Understanding the implications of carbon taxes and cap & trade regimes.

By Cheryl Slusarchuk

While the overall impact of changes to environmental legislation on business remains uncertain, at least one change - the pricing of carbon emissions, either by way of carbon taxes or cap and trade - will have an impact on existing business-to-business relationships and contracts. This impact will be felt most by supply chain manufacturers, producers and intermediaries that cannot pass on the increased cost to the end consumer.

This will not be a significant problem for carbon taxes imposed at the point of sale or use by end consumers, such as the recently imposed British Columbia tax, but it will be a challenge if carbon taxes are imposed further up the supply chain - to the extent they are applied to existing contracts. It will also be a problem in cap and trade regimes, and for companies with contracts negotiated prior to the concept of pricing carbon emissions.
To remain competitive and profitable, then, businesses will need to consider the implications of such carbon taxes and cap and trade systems, particularly during contract negotiations or renewals.

Carbon taxes
A carbon tax is one of the simplest methods of reducing emissions because it can be implemented by taxing the sale and use of any source of greenhouse gas emissions. From a macro perspective, economists and governments tend to favour this tax for its directness - it discourages the "bad" (e.g. CO2 tailpipe emissions). It also has much lower administrative costs and less complexity for the overall economy than do other policy approaches.

British Columbia’s carbon tax is one that goes toward encouraging the "good" (in this case, increased income) rather than just discouraging the "bad." It mandates that all carbon tax money be returned to consumers and business via income and corporate tax reduction instead of going into government coffers. Further, a carbon tax such as British Columbia’s imposes the cost at the end of the supply chain - either on consumers or business users - thereby avoiding creating substantial hidden costs to business.

An example of a carbon tax possibly creating hidden costs can be found in Quebec, where the tax applies solely to energy firms. If the tax cannot be passed down the supply chain to the end consumers via increased prices, it creates hidden costs for those firms. This is what makes flexibility in contractual terms among suppliers critically important. Without flexibility, one of the intermediate business parties will bear the increased cost but be unable to pass that cost along through the supply chain.

To minimize the potential for increased unexpected costs, some businesses are beginning to include a concept of "carbon tax" or of "carbon emission taxes or levies" in the taxing allocation clause, or as part of the price adjustment mechanism in their contracts to account for increased taxes, such as the carbon tax. With either of these two types of clauses, the approach is to push the increased cost down through the supply chain to the end consumer or user.

Cap and trade systems
In a "cap and trade" system, a central authority (such as a government) sets an annual "cap" that limits the amount of greenhouse gas that can be emitted by regulated companies. These take the form of permits that allow each company to emit a specified amount of greenhouse gas, with the central authority steadily lowering the cap. Companies that need to emit more greenhouse gas than they have permits for must buy additional permits from other companies. Buyers pay for carbon while sellers are financially rewarded for reducing their emissions. This system is meant to encourage those who can reduce their emissions at the lowest possible economic cost to do so.

A regional cap and trade system is being developed by the Western Climate Initiative (WCI), which so far comprises four Canadian provinces (British Columbia, Manitoba, Ontario and Quebec) and seven American states (Arizona, California, Montana, New Mexico, Oregon, Utah and Washington). The initiative’s goal is to cut greenhouse gas emissions to 15 per cent below 2005 levels by 2020. Much of this reduction will result from the implementation of WCI’s cap and trade system, the terms of which are scheduled to be ironed out by mid-September. (For more information on the WCI, see www.westernclimateinitiative.org.)

The Canadian federal government attempted to enact its own cap and trade system, but that bill died on the Order Paper last year. Nonetheless, both government and industry expect that some form of federal cap and trade system is inevitable, as evidenced by the introduction of Environment Canada’s Early Action Program. Under this program, companies that voluntarily invested in emissions reductions after 1992 and prior to the end of 2006 may be given credits to help minimize the disadvantage of having taken action before the proposed cap and trade regime was set out.

Cap and trade systems can alter the cost of goods sold and manufactured, so they can create a clear cost in the supply chain. Companies must be mindful of the potential financial impact of new cap and trade systems when negotiating the terms of new contracts — especially if these contracts operate over longer periods. One approach is to include a price adjustment mechanism for increased costs resulting from the purchase of offsets. A variation of this approach is to include a right to renegotiate if the financial impact of a cap and trade system should come into effect or is in a dollar amount outside of an acceptable dollar range or percentage of the price of the goods. One of the difficulties with a cap and trade system is that the attribution of the cost of the offsets may not clearly relate to any one product line or contract.

Regardless of the type of emissions reduction regime enacted, businesses can end up bearing the costs of new emissions regulations if their contract doesn’t account for potential mid-contract changes. Business partners need to set appropriate expectations with each other, and lawyers need to ensure either that the required flexibility exists in long-term contracts or that the risk of such costs are expressly allocated as agreed to by the business.

Cheryl Slusarchuk is a partner in the Vancouver office of McCarthy Tètrault LLP practicing in the business law and technology groups. She is the president of the B.C. Premier’s Technology Council and serves as Chair of the B.C. Climate Action Team.

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