It is now become increasingly clear that the federal government wishes to see a carbon price in all parts of the country. While specific details will remain unclear in the near future, in the next 6 months working groups will study carbon pricing and other climate policies that will shape a pan-Canadian climate plan. As part of our ongoing blog series, we are exploring some of the difficult questions around coordinating carbon pricing across Canada. This blog explores the important interactions of carbon pricing mechanisms with overlapping climate regulations.

Calls for complementary climate regulations

In its inaugural report on carbon pricing, The Way Forward, the Commission argued that carbon pricing should be a central element of a comprehensive policy package to reduce GHG emissions. It also suggested that other policies could play important complementary roles.

Others have picked up this theme. Paul Boothe and Félix-A. Boudreault from the Ivey Lawrence Centre recently released a report that suggests that the federal government could drive complementary regulations such as building codes. In a recent Policy Options article, Mark Jaccard from SFU, made the case for increased reliance on regulations such as coal phase-outs and vehicle emission standards to achieve our emission targets. The new think-tank Smart Prosperity also suggests strong regulatory standards as a necessary complement to pollution pricing.

While some or all of these regulations could be justified, given that broad based carbon pricing policies currently exist or are scheduled in many Canadian provinces, it is also critical to think through the interactions of carbon pricing with these additional climate policies.

The risks of overlapping climate policies

In general, the choice between cap-and-trade and a carbon tax matters less than the details of design. Still, there are differences. In particular, under a cap-and-trade policy, additional climate regulations stand the risk of not contributing to additional emission reductions, whereas this is not true with a carbon tax. Why is this the case?

An economy-wide cap-and-trade program sets a limit on the annual quantity of emissions, allocates emission permits, and creates an active market in which firms can trade the permits at a market-determined price. Such a program exists in Quebec and is scheduled in Ontario. Suppose now a government puts in place an additional climate regulation, such as a vehicle emission standard. Further, the second policy overlaps with the first, meaning that it targets a sector covered by the cap-and-trade system. By reducing emissions in the transport sector, this regulation will reduce the transport sector’s demand for permits, and as such put downward pressure on permit prices. This will lead to increased emissions elsewhere in the economy. Therefore, under a cap-and-trade policy, overlapping climate regulations stand the risk of simply reallocating emission reductions but not changing overall emissions.

Given that a carbon tax fixes a carbon price as opposed to an emission level, overlapping climate regulations can lead to additional emissions reductions. However, because regulations are generally not as cost-effective as carbon pricing, this reduction could occur at a greater cost than by simply increasing the level of the tax.

These risks for cap-and-trade programs are not just theoretical. They are being brought to prominence by experiences south of the border and in Europe. The Californian government has been increasingly leaning on its complementary climate policies such has its Low Carbon Fuels Standard (LCFS) instead of its economy-wide cap-and-trade program to reach its emissions program. As pointed out by Harvard economist Robert Stavins: “The LCFC has the perverse effect of relocating carbon dioxide emissions to other sectors but not reducing net emissions”.

Policy interactions under multiple levels of government

These issues could matter as the federal government considers layering additional policies on provinces. Consider the example of the European cap-and-trade market (the EU ETS) and the UK. The UK unilaterally decided to impose an additional carbon tax on top of the permit requirements for the GHG emissions of its electricity sector. While it is expected that this policy will lead to greater emissions abatement in the UK, is it likely that these efforts will be simply offset by emissions increases elsewhere in Europe as it puts downward pressure on permit prices.

Solutions for smart policy design

If a government prefers a cap-and-trade program to a carbon tax, design options are available that would allow it to alleviate risks from potential overlapping climate regulations. The first would be to implement a high enough floor price. This would prevent too much depreciation on permit prices and therefore maintain the level of the carbon price incentive in all parts of the economy (which is necessary to not only spur behavioural change, but technological change in the long run). Another option would be for government to adjust caps by essentially removing permits if such new policies are put in place. The downside of this option is that it introduces uncertainty into the program.

As with all policy implementation, design details matter. The interaction of overlapping climate regulations with existing carbon pricing schemes presents some challenges. However, not all additional policies have distortionary interactions with carbon pricing. Regulations and subsidies that target separate externalities, such as knowledge spillovers which create an under-supply of R&D, could even help reduce overall policy costs. Stay tuned for more blogs on this topic.