Policy interactions untangled: Carbon pricing and low-carbon fuel standards - Canada's Ecofiscal Commission

Policy interactions untangled: Carbon pricing and low-carbon fuel standards

policy interactions
Climate and Energy

Canada will have a nationwide carbon price by 2018. As such, it’s time to think about how carbon pricing interacts with other, non-pricing climate policies. Ecofiscal’s latest report, considers how the right non-pricing policies can support carbon pricing in driving low-cost emissions reductions… but also how the wrong policies can undermine carbon pricing. In this blog, I explore our framework by looking at one element of policy complementarity: policy interactions.

Less than the sum of its parts?

Governments have introduced a range of non-pricing policies to reduce emissions. But to what extent do these policies make sense with a nationwide carbon price? Do they result in emissions reductions in addition to those from a carbon price? The answer depends, in part, on whether policies are layered on top of a carbon tax or a cap-and-trade system.

To illustrate, I focus on interactions between carbon pricing and one other policy: a low-carbon fuel standard (LCFS). This policy requires fuel distributors to reduce the average carbon intensity of their fuels over time. Fuel distributors can comply by selling biofuels, electricity, or any other fuel with a smaller carbon footprint than fossil fuels. Compliance permits are also tradable, which helps lower the policy’s overall cost.

I consider these interactions in three different policy contexts in three different jurisdictions.

LCFS under a carbon tax

Generally, policies layered on top of a carbon tax result in additional emissions reductions. This is because they can create additional incentives to reduce GHG emissions, above and beyond the carbon tax. But incremental emissions reductions come at a cost. Emissions reductions may or may not be less costly than with a carbon tax alone. It depends on how the policy is designed and implemented.

British Columbia implemented its LCFS in 2010, layered on top of its carbon tax. The two policies overlap, in that they both apply to transportation emissions. Overall, the LCFS resulted in emissions reductions that are in addition to those from the carbon tax. Analysis by Wolinetz and Axsen, for example, finds that the LCFS (coupled with the provincial renewable fuel mandate) reduced annual emissions in the province by about 1 Mt in 2012, or 1–2% of total provincial emissions.

These emissions reductions, however, came at a high cost: as much as $172 per tonne based on recent trading data. This is well above the $30 per tonne imposed by the carbon tax. But while these costs are comparatively high, they are independent of the carbon tax.

LCFS under cap-and-trade

Additional policies that overlap with a binding cap-and-trade system, however, tend not to lead to additional emissions reductions. While policies may lead to additional emissions reductions within a given sector, the total number of permits remains unchanged. As a result, emissions reductions from additional policies are offset by higher emissions elsewhere in the cap-and-trade system.

(Wonk sidebar: if permits sell at the price floor, it suggests an over-allocation in permits and a cap that is not binding. In this case, emissions reductions from complementary policies can be additive).

California’s LCFS parallels the policy in British Columbia, and overlaps with its carbon pricing policy. The difference is that the LCFS in California is layered on top of its cap-and-trade system.

California’s LCFS reduced emissions by about 2 Mt per year from 2011 to 2015. But unlike the case in B.C., this mitigation was not additional. It displaced mitigation that would have otherwise occurred within the cap-and-trade system.

This also means the combination of policies likely has greater costs. It achieved the same level of abatement that the cap-and-trade system would have achieved on its own. Moreover, the price of tradable compliance permits in the California LCFS suggests that the emissions reductions were considerably more expensive. LCFS permits traded at $62 per ton in 2015—more than four times the price of emissions permits under the state’s cap-and-trade system.

LCFS under linked cap-and-trade

Policy interactions are even more complicated when cap-and-trade systems are externally linked (i.e., when jurisdictions trade permits). Quebec’s cap-and-trade system, for example, links to California’s, which Ontario plans to join in 2018.

If the cap is binding, complementary policies affecting covered emissions do not lead to further emissions reductions. This is the same result as above.

But because the systems are linked, the complementary policy in one jurisdiction changes permits flows. Demand for permits falls in the jurisdiction with the complementary policy. This reduced demand results in fewer imported permits if the jurisdiction is a net importer. If it’s a net exporter, it exports more permits. This activity also changes financial flows: for net importers, financial transfers to the exporting jurisdiction fall; for net exporters, financial transfers received from the importing jurisdiction rise.

In either case, total GHG mitigation in the overall system remains unchanged, but the distribution of emissions is affected. The overall cost of mitigation under the cap-and-trade system can also rise. This is because complementary policies cause mitigation actions to change, relying on costlier emissions reductions than with a carbon price.

Consider, for example, Ontario’s proposed flexible fuel mandate, which is similar to an LCFS. Under the linked cap-and-trade systems, Ontario will likely be a net importer of permits from California. The expected impact is thus more emissions reductions within Ontario, fewer in California, but the same quantity of emissions overall. The economic implications of this are higher overall costs for the system and higher costs of compliance for Ontario. But it also means smaller financial flows from Ontario to California.

Zooming back out

Untangling the interactions between carbon pricing and non-pricing climate policies can be dizzying. This blog only looked at the key interactions from a single policy, which, by itself, is complicated. Understanding the interactions between the entire package of climate policies is a much bigger and complex task. Ecofiscal has initiated the conversation by providing a framework for how to think about these complex issues.

Complexity aside, however, this type of analysis is important to understanding the effectiveness and cost-effectiveness of our climate policies. As Canada moves ahead with its nationwide carbon price, we should adopt policies that genuinely complement carbon pricing, and get rid of those that do not. These policies will drive more emissions reductions at a lower economic cost than carbon pricing can on its own. They will also be critical to meeting Canada’s climate obligations.

2 comments

  1. Ian Thomson

    Thanks Jonathan for digging into policy interactions. I do, though, need to point to several problem here regarding data accuracy, and flagging the risk of being far removed from the market being quoted (and taking what’s posted on website too literally). ‘The map is not the territory.’

    1. The $172/tonne is not an accurate depiction of the actual market. Yes, it is the reported cost, but market participants will tell you that the circumstances for the exchange of credits that generated that $/t was atypical, and very unlikely to be repeated. There have been no reported trades since. Assessing a levelized/stable BC RLCFRR cost like those costs reported for California is simply not possible with such intermittency )(and small market size)
    https://www.arb.ca.gov/fuels/lcfs/dashboard/dashboard.htm

    2. The biggest problem, however, is that this in NOT the cost of emissions reductions. It is the last and highest marginal cost when all other options have been employed by obligated parties and they need to go to the market to secure their remaining (small) volume of credits. This is a common misunderstanding; market-based mechanism prices are the same as compliance costs. To label the $172/t as the emission reductions cost, even the the caveat of ‘as high as’, is misleading. What needs to be reported are the average costs. The recent Navius report does this, at least for biofuels, which have been the largest reduction source in the RLCFRR so a reasonable proxy. http://www.naviusresearch.com/publications/biofuels-in-canada/

    best regards,

    Ian

  2. Jonathan Arnold
    Jonathan Arnold

    Hi Ian,

    Thanks for your comment. You’re right about the issue of marginal vs. average cost. I could have made this clearer; we do understand that the average cost will be lower than the $172/tonne value.

    However, the marginal cost of $172/tonne does indicate that at least some producers are paying a relatively high price for permits, even if the quality of data is not as robust as the California LCFS. This point also does not detract from the main thrust of my blog, which is more about the interactions between complementary policies and carbon pricing.

    Thanks for sharing the Navius report. It looks like a very interesting piece of analysis. We’re still digging through it, and might be responding to it later.

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