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An Election Primer on Cap-and-trade vs Carbon Tax

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Ok, I am back at it, after a long absence. And to kick off, I am posting a rather long diatribe on cap-and-trade vs tax. At this point in the federal election, I thought it would be good to post a good look at the differences between cap and trade and tax. Cause the federal parties are certainly not going to shed any light on the differences, since they are stuck in a perpetual school yard tiff — “your climate policy sucks” “Oh yah, yours sucks more”. So this primer is not to be confused with the current primary school debate between the parties. And these guys are to be awarded the keys to the Treasury. Yikes.

So, here goes…

A national debate has exploded in this federal election surrounding the preferred mix of climate policy instruments – should Canada have cap-and-trade or carbon tax? In this post I look at what is likely driving this shift. A second objective is to provide an overview of how this shift is perceived by stakeholders. I conclude that design matters, and in every policy there will be winners and losers, and thus the policy preference is rooted in perceived interests and bias.

Since the early 1970’s economists have argued that either cap and trade or a tax on emissions can be equally desirable at achieving cost-effective emission reductions. Over time, economists have further muddled the instrument choice distinction by advocating a mixing and matching of design elements of both so that cap and trade systems adopt the desirable elements of a carbon tax and vice versa. Notably, concern over cost containment (price certainty) has led cap and trade systems to have price safety values, like the Liberal government’s $15 price guarantee and the Regulatory Framework’s Technology Fund. Taxes have similarly been designed to be adjustable so that emission reduction certainty (quantity certainly) is achieved through adjusting tax rates. This blurring of the lines between cap and trade and tax has led many economists to observe that policy design more than the choice of instrument is the major driver of economic, environmental and distributive outcomes.

Of course economists are not the decision-makers and cap and trade has become the dominant pricing policy due to political acceptability. But as the Canadian cap and trade system has been slowly revealed, there is a growing concern amongst the regulated community and ENGO’s alike due to complexity and uncertainty. Issues of environmental effectiveness, administrative simplicity, transaction costs, risk and uncertainty and the equitable sharing of the burden of reductions all lead to questioning the current design of cap and trade. But, make no mistake, the inertia behind cap and trade in Canada, typified by many years of consultation, and the need for linkages to regional and international trading systems likely means that cap and trade is here to stay. The question is then not a matter of cap versus tax, but when can a carbon tax be complementary?

With the inability of a cap and trade system to include all emissions in the economy, and notably small emitters, cars and buildings, cap and trade in Canada has emerged as a cap, credit, trade and rule system. With carbon tax as a politically unacceptable option, the designers of Canada’s cap and trade system have had to design a complex carbon policy by enabling broad-based offset credits and other regulatory rules in an attempt to obtain widespread reductions. In theory, broadening the scope of emission reductions through broad-based offsets lowers costs for the regulated emitters. In practice however, there are real concerns over additionality, which is how to demonstrate that reductions for sale as credits are real, and permanence, or how to account for agricultural or forestry sinks which will release emissions in the future. Also, regulations tend to be technology prescriptive, thus taking away decision making flexibility that can lead to cost-effective reductions. Many are now arguing that a simpler approach would be to have a complementary carbon tax that covers emissions outside of the 50% of the large emitters under cap and trade.

The rise of cap, credit, and trade has obviously led to new business opportunities for those involved in credit supply either directly through credit sale or indirectly through transactions. But while sellers see opportunities, buyers face more complexity adding both risk and cost. This then explains why there are splits within industries on the preferred policy mix — sellers of emissions such as small emitters or those with relatively lower emission intensities may perceive themselves benefiting while those larger emitters and higher intensity emitters face compliance risk and higher cost. Given the complexity of the trading system that is emerging, and the associated risks and costs, it is no wonder that many large regulated emitters are looking to alternative compliance options such as the Technology Fund under the federal government’s Regulatory Framework. These flexibility mechanisms define cost and minimize uncertainty while avoiding the complexity and uncertainty of the trading and offsets markets. The one glaring gap in the Technology Fund, of course, is that it is unable to define, with any reasonable degree of certainty, actual GHG reductions as a result of such investments.

This perceived complexity and uncertainty of cap, credit and trade has led a surprising cross-section of interests to advocate a carbon tax. Administratively simple, the carbon tax can work within existing tax structures, can be applied at the point of fuels sales based on carbon content and virtually cuts away many of the decisions and structures around cap setting, allocations and offset. Issues of revenue recycling can be resolved, but do raise legitimate concerns about equity, with industries or regions receiving possibly less than they may pay. It is also more equitable, as it sends a price signal to those not facing a carbon price under the cap, credit and trade system.

Further supporting the argument for a carbon levy/tax measure, there continues to be a perception by many in industry that cap and trade places a check/limit on production. Whether or not this is a real concern is an open question, and a function of how the cap and trade system is designed. Indeed, a carbon tax could be designed to act like a binding or hard cap with both systems more or less influencing output the same if they send an equivalent emission price. Any impact on output would then be related to how emission permits are allocated in cap and trade or how tax revenue was recycled under a carbon levy. But if allocations or recycling are tied to economic output in a sector, there would be an incentive to expand output since compensation, in the form of free allocations or recycled carbon tax revenue is tied to output. Again, from an environmental perspective, there is a trade off to the extent that with more output comes more emissions. This is another example of how cap and trade and tax can be designed to operate similarly, where differences really stem from how they are designed and implemented.

While business is worried about containing costs, ENGOs are focused on emissions reductions and policy effectiveness. While in theory cap and trade addresses emissions certainty through cap setting, again design matters and rising emissions under the current intensity based system and the associated suite of compliance options such as the Technology Fund has ENGOs concerned. This, coupled with the perceived ineffectiveness of offsets and the lack of a broad based price signal on business, buildings and transportation have further give rise to ENGO support for carbon taxation. ENGO proposals that seek economy-wide emission pricing through a carbon tax also introduce revenue recycling to address regressive impacts on households and to incent new emissions reducing technologies in transit and buildings. While cap and trade can raise revenue from auctioning, a carbon tax is seen as a more expedient means to raise revenue.

While many outside of government have looked to a carbon tax, it is not until very recently that both federal and provincial politicians have pondered the possibility of a carbon tax. While many motives likely drive this, a number can be readily identified:

• The ability of the tax to raise funds for additional priorities;
• The relative administrative simplicity of a tax is more closely aligned with existing administrative functions and tax authorities;
• A broad based signal, where all in the economy can targeted; and,
• Reduced compliance costs through revenue recycling and tax shifting, where distortionary labour and capital taxes can be reduced.

Finally the public (yes you) is much more fickle in their preference. Generally, there is a perception that carbon reductions will be costless. Social marketing has led many to believe that technology investment in hybrid vehicles and compact florescent lights, for example, are both sufficient to meet the challenge and are costless through energy savings. But in reality, the emission reductions contemplated by most governments come with a price that consumers will ultimately bear to some extent. This then leads to emerging public perception that carbon policy will cost, and perhaps a carbon tax is relatively more punitive than technology standards. But with tax shifting in British Columbia this perception is likely changing. After all, Canadians may just dislike income taxes more than carbon taxes. But then again, perhaps not.

While support for a carbon tax is growing, it is unlikely to displace cap and trade given its inertia. A more realistic policy package that could emerge is cap and trade for large emitters with offsets. But this would narrow the scope of application of the carbon policy leading to higher abatement costs and likely a level of complexity that would become onerous in time. A more cost-effective policy would shift towards a carbon tax focused on the remaining 50% of national emissions outside of the large emitters. Offsets would still have a place in the policy given emissions from agriculture and forestry, and targeted regulations in buildings and transport would be required to address emissions insensitive to emission pricing. This policy package would then retain the benefits of cap and trade while enabling an equitable price signal throughout the energy economy with a complementary carbon tax.

A final balancing of cap and trade versus tax then comes down to design and perceived interest. In Canada, the perception that a cap and trade would place a real cap on production along with the rise in complexity of a cap and trade system that contains an intensity target, broad range of offsets and a technology fund (ironically, these are features developed at the behest of industry in the first place) has led many to argue that a carbon tax is preferred. But regardless of instrument design, it is the perceived cost burden that really drives instrument choice preferences. This then indicates that preference over cap and trade or a carbon tax requires a careful examination of the financial implications of the policy on an operation.

But then again, knee jerk reactions to the word “tax”, which is being dogmatically perpetuated for political gain, will mean we get just what we want least — a high cost climate policy.

Written by Dave Sawyer

September 25th, 2008 at 3:48 pm

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