Canada: The Canadian Climate Exchanges – The Future Of Canadian Emissions Trading

Currently three Canadian exchanges have declared their intentions to enter into the carbon market: the TSX Group, the Montreal Exchange ("MX") and the Winnipeg Stock Exchange ("WSE"). All three of the exchanges are waiting on the Canadian government to finalize the proposed federal Clean Air Act ("Bill C-30")¹ and to stop waffling on its intentions with respect to meeting its commitments under the Kyoto Protocol including meeting Kyoto Protocol targets, implementing the Large Final Emitters ("LFE") program, introducing a domestic cap and trade system for green house gases ("GHG") and participating in international emission trading markets. The development of carbon exchanges in Canada has been hampered in their development by an uncertain regulatory climate in Canada in the GHG area and the exchanges are currently waiting on enabling federal Canadian legislation in order to begin their operations.

The following is a brief description of the proposals put forward by these three Canadian exchanges for the development of the Canadian carbon markets.

The entry of the MX into the derivatives market was the result of the 1999 agreement between the Vancouver, Alberta, Toronto and Montreal stock exchanges that resulted in the restructuring of the Canadian capital markets. As a result, the MX became Canada’s only derivatives exchange for a 10-year period. The MX runs Canada’s market for equity, currency, index and interest-rate derivatives. It also provides central counterparty clearing services for MX listed products through its wholly-owned subsidiary, the Canadian Derivatives Clearing Corporation.

In December of 2005 the MX announced the signing of a Letter of Intent with the Chicago Climate Exchange ("CCX") to develop a new joint venture to create the Montreal Climate Exchange ("MCeX"), a Canadian environmental products market. On July 12, 2006, the MX and the CCX entered into a joint venture to establish the MCeX. The MX is currently the only derivatives exchange in Canada while the CCX operates the only North American GHG emissions trading system.

The MCeX’s stated mission is to offer price transparency, environmental integrity, low cost, wide access and reliability to the many sectors of the Canadian economy involved in air quality and climate change concerns. The MCeX intends to provide cost-effective trading products for the Canadian carbon market through trading in carbon dioxide emissions contracts, and plans to develop trading, clearing, as well as registry services for Canadian environmental products. The MCeX will be geared towards trading by companies which are end users, but retail investors and hedge funds are also expected to trade. The MX advocates for a market-based risk management approach where price is managed in futures and options. The MX recently announced that it will go ahead with the launch of its trading platform for GHG credits and derivatives of GHG credits, which will also provide companies facing new emissions reduction targets the ability to hedge against the cost of abatement.

The MCeX hopes to build on the CCX experience in North America and in the European Union ("EU"). The CCX operates a GHG registry and trading system in the U.S. Participants of the CCX consist of both major public and private sector North American entities, including Canadian companies such as Abitibi-Consolidated and Manitoba Hydro. Membership in the CCX is voluntary. The U.S. is not a participant in the Kyoto Protocol and while there are emissions trading programs in the Eastern States and legislation being developed in California regarding the transport sector, the U.S. does not currently have a national system in place.

The CCX system supports both exchange-cleared trades, which preserve anonymity, and the exchange of electronic bilateral trades, which are established through private negotiations off-system. The CCX has an offset program, including agricultural offsets based in Canada. Under the CCX model, participants enter into agreements to set targets for reducing their GHG emissions by a specific amount within a certain period. If the companies meet and exceed those targets, they generate emission credits which they can either keep for themselves for future use, or sell to the highest bidder on the CCX. If the company is unable to meet its initial target, it will then have to buy the credits on the CCX or face possible penalties.

The CCX participates in the EU Emissions Trading System ("EU ETS"), through the European Climate Exchange ("ECX") which is a subsidiary of CCX that manages sales and marketing of environmental instruments in Europe. The EU ETS was developed in response to the requirements of the Kyoto Protocol, which came into force in 2005 imposing GHG emission limits for the period commencing in 2008 through 2012, the first Kyoto Protocol commitment period. The EU ETS is based on a directive adopted in October 2003 by the EU Parliament for a pan-European emissions trading system establishing a scheme for GHG emission ‘cap-and-trade’ system within the EU Member States. The system currently has approximately 12,000-15,000 participants, making it the largest such system in the world.

While details of the future operations of the MCeX are not clear, it would appear that the preferred model for the MCeX is the European one as opposed to the CCX voluntary model. However, whether the MCeX follows the CCX model or the EU approach will depend on the type of regulatory regime adopted by the federal Canadian government to deal with climate change and its Kyoto commitments.

The MX has stated that before it can set up a form of exchange that would be similar to the system found in the EU, a regulatory framework with guidelines for compliance would be required, including:

• absolute targets for emissions reductions under a cap-and-trade system;

• a regulatory framework for the certification and registration of GHG emission reductions;

• a framework to include offset projects developed in Canada;

• a phased-in approach to the emissions market which will allow the early launch of a futures market; and

• a system that provides for international trading and linkages which allow for the exchange of current and energy trading surpluses with the EU ETS, the Regional Greenhouse Gas Initiative system in the northeast U.S. states, and the CCX.

The TSX Group operates Canada’s two national stock exchanges, the Toronto Stock Exchange serving the senior equity market, and the TSX Venture Exchange serving the public venture equity market. The TSX Group also operates the Natural Gas Exchange ("NGX"), an exchange for the trading and clearing of natural gas and electricity contracts and the Shorcan Brokers Limited, a fixed income interdealer broker. The TSX Group first announced its intention to launch a global exchange for pollution emissions credits in June 2005. More recently the TSX has re-declared their interest in establishing a carbon exchange. On February 27, 2007, the TSX published a news release summarizing their submission to the federal Canadian government legislative committee on Bill C-30 .

The TSX Group has urged the federal government to act quickly in establishing a carbon-emission contract registry and to establish a framework of basic policies to support more efficient and complementary trading services in the emissions trading sphere. As in other emissions trading markets, a commodities market in Canada would allow companies to buy credits and offset any creation of GHG. On the other hand, renewable energy producers could sell credits to finance expansion.

The TSX’s view is that it is in a good position to create better trading solutions for the reduction of GHG emissions because many of the TSX’s existing clients are the LFEs of the Canadian economy. The TSX is not seeking to be the sole carbon market in Canada but rather welcomes the opportunity to compete with other carbon and environmental markets such as the MCeX. It feels that competition will ultimately benefit the market because it will reward the most innovative solutions and the most efficient facilities, leading to more cost effective solutions for participants.

On March 5, 2007 the TSX and the International Securities Exchange ("ISE") announced the creation of DEX, a new derivatives exchange. DEX, which is scheduled to begin operations in March 2009, will be owned 52% by the TSX Group and 48% by the ISE and will list and trade options, futures and options on futures on a range of Canadian securities.

The Winnipeg Commodity Exchange ("WCE") has also been studying emissions trading, and has set up the Canadian Climate Exchange ("CCE") to pursue the domestic market. The CCE was established in February 2003, but since the Canadian Government has not yet enacted clear market rules, trading has been stalled. CCE Inc. was created by WCE Holdings Inc., the parent company of the WCE, in order to trade emissions credits and to provide market-based solutions for the reduction of GHG emissions in Canada.

There is still a great deal of uncertainty regarding the new federal proposals which provide for a broad based consultation process and a prolonged timeline for implementation of GHG targets. The federal government is expected to release in the coming weeks targets and timelines for major industrial polluters to reduce emissions of GHG and also to spell out the degree to which companies can purchase credits to offset shortfalls in their efforts. At the same time, the federal government has indicated that it will limit the trading of credits to a Canada-only market. It is not clear whether domestic emissions trading will interface with the international markets although the trend is for the federal government to align Canadian regulations in the area of GHG emissions and other air pollutants with U.S. regulations and standards. This was evidenced by a recent announcement by the federal Environment Minister that the Canadian government would begin negotiations with the U.S. for a new bilateral clean-air agreement. In addition, several of the provinces have announced that they are speaking with U.S. states to build a North American emissions trading system. British Columbia and California have agreed to work together toward an emissions trading system that would include members of the Western Regional Climate Action Initiative, and Ontario is considering joining to develop a market for emissions credits.

However, it is still unclear what the federal government’s intentions are in terms of linking up with the EU markets. For example, linking Canadian emission allowances and offsets with Certified Emissions Reductions ("CERs") and Emission Reductions Units ("ERs") in the EU ETS. These issues – timing, targets and interface with international systems – raise considerable uncertainty with respect to the future of emissions trading in Canada.

In the meantime all three exchanges are maintaining a watch on the federal Conservative government which currently occupies a minority position in the Canadian federal Parliament. At this point the details of the type of carbon exchanges that these three exchanges would operate is unclear. Canadian exchanges will only be in a position to develop their climate exchanges once the final form of the Canadian domestic emissions market is settled and accessibility to international emissions markets is clarified.

1. An Act to amend the Canadian Environmental Protection Act, 1999, the Energy Efficiency Act and the Motor Vehicle Fuel Consumption Standards Act (Canada’s Clean Air Act); please see discussion under "Proposed Federal Clean Air Act".

© Copyright 2007 McMillan Binch Mendelsohn LLP