In addressing interactions between policies, modernizing industrial carbon pricing and finalizing methane regulations should be governments’ top priorities.
In spring 2024, 440 Megatonnes published an analysis breaking down the impact of different climate policies on Canada’s emissions. It projected that the two policies with the greatest impact on emissions would be industrial carbon pricing and an emissions cap for the oil and gas sector.
Yet, as the analysis explained, there is a catch. These two policies are designed to overlap, creating a risk that one measure could undermine the other and lead to fewer emissions reductions than the policies’ full potential.
Since we published our previous analysis, the federal government released additional details regarding the planned emissions cap. This Insight presents updated analysis about the projected emissions reductions from these two measures, conducted with Navius Research, showing that risks of policy interactions remain. Reconciling those interactions will require deliberate choices from governments.
Modernizing industrial carbon pricing offers one path to additional emissions reductions
There are a few ways for policies to deliver additional emissions reductions in Canada. One of the simplest is to strengthen existing measures, including addressing policy interactions.
Industrial carbon pricing—also known as large-emitter trading systems or LETS—is already Canada’s broadest, most important climate policy tool. When designed well, LETS can deliver more emissions reductions than any other existing or proposed climate policy in Canada. These systems are also designed to minimize competitiveness risks while attracting investment for low-carbon projects. Yet there is still room for improvement.
As 440 Megatonnes has written before, LETS require modernization to deliver their full potential. The carbon markets they create are at risk of underperforming with market prices well below the minimum national carbon price, and with demand shrinking as some participants leave. According to the latest analysis, updates that address these challenges could deliver an additional 25 megatonnes (Mt) of emissions reductions in 2030, on top of the reductions already underway.
An oil and gas emissions cap could deliver similar reductions
Another way for policymakers to find additional emissions reductions is to follow through on measures that are yet to be fully implemented.
The federal government’s proposed oil and gas emissions cap fits into this category. This cap would create a new cap-and-trade system specific to the upstream oil and gas sector, requiring participants to reduce their emissions in line with the cap.
The new 440 Megatonnes analysis conducted with Navius Research projects that if the federal government implemented the emissions cap—as defined in the government’s latest Regulatory Impact Analysis Statement— without modernizing LETS, the gains from this measure would be just over 24 Mt in 2030, comparable to what strengthened LETS could deliver.
Both scenarios assume that the federal government also implements strengthened methane regulations for the oil and gas sector. Significant emissions reductions expected under the (almost final) methane regulations means that the emissions cap has less “work to do” to deliver the required emissions reductions in the oil and gas sector, as long as the methane regulations proceed as planned.
Both scenarios also account for Alberta’s large bank of TIER credits, which are subject to use-it-or-lose-it provisions due to their age. This results in nine to 10 Mt of annual compliance through 2030 being met with banked credits, cutting market demand by roughly 45 per cent and adding further downward pressure on credit prices.
Combining the two policy changes delivers less than the sum of their parts
The emissions reductions from implementing the emissions cap and those achieved from modernizing LETS would happen in different places, as Figure 1 illustrates.
Whereas improvements to large-emitter trading systems incentivize emissions reductions across many sectors such as electricity, cement, and chemicals, reductions under the cap would be concentrated in the oil and gas sector. And in the cap scenario, emissions rise in other sectors. This result hints at some of the complicated ways an emissions cap would interact with the large-emitter trading systems.
Figure 1
As Figure 1 illustrates, the combination of both policy changes—the emissions cap and updates to LETS—do not result in the combined maximum emissions reductions across all sectors. Together, the measures deliver less than the sum of what they achieve independently—though still more than what each policy can deliver on its own.
Put another way: implementing the cap in addition to tightening LETS only drives an additional 7.1 Mt of emissions reductions in 2030. That’s not nothing, but it’s far from a neat and tidy exercise of adding the two emissions numbers together. Our numbers here are similar to the federal government’s own estimates of the impact of the cap. The relatively small emissions number for the combined scenario is a function of how the two policies overlap and interact negatively.
These interactions also raise the question of which policy should be prioritized, given that both deliver similar levels of reductions on their own.
LETS modernization is significantly more cost-effective than the emissions cap, with total costs about 20 per cent higher under the cap. Basic economics are at play here: the broader mitigation pool under the large-emitter systems allows lower-cost abatement to be used, whereas opportunities are more limited in the oil and gas sector.
In the cap scenario, carbon capture, utilization, and storage (CCUS) is deployed at twice the level as that of the strengthened LETS scenario. That has a high cost. Since most of the oil and gas emission reductions projected in the scenario come from CCUS, and at costs well over $200 per tonne, it’s not surprising to see such a large cost differential for the same level of reductions.
As always, the actual emissions reductions that these policies will deliver are uncertain, and depend on how the measures are implemented. The outcome will depend on regulators’ ability to actively balance the two markets and manage negative policy interactions. If regulators get it exactly right, and that’s a big if, both policies could, in theory, deliver their full reduction potential of nearly 49 Mt—but at a total cost 1.7 times higher than implementing the two policies independently and with a reliance on CCUS that looks infeasible.
Policy interactions mean lower incentives for some sectors
So what are these interactions?
The oil and gas emissions cap would create another policy with additional incentives for emissions reductions in the oil and gas sector, on top of existing large-emitter trading systems. As oil and gas facilities reduce their emissions to comply with the cap, they could generate credits for those reductions within the large-emitter trading systems. These additional credits could flood industrial carbon markets, swamping demand and leading to additional downward pressure on credit prices, if LETS performance standards are not tightened even more to reflect the contributions of the cap.
All the other sectors that participate in the industrial carbon market would then be left with much less incentive to invest in their own emissions reductions.
The new 440 Megatonnes analysis confirms that even if LETS are modernized—as we have recommended—the fixes may not be enough to offset the effect of interactions on credit prices. The major risk is that performance standards will not be sufficiently tightened to soak up the new supply created by the cap, placing downward pressure on the LETS credit prices.
The combination of LETS and the emission cap could be made more additive, but doing so would require tightening performance standards for large emitters even further than required in the absence of the cap. That would risk increasing competitiveness pressures on Canada’s emissions-intensive and trade-exposed industries.
Figure 2 illustrates what these policy interactions mean for the main oil and gas producing provinces. The price holds in B.C. and falls in Saskatchewan, but the impact is greatest in Alberta. It is by far the country’s largest and most important carbon market, representing 57 per cent of industrial emissions. There, the price collapses to zero, totally negating the incentive for sectors outside oil and gas in that province to invest in emissions reducing projects.
In other words, the additional emissions reductions that the cap drives within the oil and gas sector come at the expense of emissions reductions elsewhere in the province. That would have significant impacts on existing projects across the economy. Outside the oil and gas sector, some projects that are counting on earning valuable carbon credits would be deprived of a potential source of revenue. And even projects inside the oil and gas sector, such as carbon capture projects, would earn less than they would if their credits could trade at full value.
Figure 2
The modernization of LETS should be the first priority
It is inevitable that some emissions-reducing policies will overlap, and some of these overlaps will be unhelpful. However, it’s worth identifying when these effects are particularly counterproductive, as in this case, where the interactions could undermine much-needed incentives to invest in emissions-reducing projects.
Governments can address policy interactions in several ways. Our analysis suggests regulators could, in principle, balance the two markets. Doing so would require market data that currently doesn’t exist—such as real-time credit price tracking—and more frequent adjustments to benchmarks and credit supply, notably using market stability mechanisms that don’t yet exist. The cost risk from policy interactions also looks high, which is acute given the current geoeconomic uncertainty facing the country.
But the most straightforward step in the near term is to strengthen what already exists. That means modernizing Canada’s LETS, which are already operating and driving reductions across a broader set of sectors. We cannot emphasize enough the urgency of decisive policy action: investment requires policy certainty and robust credit markets, and waiting to make those changes until 2027 (as planned under the current federal rules) will increase—not decrease—risk for investors.
By the same token, the federal government should also finalize its strengthened methane regulations, which show minimal negative overlap with other policies, as soon as possible. Governments should be searching for additional emissions reductions, and the first place to look is at the measures that are already in hand.
Ross Linden-Fraser is a Research Lead at the Canadian Climate Institute. Dale Beugin is Executive Vice President at the Canadian Climate Institute. Dave Sawyer is Principal Economist at the Canadian Climate Institute.