common threads: linking carbon pricing policies

Last week marked a significant milestone for carbon pricing in Canada: the Ontario government released final details of its cap and trade program. In 2017, Ontario’s system—responsible for nearly one-quarter of Canadian emissions—will operate on its own. But in 2018, it will link with Quebec and California’s cap-and-trade system, creating a common market. As part of our ongoing blog series, we are exploring some of the difficult questions around coordinating carbon pricing across Canada. Recent blogs have discussed the potential role of the federal government, but, as we’ll see, not all mechanisms for coordination require federal involvement. This blog discusses how linkages between provincial carbon pricing policies could harmonize carbon prices.

Linkage leads to common carbon prices

The concept of linkage is most familiar in the context of joining two or more cap and trade systems, as in the case of Quebec, Ontario, and California (and perhaps Manitoba). Linkage allows emitters in one jurisdiction to use permits from the other jurisdiction(s) to comply with the policy. It essentially creates a common market for permit trade across national or subnational boundaries.

Linking carbon markets lowers overall costs of abatement. If the price of permits is initially lower in one emissions market, increased demand for these lower-cost permits eventually drives up the market price until it approaches the price in the other jurisdiction(s). This allows emitters with higher emission reduction costs in one jurisdiction to comply with the policy at a lower cost by accessing cheaper permits from the other jurisdiction. Providing that trade is unrestricted, the market price of permits will eventually converge to a single price.

One of the big benefits of a single carbon price across different jurisdictions is that it helps reduce competitiveness concerns. In a world with different carbon prices, businesses may have an incentive to invest in jurisdictions with the lowest carbon price, leaving global emissions unchanged. Instead, a common carbon price helps level the playing field for businesses in each jurisdiction and reduces the possibility of carbon leakage.

Finally, having a bigger emissions market with a single price also increases the liquidity of permits, providing greater price stability during unanticipated swings in the demand and supply for permits.

Systems can “indirectly” link via common offset markets

If the goal for provinces is harmonizing prices, mutual permit trade isn’t the only way to get the job done. For example, carbon pricing policies can “indirectly” link by establishing common carbon offset markets. If sufficient low-cost, high quality, offsets are available, the price of carbon will be pulled down toward a common offset price.

Common carbon offset markets could even link together different carbon pricing policies. Unlike cap and trade systems, carbon taxes are not based on tradable permits—i.e. there is no explicit market for emissions. But if emitters can purchase offsets to reduce their carbon pricing costs, indirect linkage could be a mechanism for interprovincial harmonization. Indeed, there are other more technical ways to link carbon tax policies of different types, but we’ll save that topic for another blog.

Linkage can also have some challenges…

Although the potential benefits of linking carbon pricing systems are big, it can also face challenges. For one, purchasing permits from other jurisdictions can sometimes be politically tricky. Even though it means avoiding higher cost emissions reductions at home, purchasing out-of-province permits implies financial flows leaving the provinces. That may be part of the reason why Alberta, for example, only allows domestic offsets.

A second issue is that linkage means that individual governments have less control over their own carbon pricing policies. Linked systems can’t, for example, have different price floors and ceilings given they share a common market.

…and that brings us to California

This means that a federal backstop, or minimum carbon price, could be complicated for provinces linked with California as part of the Western Climate Initiative (WCI). If, for example, a minimum price set by the federal government is higher than the WCI’s scheduled price floor, Quebec and Ontario won’t be able to unilaterally implement a higher price floor than California to match the federal carbon price.

Maybe this means considering layered carbon prices, with multiple instruments. But as we’ll see in our next blog, interactions between multiple policy instruments create challenges as well.