Understanding the recent changes to the federal carbon price

Climate and Energy

Earlier this week, we learned that the federal government is making some changes to its carbon pricing system; specifically, the part that will apply to industrial sectors. While the design choice is an important one, its significance has been blown out of proportion. Let’s take a look at the change and what it means.

A bit of context

Under the Pan-Canadian Framework on Clean Growth and Climate Change, the federal government plans to impose a carbon price on any province that doesn’t have one of its own.

This federal carbon pricing system has two parts. The first (and main) part is applied across the economy to GHG-emitting activities like driving and home heating. The second applies only to industrial sectors that produce a lot of greenhouse gas (GHG) emissions and face international competition in what they produce and sell – so called “emissions intensive and trade exposed” (EITE) sectors. It’s this second part where a change has been made.

Why the different treatment?

The federal system treats EITE sectors differently to prevent something called leakage. If it imposed the full, regular carbon price on these sectors, it would risk putting them out of business only for their place to be taken by international competitors. Production (and the associated emissions) would fall at home, but rise elsewhere. (In this way, emissions would “leak” from Canada to other countries.) Leakage risks creating a cost to Canada for little to no global GHG reduction benefit.

To avoid leakage in EITE sectors, the federal system uses something called output-based pricing. Essentially, output-based pricing maintains the incentives from carbon pricing, but reduces its cost to firms to help them stay competitive. It does this by returning some of the carbon pricing revenues back to EITE sectors (we’ll return to this below).

Output-based pricing lowers emissions by making Canada’s EITE sectors cleaner instead of smaller. It offers us a way to price carbon and reduce emissions in EITE sectors while the rest of the world catches up on carbon pricing.

Understanding the change

What changed on Wednesday is the amount of carbon pricing revenues the government plans to return to these EITE sectors in order to protect their competitiveness and avoid leakage. Previously, it had planned to return 70% of what it collected from these sectors. Now it plans to return 80%, or 90% if the sector is particularly vulnerable.

Some reporting on this change has suggested that it means the price companies pay has fallen from 30% of the full carbon price to 10-20%. But this isn’t accurate. While it may be true for the sector as a whole (and even then, only half-true), it is not at all true for individual companies. The amount they get back will depend on how emissions-intensive they are. This distinction matters a lot, so let’s unpack it.

The two-step

It’s best to think of output-based pricing in two steps. In the first step, companies pay the full carbon price on their GHG emissions. In the second step, the government returns some of the revenues to them as a subsidy. The two are actually independent of each other because they’re based on different things. Step 1 depends on the quantity of GHGs that a company emits in a given year. Step 2 depends on how much stuff they produce.

Let’s come back to those numbers above using petroleum refining as an example. After the policy change, the refining sector would get an 80% subsidy. This subsidy figure is based on the industry-average emissions intensity of production (i.e., how much GHG emissions the sector produces, on average, to make a unit of refined petroleum). It means that the “average” refinery will receive back 80% of what it paid.

But in reality, all refineries are different. An older or less efficient one will have a higher emissions intensity than a more efficient one. But critically, the subsidy in Step 2 ignores these differences. Revenues are returned to both facilities as if they were an industry average one. So, in Step 1, some refiners will pay more carbon tax on their production and some will pay less, but in Step 2, they will all (per unit of output) get back the same amount. The result is that a high-emitting facility will pay a higher net carbon tax, and a low-emitting facility will pay a lower one.

In this way, output-based pricing distinguishes companies and facilities in EITE sectors based on how emissions intensive they are. It protects the overall competitiveness of a sector, but tilts the playing field in favour of the cleaner operators and gives both clean and dirty operators an incentive to find ways to get cleaner. It also preserves the original incentive from the carbon price, since any emissions that a company can reduce will lower their carbon tax bill by the full amount of the tax. Basing Step 1 and Step 2 on different things is what makes this possible.

What motivated the change

Changing the output subsidy to being 80% (or 90% for high-risk sectors) instead of 70% means that the subsidy that companies get in Step 2 will be larger. The policy will now go even further to protect EITE sectors’ competitiveness and avoid leakage. So why do this?

First, this change comes after lengthy consultations with industry and stakeholders. The initial 70% was seen as a starting point, and the government has decided to make a change based on what it heard in these consultations. We can’t say what exactly motivated their decision, but we do know there are legitimate reasons to be concerned about Canadian firms’ competitiveness these days. A large corporate tax cut in the US coupled with tariffs on steel (and the threat of more) mean the competitive landscape has changed since the 70% number was floated.

Further, the new 80% figure isn’t necessarily permanent. If it proves to have been more than was necessary to protect competitiveness, the government can tighten it up. But they can’t go the other way. If the 70% proves too stringent and leads to a decline in Canadian EITE sectors, the decline can’t be undone by simply raising the threshold. For this reason, some caution is warranted.

Whether there were other, political motivations at play behind this change is tough to say. But worries about competitiveness and the irreversibility of a decline in EITE sectors are valid enough reasons for the change.

Some perspective

Let’s zoom out a bit. This change tweaks an important design feature in the federal carbon pricing system. But it changes only one part of that system – output-based pricing for EITE sectors. The carbon tax on fuels – which will cover more emissions than output-based pricing – hasn’t changed.

In addition, the change does not weaken the carbon price that EITE sectors face; rather, it changes the amount of output subsidy they get. This means their incentive to reduce emissions isn’t that different than it was before.

Finally, the change isn’t out of step with other jurisdictions. The new federal thresholds align with those used in Alberta’s system (in fact, they’re still slightly more stringent). And they’re broadly consistent with what’s done in other international carbon pricing systems, like the European Union’s.

A welcome debate

In many ways, the conversation that this change has sparked is an encouraging one. We’re talking about how we’re going to price carbon in EITE sectors instead of whether we’re going to. But output-based pricing is complex, so it’s important that we clearly understand what we’re talking about and what it means.

At the end of the day, this change is not about carbon prices. It’s about how we use the revenues from carbon pricing. When it comes to revenue recycling, governments have lots of options, and using them to protect vulnerable sectors’ competitiveness is a legitimate one. This policy change means that a bit less revenue will be available for other priorities. But this comes with the territory. All revenue recycling choices have trade-offs.

It’s fair to ask whether these changes go further than they need to. At this point, it’s not clear whether they do. But saying that they represent a major weakening or reversal of the federal carbon pricing plan is a significant exaggeration.

2 comments

  1. Russell Alan Williams

    I find it problematic that you would go to such great links to correct the way people talked about the subsidy increase last week, without also clarifying that increasing that subsidy does reduce the scale of incentives to reduce emissions and does move Canada further from meeting its Paris targets. It seems to me that an honest discussion of the instruments we are using to achieve emission reduction should also include that reality. We can debate the merits of competitiveness and leakage concerns, but when we do so we should do it the full knowledge that moving from 70% to 90% will result in higher overall emissions from those sectors. Personally, I think this important in that many of the stakeholders in this debate have a vested interest in reducing the impact of carbon taxes on their sector AND benefit from confusion about how these instruments work.

    • Jason Dion
      Jason Dion

      Hi Russell. Thanks for your comment. I take your point. However, part of what we were trying to highlight is that it’s possible to honour the letter of our Paris pledge but not the spirit. If our reductions are offset by increases elsewhere because of leakage then they’re not real reductions.

      You’re right that the policy change may lead to greater total production, which would mean greater emissions. But if this would have otherwise leaked then it’s not clear what the real net effect would have been. And with the change, the incentives to make Canadian production cleaner are still there, which they may not be in the jurisdiction that would have otherwise hosted it.

      Leakage is a reality we have to confront in designing Canadian climate policy. I fully agree that we need to be careful not to overdo it. Whether or not we’ve now done so is still an open question. But either way, media reporting that the government majorly reversed course with this change was exaggerated. This is why we chose to weigh in.

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