Pricing Carbon: Cap-and-Trade or a Carbon Tax?
“Carbon” by Chris Leboutillier is licensed under Pexels
In Glasgow, Prime Minister Justin Trudeau pushed the world to implement a global price on carbon by 2030 without actually specifying what type of carbon pricing he would like to see the world adopt. There are two main types of carbon pricing: emissions trading systems (ETS), sometimes referred to as cap-and-trade, and carbon taxes. Canada, where provinces have relatively strong autonomous powers, has demonstrated that the latter can also provide sensible climate policies. The country’s four largest provinces have implemented carbon pricing, with British Columbia and Alberta adopting a carbon tax and Quebec and Ontario opting for cap-and-trade. The East and West coast’s respective policy choices make it convenient to compare the two policies and see which is more effective at curbing emissions. In theory, carbon pricing is an effective tool for reducing greenhouse gas (GHG) emissions because it allows consumers to be influenced by the fact that the prices of products and services reflect the quantity of GHGs associated with them.
Carbon Tax and Cap-and-Trade
Carbon taxes subject emissions to a transparent and explicit price, usually in the form of a fossil fuel tax or charge. The tax rates vary depending on the fuel and the amount of GHG each generates. For example, a general carbon tax of $10 per ton of carbon dioxide equivalents would result in a royalty of $ 0.0221 per litre for gasoline, $ 0.0155 per litre for propane, and $0.0196 per cubic meter for natural gas. The carbon tax increases with time to incentivize producers and consumers to choose to reduce or limit CO2 emissions.
In a cap-and-trade system, the amount of GHG that can be emitted in an economy or industry during a time period is capped at a predetermined level. The government issues emission rights that correspond to the cap on GHG emissions for the period in question. Governments can distribute several rights free of charge to their issuers depending on their goals, and the rest are usually auctioned. In each period, listed emitters must ensure that they have enough emission rights (rights acquired free of charge from the government, rights acquired at auctions or from other listed emitters or verified offset rights) to cover their emissions. In the long term, the policy can be made more stringent, for example by lowering the ceiling on GHG emissions, which generally has the effect of increasing the price of emission rights.
Assessing the Performance of Carbon Pricing Policies
A key stakeholder in the construction of the IPCC since 1995, Erik Haites, looks at the performance of two carbon pricing systems: the carbon tax and emission trading systems (cap-and-trade) throughout 2005-2015. He finds that jurisdictions (Norway, Sweden, Denmark, and Finland) that implement a carbon tax were found to yield only small reductions (up to 6.5% over a few years); however, their greenhouse gas emissions continued to increase. In a few of these jurisdictions, the carbon tax included a reduction of energy taxes. The small impact reflects extensive tax exemptions/reductions for the trade-exposed firms, the low incremental tax burden on fuels, and relatively inelastic demand for fuels in the sectors where the tax was implemented. The author lists two reasons for the carbon taxes being inefficient: the tax being too low and uncertain rate changes.
Cap-and-trade systems on the other hand have proven to be more effective. In fact, in every ETS, emissions have fallen. However. that is not only due to the carbon pricing system implemented; recessions, impacts of other policies, and economic development make it very difficult to analyze exactly how much ETS played in the role of reducing emissions. Thus, the author deems it inconclusive.
Expected Results in Canada
Environment and Climate Change Canada endorses Canada’s Pan American Approach to Pricing Carbon Pollution in which carbon pricing is a central component of the plan for not only fighting climate change but also, for economic growth. It is estimated that under this policy, greenhouse gas emissions would be reduced by between 80 and 90 million tonnes by 2022. That is a significant amount, but it is not significant enough to reach Canada’s emission targets (the price per tonne would have to be substantially higher); therefore there are complementary measures added to incentivize innovation. Entrepreneurs and businesses will look to transition their productivity in an eco-friendly way. In short, carbon pricing incentivizes clean air as a positive externality. It encourages producers to develop and adopt clean technologies to reduce emissions.
Carbon pricing has very little effect on the morale of the economy. The application of the policy would barely impact GDP. In the long run, it may even increase GDP because of innovation in green technologies. Furthermore, when it comes to low-income households, indigenous people, and other vulnerable groups, the provincial powers can use their carbon tax revenues to diminish the tangible effects these policies have on their personal lives. Some examples include direct rebates, tax cuts, and tax credits.
The major limitation of carbon pricing is that it depends entirely on the assumption that everything remains stable and constant (ceteris paribus). Thus, the framework always has room for mistakes. In short, the Pan-Canadian approach would ensure the cost-effectiveness of emissions abatement at a national level. It is the least economically costly policy for businesses when mitigating climate change.
Carbon pricing is a key policy to drive carbon emissions down. It can help Canada to achieve its net-zero target in 2050, yet it can only do so if it is designed to be as effective and efficient as possible. From existing climate literature, we can conclude that jurisdictions that have opted for an ETS policy should expect to fare better than those that adopted a carbon tax when it pertains to reducing greenhouse gases.