Understanding America’s Carbon Markets

Rachel Walsh:

A carbon market is both a carrot and a stick. If you emit below the level that you're allowed, you can go into the market and you can monetize the amount that you've outperformed by, essentially. In contrast, if you're above, you have to go out in the market and you have to pay for that environmental attribute essentially. And so, you both have that profit opportunity for good actors in a market and then a penalty for those that are not keeping up.

Michael Torrance:

Welcome to Sustainability Leaders. I'm Michael Torrance, Chief Sustainability Officer at BMO. On this show we will talk with leading sustainability practitioners from the corporate, investor, academic, and NGO communities to explore how this rapidly evolving field of sustainability is impacting global investment, business practices, and our world.

Speaker 3:

The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates or subsidiaries.

Michael Torrance:

BMO was a proud sponsor of the 2024 BNEF Summit in New York that brought together over 700 thought leaders and senior industry professionals to discuss the future of energy, finance, and technology. Today's episode presents key takeaways from a panel that included Rachel Walsh, Environmental Commodity Strategist at BMO Capital Markets. The panel focused on the ups and downs of America's carbon markets. Let's take a listen.

Boatun:

Hello everyone, thank you for joining us. This panel will be talking about one of the fastest growing commodities today, carbon markets. The backdrop for the carbon market expansion has really been the ever-growing list of countries and regions committing to net zero targets. We have some 149 countries and 145 states and regions committing to net zero. And, as these net zero targets increase, the popularity for carbon markets has soared. We have today 36 compliance carbon markets, covering 20% of greenhouse gas emissions and 60% of global GDP. This includes the biggest carbon markets here in North America. So California/Quebec Carbon Market as well as the Northeast Carbon Markets Regional Greenhouse Gas Initiative.

In terms of market value, it has also soared. We are almost reaching 900 billion US dollars last year in terms of traded value for the major carbon markets. And this is five times the value it was in 2018. Last year was also a great year for particularly here in America. We saw new markets emerging and existing markets hitting new price records. This year will also be a great year as we will have these major markets going through reforms and changing the market design of how this market will work and bring opportunities, but also some risks for energy transition.

We will be discussing about the role of carbon markets as well as what it means for industries, for powerhouse sector, as well as investors. My name is Boatun, I am the lead analyst for Compliance Carbon here in New York, and we have Rachel Walsh, the Environmental Commodity Strategist at BMO. Before we dive into the depth of carbon markets, let's just make sure we're at the same party so, Rachel, can you kick us off by defining what is the compliance carbon market and why it's such a buzzword right now?

Rachel Walsh:

Yeah, absolutely, and thanks for having me. First, I hope that we can all speak the same language after I'm done so we can understand the rest of this conversation. Lots of abbreviations in this market, no shortage of it. First off, there is a difference between the voluntary and compliance carbon markets, they're treated as the same in some conversations and they really shouldn't be. Voluntary carbon markets, very well named for what they help achieve, that's voluntary action. So, as an example, you can think corporate voluntary commitment. Those are things like net neutrality commitments. In contrast, compliance carbon markets, these are markets that are set up by a regulator, over regulated entities. So these are typically large stationary sources of emissions.

You can think of fossil fuel power generation stations, chemical plants, refineries, things of that nature. It's a regulator's way of putting a price on carbon but doing that in a way that allows some flexibility and trade-ability among market participants. You do see a couple different ways that they establish these compliance carbon markets. You see cap and trade markets, which are the most common structure. These are where regulator is regulating absolute emissions, so essentially they will permit emissions up to a certain level for each facility. And that's why when we talk about these markets you'll often hear the word allowances. They're allowing emissions to a certain level.

Another way you see these markets designed is through an output-based pricing system. This is where a regulator is regulating the carbon intensity of the products that are produced by those facilities. This is a very common structure in Canada, with the exception of Quebec, which is linked to California, as you mentioned. These markets are extremely fragmented. They all have their own unique rules within their borders. You'll see linkages, so the EU has one extremely large market, California and Quebec is linked, but generally very fragmented overall. But, the benefit here is regulators are able to put a price on carbon. But, again, you have that flexibility and trade-ability amongst market participants, that way they get a trade outcomes.

Capital is directed towards the lowest cost abatement opportunities in the entire industry that's regulated. And that'll lower the marginal cost of abatement for industry as a whole and is more efficient. And just one more layer here, whenever we're talking about a credit and offset in allowance we're always talking about one metric ton of CO₂ equivalent emissions that has been, in most cases here, reduced, but in some instances potentially removed from the atmosphere or avoided.

Boatun:

Exactly. So in compliance carbon market the polluter pay and the abator benefit, and in the compliance carbon market we do try to drive that least cost abatement. So again, why were we talking about compliance market now, why it's so popular right now?

Rachel Walsh:

Well, I do think regulators are trying to put a price on carbon. They're trying to signal to industry that it's extremely important for them to lower emissions. But they're also, we've heard a lot about carrots and sticks. A carbon market is both a carrot and a stick. To the point you just made, if you emit below the level that you're allowed, you can go into the market and you can monetize the amount that you've outperformed by, essentially. In contrast, if you're above, you have to go out in the market and you have to pay for that environmental attribute essentially. And so you both have that profit opportunity for good actors in a market and then a penalty for those that are not keeping up.

Boatun:

Yeah, I know you look at corporates a lot so what do you see from corporate side? How do they manage these risks with [inaudible 00:07:08]?

Rachel Walsh:

Managing political risks specifically is very challenging. I don't know if there's a silver bullet there, but I'll talk about risk management strategies at a high level from our corporate clients, but I think it depends on a few things. First off, what position do they form in the market? Are they naturally long? Are they producing allowances or offsets or are they short? Do they need to aggregate them? That can impact strategy, maturity of the markets. Depth, liquidity, price transparency, and exchange functioning futures market, if that's their traditional hedging strategies that you would see in other commodities markets are going to be available for them over a short period of time.

And then beyond that, looking either longer term or in the case where it is not a mature market, there can be more creative solutions overall. So, one of the obvious things would be if you're naturally short to invest in your own assets and lower your emissions. That's a no-brainer but in some instances that's incredibly expensive and also limited if the facility was never designed for that. And so then you need to get more creative. So could you potentially invest in other projects or do long-term off-take agreements with groups that are looking for that sure revenue over time? If you're long, you're looking at hedging that revenue source. If you're short, you're looking at hedging a cost.

And then there's other creative alternatives like potentially doing strategic investment in companies that are long. So perhaps your facility itself has an obligation, but you as a corporate entity are exposed to somebody that will profit off of the carbon market. So those are some longer-term, more creative strategies that you do see corporates listening to and engaging in overall.

Boatun:

Have you seen any real examples of Clean tech or de-carbonization projects that have been enabled by the carbon price?

Rachel Walsh:

Oh, absolutely. When you hear, I mean, it's the surety on carbon price from our corporate clients and also the cost of the technology overall. So I would say where carbon pricing is trading out in the market today, a lot of the low-hanging fruit is currently being addressed. There are a lot of emissions. You think of efficiency at an asset. Methane abatement. There are very palatable things that corporations can spend on today that are no brainers. Some of the higher-priced items, they want that carbon price surety or they're looking for some form of revenue. Like in the IRA with 45 Q, is a good example for carbon capture and sequestration that gives price surety and revenue surety over a certain period of time.

When you're looking at the carbon market, we're not quite there in terms of pricing for that signal to be there overall. So certainly where pricing is at in different markets, you are seeing corporate companies look at the compelling opportunity on their internal marginal abatement curve pursuing that. Higher-cost items need more surety and higher price for sure.

Boatun:

So what I hear is we need higher prices

Rachel Walsh:

For technologies like that, potentially yes. Or other subsidies.

Boatun:

All right. Yeah, definitely. In terms of the pulse, so I think I've heard there's a lot of moving parts and future work in progress. In BNF, we took plunge into modeling the future, and in our best case that is modeled aligned with the scoping plan 2022, the 48% by 2030. But from 99 levels, we see that the price could hit $93 per ton in 2030. And we would like to ask you, is this what you expect as well, or do you expect price to be higher? Or do you expect price to be lower? Or it's just too hard to say?

Rachel Walsh:

It's hard to say specifically on the price, but talking through how we would think about that and agree with everything you've said, but maybe add a few elements. Cross-subsidization across other programs, so things that come from the IRA. When we think about marginal abatement curve, those programs essentially are lowering the cost of those technologies. So we think about 2030 and the goals that the program has in mind, how much are those higher-cost technologies being subsidized by other programs? If it's substantial, then the price in the market would be a lot lower potentially. However, if those programs go away and policymakers keep their goals in mind then it could perhaps be higher.

Boatun:

So we talked about some risk factors. There are other subsidies that could impact the carbon price. Are there other factors that you think could impact?

Rachel Walsh:

I mean, when you're thinking about your carbon price forecast, you're trying to forecast energy transition, which is transition of entire energy systems. So yes, there's a lot of factors. Challenging to model overall. I think technical innovation is one of them. Removals, what is the ultimate cost of removals? If we have a technological breakthrough and you have a low-cost removal, to Eric's point earlier, that's really going to cap your compliance carbon market price. Linkage is absolutely one of them.

Not to bring another layer of complexity here, but under article VI, the parents' agreement, there is a tradable element and element for cooperation there. Do regulators allow any fungibility of article VI credits into regulated systems that could provide additional supply and lower costs? So there is no limit to the number of variables here that could impact pricing overall. You have to keep a pulse on a lot of different areas of the market to see where things are going.

And to bring another variable into it with cap and trade systems, they regulate absolute emissions. One variable is economic events. So the financial crisis caused massive oversupply in the EU ETS. If you see another event like that, general productivity in an area, all of these things impact emissions overall.

Boatun:

Yeah, definitely. So on the supply side, we have the policy uncertainties and how the supply actually breaks down into auctions and allocations on the demand. We have so many on consumer behavior, on technology. Maybe one thing to bring up, American carbon is probably where we do see the overlap between compliance and voluntary. So in our analysis, we look at compliance world and voluntary with offset brands for offset doubters and offset pretty much majors. So we have those doubters that are New Zealand, EU and UK that don't allow any offsets, New York seemingly, to join that group with no offsets. But here in North America, otherwise our carbon markets do allow offsets. And Quebec seems to really dig into the role of offset in this review. So what is your take in how should this market reform to be more robust of how they bring in offsets?

Rachel Walsh:

I won't specifically talk about the voluntary concept of offsets, but offsets in a compliance context. So I'll talk about Alberta, which I mean, Quebec is part of the largest carbon market in North America being linked to California. But outside of that, Alberta is actually a very large carbon market, just launched a futures contract there. So we're looking for improved price transparency over time, but-

Boatun:

We just added on terminal.

Rachel Walsh:

... Yeah. At the moment, largely over the counter traded markets. And so how you see offsets playing into that market system is the government regulator has, I believe it's 18 protocols, that they give the thumbs up to. But you really see volume coming from four protocols. So think about it from the regulator's perspective, what they're doing. I talked about at the onset of this discussion that these markets regulate emissions of stationary facilities. Their regulator is looking at accelerating capital outside of that facility boundary. So one of the most popular protocols that we see spending on at the moment, and we deal with project development here and offset generation overall, is methane abatement for oil and gas companies. And that was a topic that came up earlier today.

This is generally low hanging fruit in terms of a cost, but if you don't have a regulation in place, it is an expense for companies. The Alberta government has gone and put a carrot approach, and they've abated over 4 million tons a year of methane emissions on a CO₂ equivalent basis just from this program. Now that's depressed the carbon price in the market overall, but they have gone out and accelerated capital towards those opportunities. So from a regulator's perspective, depending on what your goals are in terms of moving capital around to different solutions to lower emissions within that jurisdictional boundary, it can be pretty compelling.

Boatun:

Yeah, exactly. As long as it's measurable and real and permanent and additional, it does have a role to play.

Rachel Walsh:

Yeah, and it's funny, the voluntary market gets a lot of criticism for the quality. I would say compliance offset protocols don't necessarily stand out in terms of quality overall, but they have better governance and better measurement. Typically.

Boatun:

That closes our panel here, but we're really at the infection point for carbon markets. Carbon markets needs to grow and it will hopefully grow and it's very needed because it'll bring in the capital that we need for transition. It will help IRA to get things done, and it will also help with giving the price signal that industries, utilities and investors need. We can't take our eyes off the ball yet. We have to keep going and with those words, thank you.

Michael Torrance:

Thanks for listening to Sustainability Leaders. This podcast is presented by BMO. You can find our show on Apple Podcasts, Spotify, or your favorite podcast player. Press the follow button if you want to get notified when new episodes are published. We value your input, so please leave a rating, review and any feedback that you might have or visit us at bmo.com/sustainabilityleaders. Our show and resources are produced with support from BMO's Marketing Team and Puddle Creative. Until next time, thanks for listening and have a great week.

Speaker 1:

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