Why uncertainty regarding the value of future carbon credits is a policy problem that needs solving

Implementing Carbon Contracts for Difference (for credit prices): Part 1.

By Michael Bernstein, Dale Beugin, and Nicholas Rivers

Canadian climate policy wonks from industry to environmental organizations like the idea of Carbon Contracts for Difference (CCfD) as a means of de-risking climate investments — at least in principle. CCfDs can make carbon pricing work better. They can keep Canada competitive with the United States, even in the face of the Inflation Reduction Act. And, relative to a U.S.-style incentive approach, they can save governments money. Yet opinions regarding how, exactly, to implement CCfD remain diverse.

Canada’s federal government is currently considering how CCfD could be used to bring certainty regarding the credit prices for output-based carbon pricing systems. We’ll refer to this solution as credit price CCfD. Credit price CCfD are a more complicated issue than CCfD on the benchmark carbon price, or what we will call headline price CCfD. (Note: all three authors still support headline price CCfD in addition to credit price CCfDs and hope the federal government will proceed with both. Credit price CCfD are a complement to, not a substitute for, headline price CCfD).

The upsides of credit price CCfDs are large, given how important “bankable” credit prices are for mobilizing capital. But these CCfDs also come with some significant risks. This blog series explores these risks — and proposes some concrete solutions for the federal government.  

  • This first blog outlines the broad case for credit price CCfDs. 
  • The second blog argues for a specific design for credit price CCfDs that we call direct purchase
  • The third blog tackles a key challenge related to credit price CCfDs: how to ensure that CCfDs give provinces incentives to tighten, rather than weaken, their industrial carbon pricing systems in the future. 

Let’s start with a quick reminder: the basic idea behind CCfDs is that the government would de-risk low-carbon investments against uncertain future carbon prices. CCfDs could help across two different dimensions of risk, both of which are undermining investment in clean growth projects. 

First, headline price CCfDs transfer the risk of future policy change from industry (where such risk inhibits investments) to government (who controls such risks). If the benchmark price of carbon really is $170 per tonne in 2030 as planned, CCfDs cost the government nothing. But if not, the government compensates firms that made low-carbon investments based on the assumption of a high carbon price. That helps clean growth projects attract investment. 

CCfDs might also be well suited for tackling another, related risk. For large emitters covered by output-based carbon pricing, markets for tradable carbon credits are very likely oversupplied. That’s a problem for investment in clean growth projects too. For example, modelling of carbon capture and storage projects suggests that the revenue from credit sales should be enough for these projects to compete with incentives in the U.S. But this is only true if credits are scarce enough that prices are close to the benchmark price. Robust credit prices are likewise critical for the competitiveness of a range of other clean growth projects

Tightening output-based pricing systems — or requiring the provinces and territories to do so, by adjusting the minimum standard — could theoretically solve this second problem, but there are a number of practical challenges. First, it isn’t possible under the current rules for the federal government to require provinces and territories to tighten their systems until 2027. Current systems are locked in until then. In the meantime, uncertainty persists, undermining investment. Second, other policy changes such as availability of offsets, implementation of other policies (e.g., investment tax credits for carbon capture and storage) could further exacerbate the imbalance between supply and demand for credits. That imbalance undermines the expected value of credit prices in the future — and the efficacy of output-based carbon pricing. Third, firms and investors would still be subjecting themselves to the risk that the planned tightening never occurs, especially since project economics are based on longer-time horizons than the five-year timelines being used by government.

Credit price CCfDs could provide certainty on future credit prices by guaranteeing firms a minimum value for those credits. And as long as the federal government ensures credit markets aren’t oversupplied — through ongoing tightening of output-based pricing system thresholds, careful use of offsets, and being careful to account for policy interactions when implementing new policies — the cost to the federal government of providing this certainty will be nothing. 

Carbon contracts for difference are an excellent solution for addressing risks of big changes to future policy. But done right, they might also be a solution to risks that industrial carbon pricing systems aren’t working as well as they could. In both cases, CCfDs can de-risk the investments Canada needs to make to achieve its emissions goals and compete in an emerging low-carbon economy.

As always, however, there are some important devils in the details to maximize impact and mitigate important risks. The next two blogs discuss how to do just that. 

Read more from this blog series:

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