Backhanded complements, redux: complementary policies and linkage

emissions within cap-and-trade
Climate and Energy Pollution

Lately on the Ecofiscal blog, we’ve gone on at length about designing complementary, non-pricing policies that support — and not undermine — carbon pricing. Our focus, as always, has been policies that reduce more emissions at lower cost. But pretty clearly, some governments are also implementing some relatively high-cost ­ policies. Today, I want to consider reasons they might be led to do so.  In particular, I want to look at a weird little dynamic that could result from a mixture of policy interactions, non-pricing policies, linked cap-and-trade systems, plus a pinch of politics. (Yikes. How’s that’s for wonk click-bait?)

Policy interactions can be counter-intuitive

Let’s start with interactions between cap-and-trade systems and overlapping policies. We unpacked the details here, but the short version goes like this:

The number of permits in a cap-and-trade system defines the levels of allowable emissions (i.e., the cap). An additional policy might reduce emissions in a specific sector. But because the system’s overall cap hasn’t changed, those new reductions will just displace reductions that would have happened somewhere else.

Think of it like a balloon. The total volume of air (or level of allowed emissions) is fixed. As a result, squeezing one end just leads to a bulge in the other, not a smaller balloon.

Maybe an EV subsidy, for example, lowers transportation emissions, and fuel distributers require fewer permits as a result. But then other sectors will have access to those extra permits, and therefore will reduce fewer emissions. Additional policies don’t change the amount of emissions allowed in a cap-and-trade system—they just move emissions reductions around.

The politics of overlapping policies

In a previous blog, we looked at non-pricing policies in California, and how they interact with a cap-and-trade system. We explored the debate around these non-pricing policies. What motivates these policies? As we’ve noted, the right complementary policies make economic sense. But any additional policies —cheap or expensive— might also have political motivations.

Here’s (a very quick) summary of the debate in California (which parallels points made by Mark Jaccard here in Canada). On one hand, those policies helped keep the explicit price of carbon (i.e., the market price of permits) low, potentially making the program more acceptable to the public. On the other, they increased overall costs, but did so through implicit, non-transparent carbon prices imposed by regulations. No matter where you land in that debate, it’s clear that governments have political incentives to combine cap-and-trade with non-pricing policies, whether genuinely complementary or not.

Gains from trade or carbon mercantilism?

But guess what—there’s another political reason why cap-and-trade jurisdictions such as Ontario and Québec might be tempted to lean on non-pricing pricing policies, further increasing costs.

In a linked system, Ontario and Quebec are likely to be net permit importers from California. If emissions reductions are cheaper in California, then that makes good economic sense. That’s what the gains from trade are all about; climate benefits of avoided emissions are the same, whether the avoided emissions are in Canada or California. But trading might come with political baggage: the optics of financial flows to California can raise eyebrows. Mark Cameron, from Canadians for Clean Prosperity, for example, writes, “sending millions or billions to California instead of taking more action at home is just plain ugly.”

Here’s where policy interactions come back into play. In a linked system, additional, non-pricing policies in Ontario or Quebec that apply to covered emissions will tend to reduce the number of permits emitters would import from California. And given the politics of out-of-province financial flows, there might be political advantages to doing so.

But that introduces an interesting tension. To what extent are Ontario and Quebec trusting their carbon market, and letting Californian permits keep the costs of policy (and the price of carbon) low? Or to what extent are they undermining those gains by forcing specific reductions to happen domestically, even if they come at a high cost?

Guys. It’s time for some game theory

So it looks like provinces have two kinds of political incentives to rely more on non-pricing policies than on carbon pricing, even if that increases overall costs. First, the costs of regulations are hidden, so they might be more politically palatable than more stringent carbon pricing. And second, in a linked system, non-pricing policies can reduce permit imports and associated financial transfers out of the region.

But that’s not the end of the story. If all linking partners have incentives to implement more non-pricing policies, a kind of arms race toward regulations could be the result. Each might have incentives to keep cranking up non-pricing policy to stay ahead of the others. But as we’ve noted, more non-pricing policies are not generally better. Really expensive non-pricing policies would still serve this political purpose, despite their economic downside.

Choose carefully

Just to be clear, I’m not arguing that all non-pricing policies are problematic. Genuinely complementary policies that are chosen and designed well make economic and environmental sense, linkage or not.

Moreover, political constraints are real, and do matter. But ­elected governments are best positioned to navigate trade-offs between economic efficiency and political feasibility. Ecofiscal’s job is to point the way to lowest cost policy options and help explain the mechanisms that might matter, and the factors that might increase costs. Even (especially?) if they are weird and complex.

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