Despite its relatively small population, Canada has a role to play in the global efforts to reduce greenhouse gas (GHG) emissions to avoid the worst of these risks. Canadians do not want to "free ride" on the actions of others. They want to do their part and contribute to these efforts.

Canadians are also moving closer to agreement on how we should tackle these challenges. Several large provinces have already introduced well-designed carbon-pricing policies. And the federal government is now committed to filling in the remaining policy gaps—by requiring every Canadian province and territory to put a price on carbon by the end of 2018.

That growing consensus around carbon pricing, however, is not yet universal. Various economists and policy experts have made the case for carbon pricing as the best way to reduce GHG emissions while maintaining a strong economy. Yet recently, others have questioned the extent to which carbon pricing will affect GHG emissions. And elections are on the horizon, both nationally and in several provinces, in which carbon pricing could be a source of debate and even a key issue.

Such policy debates are healthy and necessary. Historically, significant shifts in the consensus around policy emerged only after vigorous public discussion. While free trade and balanced budgets might now be broadly accepted, they were once controversial ideas.

But debates will support good policy decisions only if they are based on facts and evidence. And there is strong evidence, grounded in solid economics and policy experience, that carbon pricing works.

Part of the problem is communication. Governments and policy analysts (including here at the Ecofiscal Commission) haven’t always done a good enough job explaining carbon pricing to Canadians. This really matters because carbon pricing affects us all. How we design these policies will influence how we live and how we do business. We all want better understanding.

In short, we need a more informed conversation about carbon pricing. So let’s have that conversation. Let’s clear the air.

The many details of carbon pricing are important for governments to consider when they design good policy. The Ecofiscal Commission has undertaken extensive economic research exploring these details, some of it fairly technical. We’ve explored how to design policy for fairness, and how to design it to ensure Canadian businesses remain competitive. We’ve considered the best ways for governments to recycle revenues generated from carbon pricing. And we’ve looked at the other climate policies that work best with carbon pricing.

Done right, carbon pricing changes household and business behaviour, reduces GHG emissions, and drives the development and adoption of the technologies that will play a key role in a low-carbon economy.

The evidence is clear: carbon pricing shifts us away from "business as usual," changing our emissions trajectory. And higher carbon prices drive deeper emissions reduction.

In addition (and this point is also often overlooked), carbon pricing will achieve these outcomes at a lower economic cost than other policies.

Together, this means carbon pricing can support both a clean economy and a prosperous one. It achieves these goals by changing incentives and unleashing market forces. It lets businesses and individuals identify the best ways to reduce their GHG emissions and at the times and places that are right for them. And it doesn’t require governments to identify specific ways to reduce GHG emissions.

This essay unpacks the overall story. What does “working” mean for carbon pricing? Where has carbon pricing worked? Why does carbon pricing work? When does carbon pricing work? Who supports carbon pricing? How do policies put a price on carbon? We provide clear answers to these questions in simple, (mostly) jargon-free language.

WATCH: Carbon pricing is the solution to climate change that makes sense for both the environment and the economy.

We focus on two key outcomes that should drive Canada’s climate policy.

First, we should be aiming to reduce our annual greenhouse gas (GHG) emissions. Not just this year but every year going forward. Moving Canada toward deep emissions reductions over time contributes to global efforts to avoid some of the costliest and most uncertain impacts of climate change.

Note that GHGs aren’t just about carbon dioxide. They also include methane, nitrous oxide, and many other gases that collect in Earth’s atmosphere and act like the walls of a greenhouse to lock in heat, raising average global temperatures. Policies that “put a price on carbon” are really designed to put a price on all the major GHGs, wherever feasible.

Second, we should be striving to sustain a strong economy—with the good jobs and incomes that come with it. We can choose to reduce our GHG emissions by having a weak economy, with little production and income, but this is a very costly way to clean up the environment. Far better alternatives are available. Our objective should be to reduce GHG emissions significantly but do so at the lowest possible economic cost.

Can carbon pricing achieve these dual objectives? Yes. We’ll show how throughout this essay.

WATCH: Carbon pricing gives people and businesses flexibility in reducing their emissions.

Carbon pricing has a track record of success. There are two basic approaches to carbon pricing: carbon taxes and cap-and-trade. It’s also possible to combine them. We’ll get to the details of how they work later. The bottom line is that they all put a price on GHG emissions, which creates an incentive to produce fewer of them.

Here, we’ll explore outcomes in three different jurisdictions that have implemented different types of carbon pricing. None of these policies are perfect, but they all illustrate that carbon pricing works.

Isolating the impact of carbon pricing is critical. Changes in emissions that happen to coincide with new policy aren’t necessarily the result of that policy. In statistics jargon: correlation isn’t the same as causation.

Below, we focus on three case studies that explicitly isolate the impacts of carbon pricing. Using statistical or modelling analysis, these studies aim to answer the question: how would emissions or economic growth be different if carbon pricing policies hadn’t been put into place?

Case Study #1: British Columbia, Canada

British Columbia’s carbon tax started in 2008 at $10 per tonne of carbon emissions, rose by $5 a year, and then paused at $30 in 2012. The tax applied to the burning of fossil fuels, or about 70% of the province’s GHG emissions.

Initially, all revenues were used to finance income-tax cuts and selected tax credits — the carbon tax was “revenue neutral” for the government.

Starting in April 2018, BC’s carbon tax will start rising again by $5 per tonne every year until it hits $50 in 2021. The BC government will use the new revenues to finance initiatives such as public transit and home retrofits to drive further emissions reductions. It will therefore no longer be revenue neutral.

Those reductions in GHG emissions were the result of various shifts, including:

• The fuel efficiency of BC’s entire vehicle fleet improved by 4% more than it would have without the tax. In other words, people invested in vehicles that would reduce their emissions and thereby allow them to pay less carbon tax by purchasing less gasoline.
• People also changed their gasoline consumption. Per-capita demand for gasoline would be between 7%-17% higher without the carbon tax by 2011. The carbon tax changed the way people drive.
• The carbon tax also affected natural gas use. One analysis suggests that tax reduced residential natural gas demand by 15% and commercial natural gas demand by 65%.

WATCH: Carbon pricing is changing behaviour in British Columbia and California.

Case Study #2: California, United States of America

California introduced a cap-and-trade system in 2012. Under the program, the state sets a cap on how many GHGs its largest industrial emitters can produce and gives them permits, or “allocations,” that allow them to produce GHG emissions.

The minimum price for emissions permits started at $10 per tonne (around $13 Canadian) and will increase at a rate of 5% per year until 2020. Over time, the emissions cap, and therefore the number of permits, will decline, so permit prices will likely increase. The carbon price (permit price) is currently just over $15 per tonne (around $19 Canadian).

The cap initially applied only to electricity producers and manufacturers. In 2015, the cap-and-trade system expanded to include fuels like gasoline and diesel and now applies to 85% of California’s GHG emissions.

In 2014, California linked its cap-and-trade program with Quebec’s, so companies in the two jurisdictions can trade permits with each other. In 2018, Ontario joined this linked cap-and-trade system.

Case Study #3: United Kingdom

The United Kingdom uses a hybrid carbon-pricing system, with elements of both cap-and-trade and a carbon tax.

Since 2005, the UK has participated in the European Union’s cap-and-trade system, which has a current permit price of less than £10 per tonne (around $18 Canadian). Since 2001, the UK has also had a domestic “Climate Change Levy,” which is a tax on electricity, gasoline, and other fuels supplied to firms. In 2013, the UK started increasing its domestic carbon tax to support the EU’s cap-and-trade system. The UK’s carbon tax differs from BC’s in a few key ways. For example, different sectors in the UK pay different levels of carbon taxes, whereas BC’s carbon tax is economy-wide.

The UK’s domestic carbon tax is now £18 per tonne (around $33 Canadian), and creates incentives additional to those created by the EU’s cap-and-trade system. In other words, domestic industries pay both carbon prices. For example, if the EU permit price were £8 per tonne, UK industries would pay a total carbon price of £26 per tonne (around $47 Canadian). If the EU permit price were to fall to zero, UK industries would still pay £18 per tonne for their GHG emissions.

As Figure 1 illustrates, the UK’s emissions have fallen faster than those in the rest of the EU, which has a cap-and-trade system but (for most countries) no additional carbon tax.

Why do higher carbon prices lead to lower GHG emissions? The underlying logic is based on an essential economic truth: prices influence behaviour.

Prices affect choices throughout the economy

First, think about prices of other goods and services. If the price of cauliflower increases, many people choose broccoli instead. If the price of parking increases, many people choose instead to take the bus or subway to work. If the price of winter beach vacations increases, many people choose instead to have local holidays. An increase in cigarette taxes helped to reduce the number of smokers. The same kind of response holds for choices all through the economy.

Here’s a specific example from history: in the 1970s, the world price of oil spiked significantly on two occasions, both of which led to sharp increases in gasoline prices in Canada. In response, drivers’ choices changed. In the short term, people drove less. In the medium term, fuel-efficient vehicles became more popular, so people might have driven the same amount, but they used less gasoline while doing so. The reason was simple: buying a more fuel-efficient car meant saving money. People (and businesses) like to save money when they can and when they have options to do so. Prices influenced behaviour.

An example: carbon prices affect driving choices

To illustrate why carbon pricing works, let’s consider our choices around driving and how carbon pricing can affect them. The carbon price will make gasoline a little more expensive. How might your driving behaviour change as a result?

Most drivers have options in how they respond. Some seek opportunities to carpool. Others take the bus or train to work instead of driving. Others take more dramatic action like buying a smaller car—some even get rid of their car altogether (thus saving money on fuel plus many other car-related expenses). Others move closer to work. Some people might not change their behaviour at all, choosing instead simply to pay the carbon price on their unchanged gasoline usage.

Why do drivers make these choices? Because of the relative costs of the various options available. If making a different choice is easy (perhaps because a driver lives close to public transit) then it has low costs (for example, in terms of the time required).

By letting drivers choose how to respond (or not), a carbon-pricing policy lets individuals—rather than governments—identify the most preferred approaches to reducing GHG emissions.

Carbon prices can also affect vehicle choices

Changes in driving behaviour probably aren’t the only — or even the most important — way drivers respond to a higher carbon price. Over time, the policy will also affect the vehicles they purchase.

Let’s consider four Canadians in very different circumstances who share the need to buy a new car:

Different vehicles have different fuel economies. This means they produce different amounts of GHG emissions, so they also have different carbon costs under a carbon price.

To unpack these vehicle choices, let’s consider the four options for a new vehicle in Table 1. We can see that different vehicles have their own advantages and disadvantages, both financial and non-financial (precise numbers will vary; think of these rankings as illustrative).

Which vehicles do our four drivers prefer? Let’s think about that question in three different contexts.

Begin in the situation without carbon pricing, in which case producing GHG emissions is costless to the individual. In this case:

Now consider the choices under a carbon price that rises over time. Emitters will therefore pay for the carbon emissions they produce. In this case:

In our example, the carbon price affects vehicle choices of two of the four drivers. It causes them to choose more fuel-efficient vehicles to save money on gasoline. It also therefore reduces GHG emissions, relative to the scenario without the carbon price.

While our example here is illustrative, it’s not far from reality. Those same UBC economists, for example, found that on average, the mix of vehicles driven in BC would have been 4% less fuel-efficient had BC not implemented its carbon tax. The carbon price will not affect every vehicle purchase, but it will affect some. Over time those choices that reduce emissions add up. In other words: carbon pricing works because prices influence behaviour.

In contrast, consider a third policy scenario. Governments sometimes try to reduce GHG emissions by providing cash rebates for consumers’ purchases of low-emission, electric vehicles. Let’s see our four drivers’ vehicle choices in this case:

We compare the outcomes across the three policy scenarios in Table 2. The EV rebate does lead to some emissions reductions because it causes Alex to buy the Bolt. But because it promotes a specific technology, the rebate has narrower impacts than the carbon price: Derek has no incentive to buy the Outback instead of the Civic, so the EV rebate does not affect his behaviour at all.

Furthermore, the EV rebate has costs that the carbon price doesn’t. Charlotte, for example, gets the rebate even though she would have purchased the Bolt anyway. Those taxpayer dollars are effectively wasted. The result? The rebate reduces GHG emissions at a higher cost than putting a price on carbon.

Carbon prices drive innovation

The story of why carbon pricing works still isn’t done. Carbon pricing will have another lasting effect: it will create long-term incentives for the innovation of low-emissions technologies.

A good carbon-pricing policy doesn’t just price emissions in the present and drive emissions reductions today, it also creates expectations for higher carbon prices in the future. In response, innovative engineers and entrepreneurs have strong and rising incentives to develop technologies that reduce GHG emissions even further.

In the context of our vehicle example, as the costs of batteries decline, so too will the costs of electric vehicles. That means a steadily rising carbon price will shift more vehicle choices. In the future, carbon pricing is likely to cause Alex and Derek to choose electric vehicles rather than gas-powered or hybrid options. Similarly, electric trucks and Sport Utility Vehicles will become available, and at more affordable prices, which means a carbon price might also affect Barbara’s choices.

WATCH: Carbon pricing produces two types of economic incentives.

Carbon prices affect choices all across the economy

To be clear, our vehicle example is just a parable. It considers four hypothetical individuals in the context of a single choice. But the lessons from this simple example have general implications for carbon pricing.

First, the choice of vehicle is only one of thousands of choices that businesses and individuals will make about their behaviour, purchases, and investments. Just as a carbon price will change the trade-offs around vehicles, it will affect choices around home insulation, fuel use in industrial processes, and investments in pension plans.

Some methods of reducing GHG emissions will help businesses or households save money by allowing them to avoid paying the carbon price. Just as importantly, some decisions won’t be affected by the price. If an action to reduce emissions is very expensive, the carbon price will not require businesses or individuals to take that action. And that’s OK:

Over time, we need deeper emissions reductions. That’s why a rising carbon price is so important. As the carbon price increases, it will affect more decisions, resulting in more emissions reductions. But even a carbon price of $100 per tonne won’t force actions that cost $200 or even thousands of dollars per tonne. A predictable and gradually rising path for the carbon price will let individuals and businesses plan for the future, again keeping costs down.

Second, millions of other Canadian consumers and businesses will also face that same choice. Every one of them will have their own context and preferences. Some will have more opportunities to reduce GHG emissions inexpensively. Others might have different opportunities, or fewer opportunities. And that’s exactly the point: those that have low-cost alternatives will respond to a carbon price in the way that makes most sense for them. As a whole, this means we can realize the lowest-cost ways to reduce GHG emissions throughout the economy, without forcing anyone to take the high-cost actions.

In short, we can extrapolate our example across all GHG emissions in Canada. Carbon prices affect choices. That’s why a price on carbon can efficiently drive emissions reductions, and why it already has done so in British Columbia, California, the UK, and elsewhere, as we saw in the Where section.

The impacts of carbon pricing aren’t instantaneous, and we shouldn’t expect immediate results. But nobody should conclude that carbon pricing doesn’t work just because things don’t change dramatically in the short term. Monitoring the GHG impact of carbon pricing is like watching paint dry.

Our story of driving and vehicles illustrates why carbon pricing works. But it also illustrates when. Figure 3 sketches a timeline for when businesses and individuals respond to carbon pricing.

The gradual impact of a steadily rising carbon price helps to keep adjustment costs low. Replacing old equipment before it is necessary can be expensive. Carbon pricing gives businesses and individuals choices as to when to make these investments. The gradual transition gives everyone time to respond to the policy and plan their investments accordingly.

All these gradual changes add up across the economy and over time

Achieving deep GHG reductions at lowest cost is a long-run objective. Carbon-pricing policies in Canada are still young, with modest impacts so far. But gradual impacts from actions taken now accumulate into enormous impacts over time. And as carbon prices steadily increase, emissions levels will decrease, and cumulative emissions reductions will continue to grow. Our analysis from a previous report, shown in Figure 4, shows how a rising carbon price can drive large GHG reductions over time. Notice that, in this example, all the revenues raised by the carbon tax are used to finance cuts in other taxes—which makes the carbon tax revenue neutral.

WATCH: Carbon pricing works because people try to avoid it.

Support for carbon pricing comes from a remarkable range of perspectives.

Carbon pricing is spreading across the world

Many jurisdictions are implementing various kinds of carbon-pricing policies. Carbon pricing has spread to every continent, as Figure 5 illustrates. Countries, provinces, and states are choosing the type of carbon pricing that suits their unique circumstances—and learning and improving as they go. China is one of the latest countries to get on board. It launched its first cap-and-trade system in late 2017.