by Mark Purdon, David Houle and Blake Shaffer

Our next report will explore the challenges and opportunities with different approaches to recycling revenues from carbon pricing. To better understand the trade-offs associated with each revenue recycling option, we commissioned a set of six papers authored by some of Canada’s leading policy thinkers. What are the advantages of each option? Under which conditions do they work best? Our new Revenue Recycling blog series provides a glimpse into some of these difficult questions, voiced first-hand by the authors of each paper.

It is an encouraging development in the climate policy landscape that the debate, recently, has gone from whether or not to price carbon (or moreover, whether or not climate change is man-made), to how best to recycle the revenue from a carbon tax or cap-and-trade program. To that end, we contribute to the Ecofiscal series on revenue recycling instruments by discussion an alternative policy: the free allocation of emission permits.

On the surface, free allocations may appear out of place in an Ecofiscal series on revenue recycling. By allocating permits for free, there may be no, or at least less, revenue to recycle. But free allocation has similarities to other forms of revenue recycling—for example, a reduction in taxes—in that it confers a benefit upon its recipients, reducing their financial burden from the climate policy. In comparison to a reduction in taxes and transferring revenue to households, or spending on public infrastructure and clean technology, we expect that advocating for the free allocation of emission permits is likely to be the least popular choice (and are bracing for the hate mail!). Many will, rightfully, ask why permits should be freely allocated to emitters? If the goal is cost-effective emissions reduction, the free allocation of permits appears contradictory. But there are three main reasons why free allocation is worthy of consideration.

Why free allocation is worthy of consideration

First, in contrast to broad-based revenue recycling, free allocation can be used in a much more precise manner. From a political perspective, there is an equity argument to be made. Those who are harmed the most from the introduction of carbon pricing can be justified in seeking compensation for their burden. So long as the compensation is decoupled from their emissions, the price signal for further emission reductions remains but the cost burden is lessened.

Second, free allocations can help build political support for climate policy by ameliorating competitiveness risks of vulnerable firms and building constituencies with a vested interest in seeing the carbon market maintained. In other words, free allocation can be the pragmatic cost of getting those most harmed on board.

Third, free allocations can be a useful tool when climate policy is not uniform across jurisdictions. A significant concern with unilateral climate policy is emissions leakage—the shifting of polluting industry from jurisdictions with stringent climate regulations to those with lax or non-existent policies. If the imposition of climate policy in one province simply means a shift of activity (and associated emissions) to another province, the policy will not achieve its desired effect of reducing emissions, while having the undesired effect of harming the regulated economy. Free allocations are a useful tool for managing through a period of patchwork climate policy and mitigating emissions leakage.

Allocating permits: grandfathering vs. output-based

In order to capture these benefits, the manner in which permits are allocated matters. We contrast two main methods: grandfathering and output-based allocations. Under a grandfathering allocation, firms retain the full incentive to reduce emissions as doing so allows them to sell their allocated permits. The receipt of the allocation—or subsidy—is independent of their emissions decision. While firms are incentivized to reduce emissions, which allows them to sell their allowances, it also creates a moral hazard as they might discount the value of free allowances or reduce production for the purpose of selling unused allowances, potentially exacerbating the problem of emissions leakage.

Under an output-based allocation, the independence between emissions decisions and the size of the subsidy is gone. Firms retain the full incentive to reduce their emission intensity (i.e. produce more while emitting less), but their incentive to reduce emissions by simply curtailing output is weakened.

Alberta

Alberta’s new climate policy offers a real world example that makes heavy use of output-based allocations. Firms within a sector (for example, SAGD oil sands production) must pay $30 for every tonne of emissions above a sectoral benchmark. This is equivalent to paying $30 and receiving an output-based allocation. The more one produces – the more one pays for emissions, but also receives in allocations. Thus the incentive to produce more while emitting less is maintained (i.e. reduce emissions intensity), however, the incentive to lower emissions by curtailing production is weaker than under a lump-sum or no allocation policy. Alberta’s policy is thus less effective in lowering overall in-province emissions, but more effective in maintaining competitiveness and preventing simply a transfer of emissions to an unregulated province.

Quebec

In the case of Quebec, the emissions trading system uses a mixed method to distribute free allowances, which rely both on output-based and grandfathering methods. The free allocation is based upon an emitter’s average historic emissions intensity between 2007 and 2011 and adjusted for production output: 100% allocation for fixed process emissions, 80% combustion emissions, and 100% for emissions from other sources. As a result, past efforts of Quebec firms to improve their emissions intensity are recognized while avoiding the moral hazard created by grandfathering allocation. While initially most the allowances were provided freely to Quebec firms, since the expansion of Quebec’s cap to include gasoline, oil and other liquid fuels, free allocations constitute less than 30% of regulated emissions.

In a world where uniform climate policy is far from a reality, free allocation—and specifically output-based allocations–offers an effective option to ease the burden of transition and limit the negative effects from unilateral climate policy. However, to realize the full economic advantages of free allocations, including limiting carbon leakage, it is important that they be allocated on an output basis that is updated regularly rather than grandfathered on the basis of historical emissions.

About the Authors

Mark Purdon is an expert on climate change policy and political economy, working at the intersection of public policy, comparative politics and international relations. He is currently a visiting professor at the Department of Political Science at the University of Montreal, after earning a doctorate in political science at the University of Toronto in 2013 and a SSHRC postdoctoral fellowship at the London School of Economics in 2014. He is also co-founder and CEO of the Institut québécois du carbone (IQCarbone).

Dr. David Houle is a SSHRC postdoctoral fellow associated with the Center for Local, State, and Urban Policy at the University of Michigan Gerald R. Ford School of Public Policy and the co-founder of the Institut québécois du carbone. His research focus on subnational climate change policy in North America, especially carbon pricing in the provinces and states. His most recent articles have been featured in Global Environmental Politics and the Journal of Public Policy.

Blake Shaffer is a PhD Student in the Department of Economics at the University of Calgary. He holds an MPhil (Economics) from the University of Cambridge and a BSc (Honours; Environmental Sciences) from Queen’s University. His area of research explores the use of market-based instruments as solutions to market failures, including environmental externalities. He has 15 years of experience in the electricity sector as the former head trader at Transalta, and senior energy trader and analyst at Barclays Capital (NY) and Powerex (BC Hydro). More recently, he advised the Government of Alberta as a member of the Royalty Review Secretariat, and acted as liaison with the Climate Change Advisory Panel.

Revenue Recycling Blog Series:
1. Reducing existing taxes
2. Transferring revenue to households
3. Investing in clean technology
4. Investing in public infrastructure
5. Reducing government debt
6. Providing transitional support to industry