Canada shows how NOT to use Carbon Contracts for Difference

Welcome to Carbon Risk — helping investors navigate 'The Currency of Decarbonisation'! 🏭

If you haven’t already subscribed please click on the link below, or try a 7-day free trial giving you full access. By subscribing you’ll join more than 3,000 people who already read Carbon Risk. Check out what other subscribers are saying.

You can also follow my posts on LinkedIn. The Carbon Risk referral program means you get rewarded for sharing the articles. Once you’ve read this article be sure to check out the table of contents.

Thanks for reading Carbon Risk and sharing my work! 🔥

---

Estimated reading time ~ 8 mins

This is the final article in a three-part series focusing on carbon pricing in Canada. The first article, Europe must learn from Canada's 'price on pollution' debacle, introduced Canada’s national carbon tax. It warns that ill conceived meddling to the household fuel tax holds important lessons for Europe as it plans to launch a second emissions trading scheme focused on transportation and buildings. The second article, Canada's oil and gas cap-and-trade scheme does not go far enough, delves into the detail of the policy, concluding that the proposed scheme while a good idea in practice, has a number of flaws in its current design.

The final article in this series focuses on the Canadian governments proposed use of Carbon Contracts for Difference (CCfD) to support the development of carbon capture and storage capacity (CCS). To recap, a CCfD involves the government setting an effective guaranteed or “strike price” for carbon. The strike price might be set at a level that covers the incremental capital (“capex”) and operating (“opex”) cost of developing the CCS capacity.

In theory it should work like this. Assume that a company developing a carbon capture facility signs a CCfD agreement with the government. If at the end of a specified period the carbon price is below the strike price then the project developer is guaranteed to receive a payment from the government reflecting the difference multiplied by every tonne of CO2 captured. If the carbon price is higher than the strike price then the developer pays a certain amount back to the government. In 2022 I published an article outlining why CCfDs can be so useful to governments and industry looking to accelerate the energy transition:

The carbon price is the ‘Currency of Decarbonisation’. Jurisdictions need to keep it high enough to incentivise investment in low carbon technology, but not too high that it becomes socially unacceptable. Achieving a stable high price of carbon is one thing, but without the ability to hedge against future carbon prices it is very difficult to leverage the investment necessary to build-out the required capacity.

CCfDs enables very long-term carbon price hedges to be put in place, i.e. one that covers several years or more. The CCfD also allows the agent to hedge against adverse regulatory risk, of the kind that could occur in the event that a new government was elected and decided to rip up the entire existing climate change legislation. Unlikely perhaps, but not impossible. Being protected from carbon price volatility over the long-term means that the investment becomes a lot more bankable in the eyes of investors.

A secondary benefit of CCfDs is that they can be used by the government or institution to support and incentivise innovative, but untested technologies. For example, one technology might need higher levels of support in the early years, but less later on in the contract period. This is especially important as the variable costs of novel technologies cannot be known in advance. This could take the form of the government or institution offering a higher strike price early in the contract in return for public investment in the project, giving rights to a share of the profits in the longer term.

In short, CCfDs correct a market failure.

Even in established carbon pricing schemes such as the EU ETS, markets rarely offer the ability to hedge carbon prices more than a few years out. Even if they do there is likely to be a premium reflecting the risk that governments renege on their climate commitments. CCfDs enable companies to make long-term investments linked to the carbon price, often ones with significant upfront costs that may not be possible otherwise.