Pricing Carbon in the Economy
| In May, 2010, the ECO released its second Annual Report on the progress of activities in Ontario to reduce or make more efficient use of electricity, natural gas, propane, oil and transportation fuels. Click here for more information on this report, including videos and communications materials. | ||
A growing number of government, environmental and private sector sources are stressing the crucial need for market-based policies and regulations to “put a price on carbon”. This position is based on two key principles: 1) the need to capture the environmental externalities associated with the costs of burning fossil fuels and, 2) the need to send the right price signals into the marketplace to stimulate consumer demand for and private investment in cleaner forms of energy, thus hastening the transition to a low- carbon economy.
In January 2010, the Environmental Protection Act (EPA) was amended by the Environmental Protection Amendment Act (Greenhouse Gas Emissions Trading), 2009 (EPAA). While not yet fully in force, amendments made to section 176.1 allow the Ontario government to develop market-based regulations to control the release of greenhouse gases. The EPAA sets the rules governing how the allowances that underpin cap-and-trade (also referred to as “tradable permit”) systems will be created, allocated, traded, reported and verified.
The ECO notes and supports the manner in which the province has kept its options open in implementing this enabling legislation in recognition of the continued uncertainty surrounding the climate change policy landscape in North America. The ECO endorses the government’s clear intention in the amended EPA to reduce greenhouse gas emissions “without being limited to emissions trading”.
The policy challenge can be summarized as follows: should GHG quantities be regulated (via emission caps and tradable permits) or should GHG prices be regulated (via a carbon levy or tax)? Can both be done? And, a related question: which is best at getting a price signal into the economy while also contributing to the achievement of the government’s GHG reduction targets?
The ECO supports government efforts to put a price on carbon emissions, but remains agnostic on the merits of these two policy instruments (a cap and/or a tax), whether used in isolation or in combination with each other. And, while the ECO recognizes that consideration of a carbon tax is often referred to as the “third rail” of federal and provincial politics, other jurisdictions with similar standards of living to Ontario are in various stages of implementing a carbon tax. The ECO also notes that the Ontario government’s public consultation process on carbon pricing to date has focused only on one policy instrument: cap-and-trade. There is a need for a reasoned and balanced public discussion comparing and contrasting emissions trading and a carbon tax in terms of their ef?cacy in ensuring carbon price discovery in the economy while reducing GHG emissions.
The following discussion provides an overview of both pricing instruments from the standpoints of: 1) emissions certainty and price certainty; 2) administrative oversight; 3) transparency; and 4) implications for the transition to a low-carbon economy.
Contents |
2.5.1 – Emissions Certainty and Price Certainty
Under a cap-and-trade system, a cap is established, measured in tonnes of CO2e/year, and a fixed number of permits to emit are distributed, either by auction or free-of-charge. Over time, the cap is reduced. The caps are usually negotiated with industry and, ideally, are set on the basis of a combination of industry benchmarks and current best practices. They should not be based on historical emissions (which would in essence be rewarding inaction by laggard industries).
A tradable permit system fixes the level of emission reductions, via the cap, but leaves the price per tonne up to the laws of supply and demand. So, “benefit certainty” (i.e., the quantity of GHG reductions mandated by the cap) is achieved at the expense of “price certainty”. This price uncertainty is a key area of concern for many large companies. It is expected that a certain degree of price volatility is necessary to ensure that carbon markets work even with so-called “price collars” that provide a safety valve on carbon prices.
In contrast, a carbon tax is a price-based mechanism that fixes the price per tonne based on the carbon content of each fossil fuel but does so at the expense of certainty about when and where emissions reductions will occur. So, “price certainty” is achieved at the expense of “benefit certainty”. The National Round Table on the Environment and the Economy (NRTEE) has concluded that an effectively designed carbon pricing system (via either a tradable permit system or a carbon tax) should be able to provide a transparent carbon price signal while also achieving some certainty on emission reduction benefits.
While a tradable permit system can lead to price volatility, a carbon tax sets a stable and predictable price for carbon, providing less risk and uncertainty for households and businesses making GHG reducing investment decisions. Further, assuming revenue neutrality, a pool of funds can be created to provide tax relief to trade-exposed industries and disadvantaged households and to invest in research and development into low-carbon technologies. Auction revenues under a cap-and-trade system would generate a similar pool of funds and, depending on the market price and percentage of the cap auctioned, could generate similar (or higher) fund pools.
2.5.2 – Administrative Oversight
Carbon trading systems require the development of new institutions to operate effectively including registries, exchanges, brokerages and related legal, reporting and verification services. Ideally, these institutions provide efficient and transparent markets where companies can buy and sell permits/ allowances and carbon offsets while obtaining transparent pricing information on carbon. Key considerations include rules for 1) distributing allowances (by auction or free of charge); 2) setting reporting requirements (which Ontario has done through the enactment of O. Reg. 452/09 – Greenhouse Gas Emissions Reporting, made under the Environmental Protection Act) establishment of enforcement mechanisms; 4) setting of market requirements around banking, borrowing, offsets, price caps and floors; and 5) linkage or integration with other systems.
| The Western Climate Initiative |
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| To ensure the province is on the same page and working in tandem with cap-and-trade developments elsewhere in North America, Ontario joined the Western Climate Initiative (WCI) in July 2008, a collaboration of seven U.S. states and three other Canadian provinces working towards a common framework for the reporting of GHGs and the design and implementation of a tradable permit system. The WCI’s proposed emission reduction goal for its members is less onerous than Ontario’s (a 15 per cent economy-wide reduction from 2005 levels by 2020, compared to Ontario’s 15 per cent reduction from 1990 levels by 2020).
The stated intention is for the WCI trading platform to be up and running by January 1, 2012 but initially only covering the electric power sector plus combustion sources from large industrial and commercial entities and industrial process emissions. However, starting in 2015, sector coverage will increase to include residential, commercial and industrial fuel combustion and transportation fuel use. This will effectively capture about 90 per cent of WCI member emissions. The WCI’s recommendations regarding the distribution of allowance or permits is that member jurisdictions should sell through auction a minimum of ten per cent of cap allowances starting in 2012 ramping up to at least 25 per cent through auction by no later than 2020. In other words, over the 2012 to 2020 period, the overwhelming majority of permits – up to 90 per cent starting in 2012 and up to 75 per cent by 2020 – could be distributed to emitters within WCI member jurisdictions free of charge. |
Given these underlying challenges associated with cap-and-trade systems, several energy industry stakeholders plus non-governmental organizations (NGOs) in Ontario have indicated a preference for a carbon tax. Mechanisms do exist, in theory, to collect carbon taxes. However, significant administrative details would still need to be addressed including provincial and federal tax harmonization, the administration of revenue pools and consumer and industry tax rebates. Measures would also be needed in response to import/export tax implications, also referred to as “border adjustment mechanisms”. There would also be a need for broader tax system reform if revenue neutrality is a goal. Tax reforms may include offsetting reductions in personal, corporate and small business tax rates, as well as protection for low-income households (e.g., through a ‘carbon tax credit’ as British Columbia has done). A challenge will be to estimate and track GHG reductions associated with a carbon tax versus business-as-usual (BAU) but this is less of a concern now that O. Reg. 452/09 is in place.
2.5.3 – Transparency
While both a carbon tax and tradable permit system achieve the same goals in theory, it has been suggested that a carbon tax would be simpler to implement, more transparent, and less susceptible to political manipulation and “market malfeasance”. Concerns about gaming and lack of transparency were raised before Ontario’s Standing Committee on General Government (SCGG) in November 2009 regarding the province’s proposed legislative changes to the EPA by the EPAA. Several large energy companies, associations and NGOs attending the committee hearings expressed a strong preference for a carbon tax, noting that, as demonstrated in British Columbia, such a pricing instrument can provide a predictable cost of carbon, thus making it easier for all consumers of fossil fuels to “make decisions about … investments to reduce emissions.”
Cap-and-trade was described by one energy association representative at the SCGG hearings as having the potential for “abuse and gamesmanship.” Concern was also raised regarding the impacts of market speculation on carbon price volatility, noting that the actions of emissions allowance brokers and traders “aimed at trading on price volatility can too easily take the emphasis away from the real task of reducing emissions.”
If the majority of allowances under a cap-and-trade system are allocated free of charge, GHG compliance costs are set at a more manageable level for industry but the externality cost is not captured and the sought-after price signal is obscured. Auctioning does have the potential for government revenues to be redirected, via the tax system, to consumers or to support clean technology developments but the price signal is still obscured even if the cost of compliance is passed on to the consumer. Under a carbon tax, all consumers of fossil fuels (including fuels used in the production process) would pay, based on the carbon content of the fuel they use. (For a summary of how British Columbia’s carbon tax is administered, refer to the sidebar story.)
Can both work together? Where both a carbon tax and a tradable permit system exist (e.g., in the United Kingdom), care must be taken to avoid industry being caught under both. This is, in fact, how the B.C. system will work. Like Ontario, B.C. is a member of the Western Climate Initiative (WCI – see sidebar story on the previous page) and, assuming the WCI cap-and-trade system is launched on January 1, 2012, B.C. plans to exempt from the carbon tax those companies and industries that are captured under the WCI tradable permit system.
As noted above, to the extent that an industry or company may be able to incorporate the costs of compliance under a tradable permit system into the price of its goods and services, it can be argued that the cost of carbon is not fully transparent. On the other hand, a carbon tax sends a very clear and unambiguous price signal to all consumers of fossil fuels because it is usually published as a tax schedule showing what the price impact is by fuel type and the schedule for carbon tax increases over time.
2.5.4 – Implications for Transitioning to a Low-Carbon Economy
A central issue in the development and implementation of a carbon pricing system in Ontario concerns how the resulting policies and provisions will affect the province’s economic competitiveness. As noted earlier, there is considerable uncertainty surrounding the climate change policy agenda in North America. While the Canadian federal government has essentially ceded the details of its climate change policy plans to Washington, there is no clear indication how, when or if the U.S. Congress will move forward on the climate change file.
In the face of this uncertainty, Ontario is in a good position and has kept virtually all of its policy options open. While the reporting and trading architecture being contemplated in the U.S. is being driven largely by power sector emissions which represented about 35 per cent of total U.S. GHG emissions in 2008, the situation in Ontario is significantly different, where only about 14 per cent of the province’s GHGs were attributed to the power sector in 2008. Further, as noted above, the Ontario government expects to have reduced its total GHG emissions by a further 10 per cent by 2014, compared to 2008, through the phase-out of coal use at its remaining coal-fired power plants.
It has been argued that free allocation of the majority of permits during the early stages of a cap-and- trade regime, as well as access to “credible offsets”, are crucial cost-containment provisions that Ontario companies will need in order to manage the transition to a low-carbon economy. The ECO questions this focus on near-term cost-containment. It reflects a short-term emphasis on the next quarter’s balance sheet at the expense of the longer-term financial health of the company. It also ignores the equally important issue of cumulative effects and the broader costs to society from GHG emissions.
The NRTEE recognizes the competitiveness issues associated with imposing too high an initial compliance cost on Canadian industry, but recommends that 100 per cent of permits be auctioned by no later than 2020. Others have pointed out that 100 per cent auctioning as early as possible eliminates the administrative burden (and political interference) associated with who gets “free” allowances while also recognizing and rewarding companies that took early action, “because those that have already reduced their emissions have fewer allowances to buy.”
A PriceWaterhouseCoopers study suggests that, over time, it will usually be cheaper for a company to invest in new, lower-emitting technology up-front, rather than relying primarily on trading and the acquisition of offsets for compliance purposes. A company that invests in new technology to lower its carbon footprint (either for compliance purposes or as a hedge against stricter caps in the future) may only have to do this once during its first compliance period (e.g., from 2012 to 2020 under WCI rules) to stay under its initial cap, and the emission reduction benefits from this investment will accrue for the life of the equipment. On the other hand, a reliance on offsets and tradable permits for compliance purposes requires that these instruments be purchased in full every year to ensure the company meets its compliance obligations.
The key question is: Should Ontario move forward on pricing carbon in the economy if the U.S. or WCI does not proceed or should Ontario wait until the U.S. takes the initiative? Some observers have stressed that waiting for policy certainty at either the federal (Ottawa/Washington) or regional (WCI) level could jeopardize the early development of the low-carbon economy envisaged by the Green Energy and Green Economy Act (GEGEA) and identified as one of the key policy objectives of Ontario’s Climate Change Action Plan.
Finally, as discussed in Section 2.1 of this report, there is the growing realization that current levels of GHGs in the atmosphere and the oceans are seriously interfering with the planet’s climate system. The scientific consensus is that the target concentration for equilibrium in the atmosphere should be 350 ppm, a level that has already been exceeded. As such, the need to put a price on carbon becomes more urgent. This reinforces the ECO’s position that Ontario’s current GHG reduction targets are modest at best and that all policy instruments, including an aggressive and transparent carbon pricing signal, are needed – and needed soon – if Ontario is committed to showing true leadership in climate change policy.This leadership must include broader public discourse concerning how best to price carbon in the economy. The need for a transparent carbon price signal has been noted earlier by both industry and the broader public with some favouring a carbon tax. While cap-and-trade is one way to price carbon in the marketplace, it is not the only way.
| Recommendation :
The ECO recommends that the Ontario government undertake a formal public review to compare emissions trading and a carbon tax in terms of their efficacy in providing a transparent price signal to the economy. |
| While several countries within the European Union have implemented carbon taxes, very few jurisdictions within North American have done so. In 2008, British Columbia became the first jurisdiction in Canada to implement a broad-based tax on carbon-based fuels, including gasoline, diesel, natural gas, heating fuel, propane and coal. Also included are peat and tires when burned to produce energy or heat. The burning of these fossil fuels represents approximately 77 per cent of the province’s total GHG emissions. In general, the tax is applied to all fuels that are purchased, transferred or used within, or brought into, the province.
The tax rate is based on the amount of carbon dioxide equivalent (CO2e) emissions released by each fuel and is designed to increase on an annual basis. As of July 1, 2009, the rate was $15 per tonne of CO2e and will increase by $5 per tonne to $30 by 2012. Future prices have not yet been established, and the limited time horizon allows increasingly stringent prices to be applied if necessary in four years’ time. By starting at a relatively low rate, and clearly outlining future increases, citizens and businesses are provided with time to adjust their patterns of fuel consumption in order to reduce the amount paid. For individuals, the main impact of the tax relates to transportation and heating costs. For businesses, the main impact relates to transportation, building heating, and fuels used for industrial processes. To provide transparency, future tax increases by fuel type are published. For example, the price impact of the tax on a litre of gasoline was 3.33 cents per litre (¢/litre) between January and June 2010. By 2012, this amount is scheduled to increase to 6.67 ¢/litre. For heavy fuel oil, which has a higher carbon content, the rate will increase from 4.73 ¢/litre in 2010 to 9.45 ¢/litre by 2012. A key element of B.C.’s carbon tax is its revenue neutrality which means that reductions must be made to other taxes in order to fully return to taxpayers the amount generated by the carbon tax. In order to achieve neutrality, the government reduced personal and business taxes. Personal income taxes, for example, have been reduced by 5 per cent on taxable income up to $70,000. For general corporate income taxes, the rate was lowered from 12 per cent to 11 per cent in July 2008, with a further decrease of one per cent scheduled for January 2011. For small businesses, the income tax rate was reduced from 4.5 per cent to 3.5 per cent in July 2008 and is scheduled to drop to zero by April 2012. To provide transparency around revenue neutrality, the government is legally required to present an annual plan outlining the manner by which carbon tax revenues will be balanced by a corresponding tax reduction. According to the B.C. government, more money has been returned to taxpayers in the form of other tax reductions to date than has been collected through the carbon tax. Rather than being used as general revenue, the monies collected through the carbon tax are redistributed for various purposes. Along with lowering personal and corporate income taxes, the revenues are used to fund clean energy development. As well, a portion of the revenue is returned as a grant to communities that have pledged, and are making progress, to become carbon-neutral by 2012. To ensure that the tax is not regressive, a refundable ‘Climate Action Tax Credit’ was established to assist low income individuals and families. The tax credit is indexed to meet provincial inflation and in July 2011, will increase by 10 per cent. The main goal of the carbon tax is to reduce overall GHG emissions and it represents a key initiative to meet B.C.’s target to reduce emissions 33 per cent over 2007 levels by 2020. It has been estimated that the tax will result in an annual reduction of up to 3 Mt of CO2e emissions. While the tax is not the only measure taken by British Columbia to reduce its GHG emissions, it represents a key tool in the province’s GHG reduction toolkit. |
Citing This Article:
Environmental Commissioner of Ontario. 2010. Annual Greenhouse Gas Progress Report 2009/2010: Broadening Ontario's Climate Change Policy Agenda. Toronto, ON : Environmental Commissioner of Ontario. pp. 22-28
