Nova Scotia is moving forward with a provincial cap-and-trade system. It’s great the province is embracing carbon pricing, and Ontario and Quebec have shown that cap-and-trade can work. Still, choosing carbon pricing is just the first step. Carbon pricing is the lowest-cost approach to reducing GHG emissions—but only if it’s designed well. What do we know so far about Nova Scotia’s design choices? And how should they proceed in making design choices that so far remain undetermined?

Nova Scotia has a history of climate policy action, which has contributed to its declining GHG emissions. Still, Nova’s Scotia has historically relied on a regulatory approach with potentially high costs of abatement. A well-designed cap-and-trade system could build on past successes, while also reducing additional emissions at lowest costs, moving forward.

Instrument: Cap-and-trade is a good way to price carbon

The first step to pricing carbon is choosing an instrument. Will policy define the price on carbon (carbon tax)? Or will it define allowable emissions levels, and let the price emerge from the market for tradable permits (cap-and-trade)?

Nova Scotia has chosen the latter, introducing legislation for a cap-and-trade system. And so far so good: cap-and-trade can effectively price carbon, and the Pan-Canadian Framework on Clean Growth and Climate Change (PCF for short) explicitly recognizes it as one option for doing so.

Stringency: The PCF defines the required emissions cap

One of the most important design choices Nova Scotia faces is the level at which it sets its cap, or the total number of permits allocated. Emitters covered by the policy need to have a permit for every tonne of GHG they produce. So fewer permits means a more aggressive cap, with fewer emissions allowed, and more emissions reduced. The cap on emissions defines how effective the policy will be in reducing GHG emissions.

So far, Nova Scotia hasn’t defined a cap. The Minister of Environment has recently committed to an emissions cap that will decline over time, noting that the provincial government is “prepared to take further action and reduce greenhouse gas emissions above and beyond the targets… in place.” The key question: how much further action?

A more aggressive cap generally leads to higher prices. So it’s interesting that the province’s FAQ sheet suggests that consumers won’t see (much) higher fossil fuel prices. Does that imply that the system won’t increase the relative price of fuels—i.e., gasoline, diesel, natural gas—based on their carbon intensity? Or that the system won’t increase prices as much as an equivalent carbon tax would?

Yet Nova Scotia may not really have flexibility with respect to cap setting. The PCF spells out the required policy stringency explicitly. Its cap must require emissions reductions consistent with a carbon price of $10 per tonne in 2018, rising by $10 per year to $50 per tonne in 2022.

In other words, Nova Scotia’s current path of declining emissions shouldn’t affect the stringency required going forward. Yes, Nova Scotia is on track to meet its provincial GHG targets, as a result of a combination of previous policies (in particular, its renewable electricity standard) and socioeconomic trends. But reducing emissions relative to historical emissions isn’t necessarily the same as achieving the additional emissions reductions required by the rising carbon price as defined by the PCF. The PCF requires reducing emissions relative to “business as usual” (that is, relative to where emissions would have been, in the absence of the pricing policy).

Declining emissions in the province certainly has benefits, as it will mean fewer emissions will be priced and that costs will be lower than they would have otherwise been. But they shouldn’t justify less-stringent carbon pricing: for additional emissions reductions, more stringent policy is required.

Permit allocation: the way permits are allocated affects the economic performance of the system

The other part of this story is how permits are allocated. The Nova Scotia government has clearly stated its intention to allocate permits for free.

Remember, free permits don’t necessarily undermine the environmental effectiveness of the system. It’s the number of permits available that defines the cap. The extent to which permits are scarce determines the price.

Permit allocation does, however, have implications for the overall costs of the policy. Free permits mean lower costs for emitters, but they also mean governments don’t have revenue to do other things, such as cut taxes or address concerns around fairness.

The particularly problematic part for Nova Scotia is providing free permits to fuel distributors and electricity generators.

In Quebec and Ontario, for example, fuel distributors have to buy permits for all the GHG emissions embedded in the fossil fuels they sell (only large emitters are eligible for free permits). Distributors then pass on these costs to everyone that buys fuel—i.e., people filling their gas tank or building owners heating their house with natural gas or electricity—via higher prices. And that’s exactly the point. The system relies on distributors to pass on their carbon costs. And as a result, consumers have incentives to change their behaviour, whether by using less fuel, or shifting to less-carbon-intensive fuel. That’s how carbon pricing works.

But what if fuel distributors get permits for free? Here’s where it gets interesting. There are a couple of possibilities, and neither is ideal.

Possibility #1: fuel distributors and electricity generators could pass on all carbon costs, despite getting free permits. This is actually what economic theory suggests they’d do. Those permits might be distributed for free, but they have value: they can be sold on the market to emitters that need additional permits. That means permits have an opportunity cost, and distributors will pass on that cost.

In fact, that’s exactly what happened in the EU Emissions Trading Scheme. Electricity generators were given free permits, passed on the costs, and collected huge “windfall profits” from selling the permits they’d been given. Nova Scotia risks repeating the same mistake, for both fuel distributors and Nova Scotia Power.

Windfall profits are a problem because they represent wasted revenue. Rather than generating revenue that could be used to realize broad economic benefits, free permits are analogous to a direct financial transfer to energy distributors. But it’s also a fairness issue: why should government subsidize firms through free permits?

Possibility #2: perhaps government can somehow ensure that all carbon costs aren’t passed on. I think the idea here is this: if an energy distributor has to buy additional credits, they’d pass on those incremental costs, but not the full costs of all the carbon embedded in the fuel it sells, given the free permits they’d received. There’d be no windfall profits, and consequently a smaller price increase for end-users.

In Nova Scotia, limiting cost-pass through is more straightforward for electricity generation: the dominant provider is Nova Scotia Power, a public utility with rates regulated by the province. Could fossil fuel distributors be compelled to not pass on full costs as well? Maybe, though it’s unclear exactly how.

Even if the government manages to ensure full costs aren’t passed on, the implication is that fossil fuel users wouldn’t see price increases that reflect the full carbon content of the fuel they’re consuming. And again, as a result, consumers wouldn’t have incentives to change their behaviour to reduce emissions by using less fossil fuel, a major source of GHG emissions. That means other sectors—such as electricity generation—have to pick up the slack and reduce more emissions (to be consistent with a declining overall cap).

Coordination: implications for the Pan-Canadian Framework?

Together, these issues around cap-setting and permit-allocation point to potentially important issues in implementing the Pan-Canadian Framework.

There are implications for overall costs for Canada. If, in fact, early action and other policies mean that Nova Scotia can achieve its cap without (much) additional action, that implies a (much) lower carbon price in Nova Scotia than in other provinces. That mismatch of carbon prices across the country raises the costs of achieving reductions overall. It means low-cost emissions reductions could be “left on the table” in Nova Scotia, thus increasing overall costs of abatement for the country. That may not be a problem for Nova Scotia, but it is a problem for the country overall in its efforts to achieve its Paris objectives at the lowest possible cost.

There are also implications for the effectiveness of the pan-Canadian carbon pricing mechanism. Will other provinces see an opportunity to negotiate caps that require fewer emissions reductions in light of early action or other policies? Should Ontario’s phase-out of coal-fired electricity “count” toward its required cap? How about Newfoundland and Labrador’s investments in Muskrat Falls? Or Saskatchewan’s support for carbon capture and storage? Opening the door to credit for early actions could undermine the effectiveness of the PCF, and make Canada’s 2030 targets harder to achieve.

Devils and details

By pricing carbon, Nova Scotia is taking a good next step in its ongoing efforts to reduce emissions. Next, it must ensure the cap-and-trade system is designed well. A good system will reduce additional, incremental emissions at lowest cost. A poor one might be ineffective, costly, and divisive in the context of the PCF.