Smooth transitions: Shifting from cap-and-trade to a carbon tax - Canada's Ecofiscal Commission

Smooth transitions: Shifting from cap-and-trade to a carbon tax

Climate and Energy

by Dale Beugin, Blake Shaffer, and Trevor Tombe

Members of Ontario’s PC Party have voted strongly in favour of replacing the province’s current cap-and-trade system with a federally administered carbon tax. There would be important pros and cons for such a transition, should the PCs come to power in 2018, and should they follow through on this plan. But politics aside, the question we ask in this blog is a technical one: if Ontario does switch from cap-and-trade to carbon tax, could the transition be a smooth one? Though there are important details for policy-makers to consider, a shift could be easier than you might think.

Decades of research and a broad consensus among policy analysts supports pricing as a cost-effective way to lower greenhouse gas emissions. Ecofiscal has written extensively on the benefits of carbon pricing, as have others, so we won’t revisit that discussion here. Instead, we note there are multiple ways to price carbon and Ontario may decide to shift from one approach to another. What are some of the main issues to consider? Would such a shift be a smooth one?

Let’s start with a (very) brief review of the fundamentals.

Cap-and-Trade vs Carbon Tax

In a cap-and-trade system (as currently exists in Ontario and Quebec), total emissions are capped and firms require a permit to emit. The number of permits available (roughly) equals the total emissions allowed under the cap, so there is certainty over what emissions will be. But the permits are auctioned, so there’s not certainty over their price.

Now consider a carbon tax system. Unlike cap-and-trade, there are no permits and firms simply pay a tax based on the fuel they use or the GHGs they emit. The tax is an incentive to change behaviour and lower emissions. While there’s certainty over the price, there isn’t over emissions.

Fundamentally, the two systems are similar. One fixes emissions, the other fixes prices.

Competitiveness Concerns

Pricing carbon in either system raises production costs, especially in emissions-intensive sectors. When these sectors are open to trade, this raises important concerns regarding competitiveness vis-à-vis regions that are not pricing carbon. To address this, governments have different tools available in a cap-and-trade system versus a carbon tax regime.

In a cap-and-trade system, governments can provide firms with some free permits. Emissions are still capped, but firms’ costs rise less than if they had to purchase all their permits. This isn’t costless, since giving free permits lowers total government revenue. For perspective, in Ontario’s current cap-and-trade system, roughly $1 billion of credits will be distributed for free.

In a simple carbon tax system (like BC’s) there are no “credits” and therefore there is nothing to distribute for free. This doesn’t mean competitiveness concerns are worse, as carbon tax revenue provides governments with other tools such as providing a direct subsidy.

A government need not explicitly provide cash payments, but could instead provide more indirect support. Firms could be given thresholds for their emissions, above which firms pay the carbon price (say, $30/t) and below which firms have some spare room left over. The spare room can be traded to other firms, just like a permit in a cap-and-trade system, or sold back to the government at the fixed carbon price.

In some sense, these thresholds are just like the free permits in a cap-and-trade system. And how they are allocated matters. Alberta—and the new federal system—will use what’s called an “output based allocation” (or, OBA) to assign these thresholds. A firm that produces twice as much as another also has an emissions threshold that is twice as much. Without going too far into the weeds, think of this as providing a fixed subsidy on each unit a firm produces.

A Smooth Transition?

The Ontario PC party wants to shift from a cap-and-trade system to the federal backstop, which combines a carbon tax with output-based allocations for large emitters. This is not a fundamental change in how firms are supported and competitiveness concerns addressed; instead, it is a modest change to how such support is allocated and administered.

Can such a transition be smooth? We consider three options.

Option 1: Delayed Transition

There is no need for the government to instantly transition from one system to another overnight. It could negotiate with the Federal government to allow a phase-in period. Or it could wait until current permits expire, then begin the OBA regime. Ontario’s first “compliance period” is set to end on December 31, 2020, and all firms must return their allowances or other credits. A new government looking to transition from a cap-and-trade system to carbon taxes could time the transition to that date.

Option 2: Accepting cap-and-trade permits as compliance

If a new government wants to transition more quickly, permits that have already been sold for the 2020 compliance period pose a complication.

Government could accept cap-and-trade permits as legitimate compliance for their emissions. Fuel distributors holding permits would be exempt from the carbon tax for any permits they hold. Large emitters could similarly use permits to cover emissions above an emissions-intensity benchmark under the OBA system.

Such a transition would need to be managed carefully. In a transition to the federal backstop, the carbon price will (likely) go up and permits would be effectively worth more. This would create windfalls for current credit holders, and also introduce a speculative incentive to buy credits in the period prior to the start of the backstop regime. One could avoid such gaming by “vintaging” the credits. That is, a credit for 1 tonne of emissions issue in a year when the carbon price was $18/t would be worth 0.6 tonnes (18/30) in a year when the carbon price is $30/t (Pembina recently proposed a similar vintaging approach to address price changes over time within the Alberta system).

Option 3: Allowing permit sales to California

Finally, Ontario could simply allow firms to just sell cap-and-trade permits back into the market. Currently, the permit auctions where Ontario, California, and Quebec permits trade is near the floor price. Firms could therefore sell their permits and find willing buyers at a price close to the floor price.

This approach, however, could be problematic from California and Quebec’s perspective. A large availability of additional permits could raise emissions above what they otherwise would have been in those jurisdictions. To the extent that the permit price is bound by the minimum, however, this is less of a problem. In this case, though, Ontario firms selling permits to firms in California and Quebec could result in lower revenues for those governments.

Concluding Thoughts

As with any policy change, a change from cap-and-trade to the federal backstop would require considering several important trade-offs.

The existing cap-and-trade system, designed by the Liberal government, might drive more emissions reductions in global terms, thanks to a more ambitious cap and the use of revenues to support low-carbon technologies and other emissions-reducing activities. Yet the price will likely be lower, given that Ontarian emitters will be able to purchase relatively low-cost permits from California.

On the other hand, the Progressive Conservatives are proposing a system that will have a higher carbon price, and thus more emissions reductions within Ontario. But permit trade with California will no longer be an option, and revenues will be used to lower taxes on households and businesses.

Those are trade-offs worth debating (as will no doubt occur during the 2018 election campaign!). But it will be a debate between real, credible options. Our purpose here hasn’t been to identify which option is better, only to note that smooth transition from one system to the other is entirely feasible.

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