Climate policy can be complicated—especially if you’re talking to economists. Carbon pricing? Complementary policies? Marginal abatement costs? Let’s unpack some of this jargon in the simplest ways possible.

What’s the problem?

Negative externalities occur when someone’s actions impose costs on others. For example, consuming energy creates pollution, which has costs. Health impacts from air pollution and increased impacts of climate change are two good examples. But when someone drives their car, heats their home, or otherwise consumes energy, they don’t pay those costs; society does. These costs to society are negative externalities. This is a problem. It means that we don’t have the right incentives to avoid those costs because we don’t bear them personally.

Fortunately, we have policy solutions to environmental externality problems.

The basics of carbon pricing

Carbon pricing is a policy that imposes a charge on emitting carbon dioxide and other greenhouse gases. It fixes the externality problem by making anyone who emits carbon pay for the damages that result from their emissions.

There are two main ways to implement carbon pricing:

• A carbon tax is a flat charge to emit a tonne of carbon. The more carbon you emit, the more you pay. That creates incentives to switch to practices or technologies that produce fewer emissions.
• A cap-and-trade system places a limit on the total emissions in the economy (the “cap”). Businesses covered by the system receive permits for the right to pollute, which they can buy and sell to one another (the “trade”). They can buy permits from other polluters instead of reducing their emissions, or they can reduce their emissions and sell any permits they don’t need for a profit. Again, that creates an incentive to reduce emissions.

One of the biggest advantages of carbon pricing is cost-effectiveness. In the context of climate policy, cost-effectiveness means reducing a given amount of emissions in the least expensive way possible. Carbon pricing is cost-effective because it uses the power of markets. It lets people and businesses decide for themselves where, when and how to reduce emissions. The alternative to carbon pricing is regulation that tell people and businesses where, when, or how to reduce emissions, and by how much. Carbon pricing lets the market decide what is cost-effective, unlike prescriptive regulations.

Other climate policies and when they make sense

Carbon pricing is the most cost-effective way to reduce emissions, but it can’t do it all. That means additional policies to reduce emissions can sometimes make sense. We call these non-pricing policies.

Non-pricing policies can support research and development or provide additional information to consumers on issues like energy efficiency. Or they might apply to emissions that are challenging to measure and price, like methane emissions in the oil and gas sector. It’s hard to measure the methane leaks from gas wells and pipelines, so carbon pricing won’t work. Complementary policies might also lead to other, additional benefits. For instance, phasing out coal can reduce asthma attacks and sick days, which reduces health care costs.

But not all non-pricing policies (e.g., regulations or subsidies) are cost-effective. Some may reduce emissions at high cost. If a non-pricing climate policy is cost-effective, we call it a complementary policy. Truly complementary policies do something a carbon price can’t and do it at the lowest possible cost.

But there’s more than one way to think about costs.

Thinking about costs

When it comes to cost-effective climate policy, we often talk about marginal abatement costs, which is the cost of reducing (“abating”) one additional tonne of carbon emissions in a specific part of the economy.

Carbon pricing, if it’s designed well, reduces emissions at the lowest possible cost. If the marginal cost of a given action is cheaper than the carbon price, better to take that action and avoid paying the carbon price. This can be anything from switching to a high-efficiency furnace to taking the bus instead of your car.

But non-pricing policies sometimes target emissions reductions that are pretty expensive. The Ecofiscal Commission found, for example, that Quebec’s electric vehicle subsidies reduce emissions at a cost of around $395 per tonne.

To optimize costs and benefits, policy should set the price of carbon equal to the social cost of carbon, which is equal to the damages to society resulting from one additional tonne of carbon. Environment Canada estimates the social cost of carbon dioxide at $40.70 per tonne, but also acknowledges there’s a good chance that it’s much higher (think $200 per tonne).  

Other issues: leakage, competitiveness, and fairness

Well-designed carbon pricing avoids leakage. Leakage is the possibility that carbon pricing creates incentives for industries to move to areas where climate policies are less strong to avoid paying the carbon price. The overall result is that emissions are not reduced, they just shift to different parts of the world.

Leakage matters in particular for industries that produce lots of emissions per unit of output (they’re emissions-intensive) and compete in international markets (they’re also trade-exposed). Cement manufacturing, iron and steel, petroleum refining and oil and gas production are typical examples. Ecofiscal analysis estimates that about 5% of the Canadian economy meets both criteria.

Fortunately, well-designed policy can prevent leakage. In particular, we can use the revenues from carbon pricing for output-based allocations, which are temporary production subsidies for vulnerable sectors. Together with a carbon price, they create incentives for firms to improve their emissions performance and efficiency but not to reduce production.

Well-designed carbon pricing ensures fairness, which means that they don’t impose disproportionate costs on low-income households. Costs of carbon pricing—from heating and driving, for example—can make up a bigger share of low-income households’ total income. However, governments can recycle revenues in different ways to address these very important concerns. In Alberta, for example, households that earn less than $95,000 get cheques in the mail to help offset costs.

A complicated problem

The world of climate policy is complicated, and full of jargon and hard choices. At the Ecofiscal Commission, our goal is to show how just how much these choices matter. Climate change is already costing us. Ensuring that our climate policies are cost-effective will save Canadians money now, and in the future.

This blog post appeared on the Canadian Fuels Association’s website in two parts (Part 1, November 30, 2017 and Part 2, December 7, 2017).