TIER Changes Raise Cost Avoidance Incentive, but Not for CCUS - CHOA eJournal - 9 February 2023

TIER Changes Raise Cost Avoidance Incentive, but Not for CCUS JARED DZIUBA, CFA, ANALYST, RACHEL WALSH, CFA, ANALYST, WILLIAMS AVILA, ASSOCIATE BMO CAPITAL MARKETS

CHOA JOURNAL - FEBRUARY 2023 I 5

Bottom Line: Higher stringency introduced to Alberta's TIER carbon tax system substantially raises the level of emissions reductions that oil sands producers are obligated to make, more than doubling average compliance costs. This should provide further cost- avoidance incentive, and underscores the need for more disruptive decarbonization options like Carbon Capture, Use and Storage (CCUS) to achieve industry-government targets. That said, we point out that compliance costs are still well below that of CCUS under the existing federal policy framework, meaning TIER alone is unlikely to promote major deployment without further policy support.

Key Points Amendments to TIER Effective January 2023. Alberta recently passed amendments to its Technology Innovation and Emissions Reduction (TIER) regulation in order to meet rising minimum standards under the federal Greenhouse Gas Pollution Pricing act.

At the heart of the changes are a meaningful increase to the rate at which emitters must reduce emissions to avoid penalties. Other changes include the creation of separate Sequestration Credits and Capture Recognition Tonnes to aid in administration, adjustments to credit use limits longevity, as well as decreases to the opt-in threshold for smaller emitters. Finally, TIER formally adopts federal carbon pricing in which levies rise from $65/T in 2023 to $170/T by 2030.

Rising Stringency, Cost-Avoidance Incentive. While a tightening rate of 1% was previously applied to facility-specific benchmarks only, a 2% annual rate will now apply more broadly, and for oil sands rises 4% in 2029 and 2030. This raises the level of mandated reductions from ~20% to 32%, which is beyond what we expect can be met by process-related improvements of producers.

As a result, most are likely to face rising TIER costs without more disruptive solutions, like carbon capture. We estimate average costs increase to $1.52/bbl from $0.68/bbl in our base case, and from a credit to a cost of $0.80/bbl under our 'Advanced Technology' scenario.

Underscores the Need for CCUS, but Not the Incentive. Although stricter rules suggest the need for more disruptive options like CCUS to avoid compliance costs, the resulting costs of TIER ($0.80-1.52/bbl) are still well below that of CCUS development for most projects ($1.66-$2.40/bbl w/carbon credits and federal ITC), implying it is not enough to incentivize large scale CCUS without further policy support.

Warding Off Cap-and-Trade? It is important to note that a 32% implied reduction by 2030 is nearly aligned with the plans of the Pathways project and federal emissions reduction plan, as well as a long-term net zero trajectory. For this reason, we suspect tighter stringency within TIER may be the Province’s attempt to avoid an additional oil and gas ‘cap-and-trade’ system previously floated by federal policymakers.

The Cost Not Shared Equally. Certain producers are least exposed to the risk of rising TIER obligations (or may generate net credits), while others face higher risk, all else equal, as a function of carbon intensity and mature, legacy assets.

Benefits to Long-term Carbon Market Stability. One positive side effect is that rising stringency should, in theory, improve the supply/demand balance of offset credits, translating to more stable carbon markets long-term.

TIER Changes Raise Cost Avoidance Incentive, but Not CCUS The Alberta government recently passed amendments to the Technology Innovation and Emissions Reduction (TIER) carbon tax regulation in order to meet rising minimum standards under the federal government’s Greenhouse Gas Pollution Pricing act and avoid the imposition of a backstop program. The amendments were announced earlier in 2022, approved in late December, and came into effect January 1, 2023. At the heart of the changes are a meaningful increase to the stringency or tightening rate at which emitters must reduce emissions intensity over time to avoid penalties. While previously a tightening rate of 1% was applied to facility- specific benchmarks only, a proposed 2% annual tightening rate will now apply to both facility-specific benchmarks and high-performance benchmarks (like electricity). What is more, for oil sands production and upgrading specifically, the tightening rate will rachet up by 4% in 2029 and 2030. We believe the tighter stringency within TIER may be the Province’s attempt to avoid an additional oil and gas ‘cap-and-trade’ system (which the federal government has floated).

Other changes include the creation of two separate buckets for credit generation (Sequestration Credits and Capture Recognition Tonnes) to aid in the administration of credit trading, as well as increases to the amount of credits used and their longevity prior to expiry. Finally, the amendment formally ratifies TIER’s alignment with the federal carbon price escalation plan, in which levies for non-compliance will be $65/T in 2023 and increase by $15/T increments to $170/T by 2030.

Bottom line: the increasing stringency under TIER raises the level of emissions reductions that producers are obligated to make without penalty from ~20% to 32%, in turn increasing average compliance costs to $1.52/bbl from $0.68/bbl in our base case, and from a credit position to a net cost of $0.80/bbl under a scenario of expanded R&D and process-related emissions improvements.

“… increasing stringency under TIER raises the level of emissions reductions that producers are obligated to make without penalty from ~20% to 32%, in turn increasing average compliance costs to $1.52/bbl from $0.68/bbl in our base case, and from a credit position to a net cost of $0.80/bbl under a scenario of expanded R&D and process-related emissions improvements.”

This reinforces the need for more disruptive decarbonization options like Carbon Capture, Use and Storage (CCUS) to achieve collective industrygovernment targets. That said, while the rising pressure and costs provide incremental cost-avoidance incentive to emitters, we do not see the cost as overly burdensome on producers relative to the net cost of CCUS under existing policy, meaning that TIER alone is still unlikely to promote large scale deployment of CCUS. This reinforces our view that incremental policy support is needed for Canadian CCUS to generate investable returns and compete on large scale with other regions.

Certain producers are least exposed to the risk of rising TIER obligations (or may generate net credits), while others face higher risk, all else equal, as a function of carbon intensity and mature, legacy assets.

Finally, one possible positive side effect of the TIER amendments is that rising stringency should, in theory, improve the long-term supply/demand balance of offset credits, translating to more stable carbon price markets long-term.

Rising Stringency, Cost-Avoidance Incentive (for some) One of the early criticisms (including ours) of TIER was that it lacked stringency to incentivize meaningful investment in carbon reduction beyond the routine, particularly for large-scale investments like CCUS. Based on the facility-specific benchmarking process under TIER, and related stringency rules, the original program only called for a reduction of ~20% of emissions by 2030 (vs. 2013-2015 average). Given the historical pace of emissions improvement from the oil sands group, this is a level of reduction that we expected would naturally be met over time by routine R&D programs of producers.

"Under the amended regulation, a 32% reduction in oil sands emissions intensity is now expected of facilities by 2030.”

Under the amended regulation, a 32% reduction in oil sands emissions intensity is now expected of facilities by 2030. This means that even under our “Advanced Technology” scenario whereby industry expands R&D investment to meet a ~25% reduction in process- related intensity, most producers are now likely to face TIER compliance costs without more disruptive solutions like carbon capture.

We illustrate this in Exhibit 1, which shows our estimate of average compliance costs under our base model (assumes 15% reduction in sector emissions intensity by 2030) increases from $0.68/bbl to $1.52/bbl with the changes on an NPV10 basis, while compliance costs under an ‘Advanced Technology’ scenario (~25% reduction in sector intensity by 2030 due to expanded process-related R&D) shifts from a credit position, to a $0.80/bbl average cost. In a status quo scenario (no assumed improvement in emissions intensity), we estimate compliance costs increase from $1.66/bbl to $2.48/bbl (and potentially as high as $3.79/bbl in 2030), as illustrated in Exhibit 2.

Exhibit 1: TIER Compliance Cost Scenarios ($/bbl, NPV10) Source: BMO Capital Markets Estimates

Exhibit 2: TIER Compliance Cost Scenarios ($/bbl, 2030E) Source: BMO Capital Markets Estimates

It is important to note that a 32% implied reduction in oil sands emissions intensity by 2030 is roughly in line with the plans of the Pathways Alliance partners. It is also interesting to note that while it is not clear what tightening rates will apply post-2030, maintaining a 4% clip would align with a net zero trajectory by 2050. For this reason, we believe the tighter stringency of TIER may be an attempt by the Province to ward off an additional oil and gas ‘capand-trade’ system (which the federal government has floated as an option to cap emissions). In our view, the rising stringency under TIER is likely a fair compromise.

Underscores the Need for CCUS, but Not the Incentive Even though the amendments call for an average reduction in emissions intensity of 32%, suggesting need for more disruptive options like CCUS, the resulting costs to producers are not overly burdensome such that it incentivizes investment in CCUS without further policy support to strengthen returns. Case in point – as we illustrate in Exhibit 3, the average compliance cost of $0.77/bbl for oil sands producers under an advanced R&D scenario (and $1.52/bbl in our base case) are still well below net zero related CCUS costs of $2.40/bbl net of the federal ITC, and costs of $1.66/bbl including carbon credits valued at $65/T+inflation to 2050.

“… the average compliance cost of $0.77/bbl for oil sands producers under an advanced R&D scenario (and $1.52/bbl in our base case) are still well below net zero related CCUS costs of $2.40/bbl net of the federal ITC, and costs of $1.66/bbl including carbon credits valued at $65/T+inflation to 2050.”

Exhibit 3: TIER Compliance Costs vs. Net Zero CCUS Costs to 2050 ($/bbl, NPV10) Source: BMO Capital Markets Estimates

The Cost (Incentive) Is Not Shared Equally Exhibits 4-5 provide estimates of TIER compliance cost by oil sands company, according to our Base Model (15% reduction in emissions intensity), and our Advanced Technology case (~25% reduction). As demonstrated, some projects are more at risk and therefore potentially more motivated by TIER itself to advance CCUS development.

Exhibit 4: TIER Cost by Company ($/bbl, Base Model) Source: BMO Capital Markets Estimates

Exhibit 5: TIER Cost by Company ($/bbl, Advanced Tech) Source: BMO Capital Markets Estimates

We illustrate the impact of implied compliance costs on the oil sands producer group relative to corporate free cash flows by time frame in Exhibit 6 for the sector as a whole. As shown, we estimate that costs consume less than 2-3% of FCF of producers by 2030 under the base case, but increases to 18% by 2050. These percentages decrease to 1% and 8%, respectively, under the scenario of advanced R&D efforts and larger process-related emissions reductions over time.

Exhibit 6: TIER Compliance Cost vs. Free Cash Flow ($/bbl) Source: BMO Capital Markets Estimates

Possible Benefits to Long-term Carbon Market Stability Another potentially positive side effect of the TIER amendments is that the increased stringency, in theory, should improve the long-term supply/demand balance of offset credits, translating to more stable carbon price markets long term. That said, a significant challenge facing Canadian CCUS development is the scale at which investment must be made to accommodate 2030 government mandates and widespread net zero commitments, which still stretches well beyond the cost-avoidance scope of TIER. We do not believe it fully addresses the issue of future price visibility, particularly under a scenario whereby the federal government somehow restricts trading of credits for oil & gas companies with other industries, (which has been suggested).

New Credit Terms, Mostly Administrative Noise In addition to the stringency changes, the government will introduce unique CCUS credits to aid in administration of credit generation and use, and to enable value to flow back to the capturing site more efficiently. The two CCUS credit types include: 1) Sequestration Credits which will enable offsets to be recognized under the Clean Fuel Regulation (CFR), allowing for possible stacking of credits for some emitters. These credits will be subject to the same usage limits as performance and offset credits (see below); 2) Capture Recognition Tonnes will allow emitters to deduct sequestered emissions from their total regulated emissions at the capturing facility, with no limit to usage, with the caveat that they cannot be banked and must be used that year. Any excess reductions may be monetized as EPCs after.

Expanding Credit Usage Limits, Accelerating Expiry The maximum allowable emission offsets (EOCs), emission performance credits (EPCs) or sequestration credits that can be used by a facility in a given year will remain at 60% in 2023, but increase to 90% by 2026. At the same time, the expiry period for EPCs will be reduced to five years (from eight years) for credits with a 2023 or later vintage, limiting the extent to which emitters can bank credits to avoid market manipulation and promote stability. Offset credits will now expire after six years, down from nine. These changes will limit supply and increase with demand, resulting in a stronger market.

Wider Industry Scope The amendments also decrease the minimum emissions threshold for opt-in facilities in emissions-intensive industries from 10,000 CO2e tonnes/year to 2,000 CO2e tonnes/year enabling smaller emitters to opt into the program and increase demand for offset credits. The scope of a “large emitter” also now includes facilities that import >10,000 tonnes of hydrogen starting in 2023.

Alignment With Federal GHG Pricing Plan With the amendments, Alberta’s carbon pricing program will officially adopt and integrate the federal greenhouse gas pricing plan which escalates from $65/T in 2023 to $170/T by 2030. This rate of price increase was already factored into our emissions compliance cost models. We note that for compliance, regulated facilities can either purchase credits up to the limit described above with the balance being paid into the TIER fund or they can simply pay into the fund entirely. TIER fund payments will reflect the federal price escalation schedule. This dynamic results in a ‘price cap’ on all credit types traded in the market. Historically, EPCs and EOCs have traded at a 10% discount to the TIER fund price.

“With the amendments, Alberta’s carbon pricing program will officially adopt and integrate the federal greenhouse gas pricing plan which escalates from $65/T in 2023 to $170/T by 2030.”

Summary of Amendments In Exhibit 7, we summarize proposed and enacted changes under the Alberta TIER system for reference.

Exhibit 7: Alberta TIER - Proposed vs. Amendments Source: Alberta Government, BMO Capital Markets

Proposed

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Jared Dziuba, CFA, Analyst, Rachel Walsh, CFA, Analyst, Williams Avila, Associate, BMO Capital Markets Jared Dziuba, CFA, has over 15 years experience as an equity research analyst with BMO Capital Markets, covering a full spectrum of subsectors within the global oil & gas industry. In his current role, Jared oversees the execution of industry thematic research, providing insight to BMO’s institutional investor clients on emerging trends that influence the longterm investment prospects of the energy business. Recent areas of focus include in-front perspectives on the Canadian oil & gas sector’s sustainability (Environmental, Social, Governance, or ESG) performance in the global context, as well as the unique decarbonization (CCUS) and energy transition potential of Canada’s oil sands producers.

Jared graduated from the University of Calgary’s Haskayne School of Business with a B.Comm in Finance (with distinction), and is a CFA charter holder.