OBPS, surplus credits are created in a quantity equal to such incremental reduction.
- Recognized Credits: a credit created by a provincial emission reduction regime that is recognized as complying with OBPS criteria (e.g. "emission offsets" created under Alberta's TIER regime); and
- Federal Offset Credits: offset credits created by offset project proponents in compliance with the OCSR.
As the OBPS system prescribed by the GGPPA only acts as a "Federal Backstop," several provinces have opted to create their own provincial carbon pricing system for industry, including Alberta, Québec, and more recently, British Columbia.
In addition, the federal CFR creates a separate regime for creating emission offset credits. The CFR applies to both producers and importers of gasoline, diesel, kerosene and light and heavy fuel oils (such producers and importers referred to as "Primary Suppliers"). Beginning in 2022, Primary Suppliers must reduce the carbon intensity of the fuels it produces or imports by a minimum amount that increases each year, starting at 2.4 gCO2e/MJ in 2022 and culminating to a 12 gCO2e/MJ reduction requirement by 2030. Primary Suppliers can satisfy their emission reduction requirements by creating or acquiring compliance credits.
The CFR creates three categories of compliance actions that Primary Suppliers, as well as "voluntary credit creators", can use to create credits:
- Compliance Category 1 (Emission Reduction Projects): actions undertaken to reduce carbon emissions of a fuel throughout its lifecycle (e.g. carbon capture and storage);
- Compliance Category 2 (Low Carbon Intensity Fuel Production or Import): producing low carbon intensity fuels (e.g. ethanol, biodiesel – including those fuels used to comply with existing federal and provincial renewable fuel requirements); and
- Compliance Category 3 (End-Use Fuel Switching in Transportation): end-users changing or retrofitting combusting devices to be powered by low-carbon fuels or other alternative energy sources.
With the diversity of carbon offset credits that can be created and applied under Canada's emission reduction regime as outlined above, businesses have several opportunities to transact and acquire credits to comply with their obligations.
2) Key Provisions of a Carbon Offset Agreement
Though many of the underlying principles of a traditional commercial agreement also apply to carbon offset purchase and sale agreement, there are certain types of provisions that parties should pay specific attention to when negotiating such contracts:
- Form and Delivery: Purchasers of carbon credits should familiarize themselves with exactly what type of emission offset credit(s) they are purchasing and how such credit(s) is (are) created. What type of project do the credits come from? Does the type of project come with a higher degree of risk of the credits being invalidated in the future? When will the purchased credits expire?
- Counterparty Risk: Negotiating counterparty risk can be a key factor in agreeing on many of the fundamental terms of an offset agreement, including price, term and whether additional performance assurance from the seller is warranted. Purchasers may want to obtain financial assurances in a form of security from the seller (e.g. a letter of credit or parent guarantee) to mitigate risk, such as the failure for the seller to generate/deliver a sufficient amount of offsets or the offsets being invalidated.
- Force Majeure: There is a trend for force majeure clauses in offset agreements of being increasingly narrowed in what they cover. Parties should pay careful attention to what is excluded from the definition of "force majeure" when negotiating an these clauses in an offset agreement.
- Invalidated Offsets: The risk of revocation or invalidation of offsets is a critical provision of any offset agreement. The risk is not purely theoretical as invalidation has occurred. For example, in California, four livestock methane destruction projects have been invalidated since 2020.
- Representations and Warranties: Entities transacting for carbon credits in Canada should watch out for certain American-isms that may inadvertently be left in a form of agreement. For example, certain representations regarding "forward contracts" under American law are not applicable between Canadian entities.
3) Trends in the Voluntary Carbon Credit Market
Though the demand for compliance credits is building, the demand for voluntary credits continues to dominate the market as businesses aim to achieve their ESG goals. In 2022, the value of the global voluntary credit market was estimated to be approximately US$1.9 billion. As the market continues to evolve, buyers are focusing on higher-quality projects and credits with specific attributes. For example, the following credits are emerging:
- Nature-based Carbon Offsets: Offsets created by nature-based solutions, where the carbon absorption qualities of natural assets such as forests, peatlands and wetlands are valuated and measured (e.g. conservation projects).
- Offset Credits with Co-Benefits: co-benefits can include increased biodiversity, job creation, support for local communities, health benefits from avoided pollution.
Corporate commitments to net-zero targets remain the main driving force behind the growing demand for offset credits. As demand for voluntary offsets grows, there are also growing demands for better oversight and transparency in the market.
4) Looking Ahead: Emerging Issues
As the market for carbon credits continues to develop, there are a number of issues that are beginning to emerge. For example, closer scrutiny of green claims (e.g. "carbon neutral", "net zero", "sustainable") across industry sectors by both governments and consumers may lead companies to pull back from making green claims to mitigate regulatory and litigation risk. See our previous blog, The Many Shades of Green – Mitigating Evolving Civil and Regulatory Greenwashing Litigation Risk for further discussion on this trend.
Additionally, continued federal-provincial tensions over the federal fuel charge will be a hot topic leading up to the next federal election, and may impact other emission reduction regulations and related programs in a post-election landscape. This tension forms part of the dynamics underlying Canada's complex energy and emissions reduction policy framework.
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