Federal government to develop approach on carbon contracts for difference

Budget 2023, released on March 28, 2023, announced the federal government’s intention to develop a broad-based approach to carbon contracts for difference that aims to make carbon pricing more predictable for large emitters.

What you need to know

• The federal government will consult on the development of the approach to carbon contracts for difference.
• Although no details on the approach have been provided, carbon contracts for difference typically backstop the price of carbon (i.e., if the market price of carbon falls below the minimum price in the contract, the federal government would compensate the counterparty for the difference).
• By entering into these agreements, large emitters can gain contractual certainty regarding the applicable price of carbon over time when otherwise they would face regulatory or political risk that the carbon price would not escalate as expected. Carbon contracts for difference can therefore facilitate investments in emissions reductions and low-carbon technology, which companies might not make in the face of carbon price uncertainty given the often long-term and capital-intensive nature of the required investments.
• It is expected that the carbon contracts for difference will complement the contracts for difference offered by the Canada Growth Fund to help manage the uncertainty around the price of certain products.

Carbon contract for difference

Budget 2023 announced the federal government’s intention to consult on the development of a broad-based approach to carbon contracts for difference that aims to make carbon pricing more predictable. Typically, carbon contracts for difference set a fixed carbon price over the term of the contract, which acts as a backstop to the price of carbon. If the regulatory or market price of carbon falls below the price in the contract, the other party (in this case, the federal government) will compensate its counterparty for the difference. These contracts can, therefore, help manage perceived uncertainties around the price of carbon and carbon credits, depending on the backstop price of such contracts, and allocate the cost of carbon to both private and public parties.

Alignment with Canada Growth Fund contracts

The federal government also expects that carbon contracts for difference will complement contracts for difference offered by the Canada Growth Fund¹ (CGF) to absorb certain risks and encourage private sector investment in low-carbon projects, technologies, businesses and supply chains. CGF will be offering contracts for difference to address demand and policy risk and improve project economics for certain products, such as hydrogen. CGF will be offering the following two types of contracts for difference²:

• Two-way contract: When the market price is less than the “strike price” (the price that enables the project to meet its target return), the project will receive a payment from CGF equal to the difference between the strike price and the market price. When the market price is greater than the strike price, CGF will receive a payment from the project equal to the difference between the market price and the strike price.
• One-way contract: When the market price is less than the strike price, the project will receive a payment from CGF equal to the difference between the strike price and the market price. CGF can participate in project upside through revenue-sharing warrants.

Approaches to the contract

The federal government has not released its thinking on how it will structure the carbon contracts for difference. Even if the federal government generally follows the same approach as the contracts offered by CGF, the strike price will likely need to be different to address uncertainties regarding the price of carbon and potential carbon credits and policy shifts.

There are multiple potential approaches to determining the strike price for carbon contracts for difference. For example, the government could potentially tie the strike price to the federal carbon price backstop under the Greenhouse Gas Pollution Pricing Act. The foregoing approach could address the uncertainties around potential policy shifts and the price of carbon. Similarly, the strike price could be tied to a market price of certain carbon credits, which tend to trade at a discount to the federal carbon price backstop. Regardless of the approach taken, the federal government will need to consider an appropriate strike price for the contracts to mitigate the above-noted concerns and drive investment in low-carbon projects.