Insights

February 8, 2024

Carbon pricing works, we just need to stop getting in the way

Carbon pricing—also known as a carbon tax—is a central element of climate policy in Canada. Setting a price on greenhouse gas emissions (GHGs) sends a simple and clear signal into the market about the cost of those emissions and creates a financial incentive for households and businesses to reduce them.

At least that’s how it’s supposed to work.

The reality of climate policy in Canada has become considerably more complicated. Over the years, the federal government has introduced a wide range of new rules, targets, policies, and regulations that are intended to “supplement” the carbon tax and accelerate decarbonization. The most recent example is the federal government’s announced intention to impose an emissions cap on the oil and gas sector.

The problem is, instead of supplementing a price on carbon, these additional measures muddy the water, increasing costs for Canadians, lowering business competitiveness, delaying or deterring investment and, ultimately and ironically, slowing emissions reduction.

This doesn’t mean a carbon tax is bad policy. In fact, the opposite is true. In this commentary, we look at how a carbon tax is supposed to work, what’s gone wrong, and why we should fix it instead of dropping it completely.

What is a carbon tax and how is it supposed to work?

A carbon tax is exactly what it sounds like. The government sets a price on emissions and charges a tax for each unit of GHGs a person is responsible for emitting. It’s a simple and fair system: the more you pollute, the more you pay.

Paying the tax obviously doesn’t reduce emissions by itself, but it does encourage people to take steps to avoid producing those emissions in the first place. A person could simply consume less, or they could explore substitutes like taking the bus, buying an electric vehicle and/or replacing their natural gas furnace. On the other hand, if you REALLY like your gas stove or outdoor fire table, all you have to do is pay a little more for the privilege. And, the higher the tax goes, theoretically the more incentive you have to change your behaviour.

Economists are generally big fans of carbon pricing as a policy tool to reduce GHG emissions. Not only is it simple and fair, but it’s also solution-agnostic: it doesn’t ban anything; instead, it uses price signals to encourage people to find the cheapest, most efficient way possible to reduce emissions. As relative prices change, businesses are incentivized to develop substitutes and new technologies without governments picking winners and losers.

Carbon pricing also captures what economists call “negative externalities”—costs that neither the buyer nor the seller end up paying for (environmental damage is the perfect example of these kinds of costs). Finally, and perhaps most importantly, it creates a stable and predictable environment for investors looking to reduce industrial emissions.

That said, not everyone can afford to replace their gas furnace or buy an electric vehicle to avoid paying the tax. That’s in part why most of the federal government’s (consumer-facing) carbon tax is rebated to households through the opaquely named Climate Action Incentive Payment. The size of the cheque stays the same no matter how much emissions a person generates, so the more they cut back, the better off they will be. For about 80% of Canadians, the rebate cheques exceed the total carbon price they pay. 

Carbon pricing in Canada

The federal government operates two different carbon pricing systems—one on fossil fuel consumption (the “fuel charge”) and one specifically on industrial emitters (the Output-Based Pricing System, or OBPS). Of these, the fuel charge is the most visible as it affects how much we pay for a litre of gasoline or to heat our homes.

Provinces and territories can either adopt those federal pricing system(s) or design and implement their own, so long as theirs are broadly equivalent to the federal “backstop.” If provinces and territories take no action, or if their approach is not deemed to be equivalent to the federal standard, Ottawa’s system will apply instead.

The federal fuel charge applies in most provinces and territories; only BC, Quebec, and the Northwest Territories have their own version in place, with Quebec’s being in the form of a cap-and-trade system.

By contrast, most provinces and territories manage their own industrial carbon price. The federal OBPS is only in place in Manitoba, PEI, Yukon, and Nunavut.

The federal government has also set a minimum price on carbon that is scheduled to increase every year until 2030. In 2023, the price was set at $65/tonne. It will rise by $15/tonne per year (every April) until it reaches $170. In order to maintain equivalence with the federal system, provincial/territorial pricing systems will need to reflect these increases. 

What’s the problem?

As stated earlier, the purpose of carbon pricing is to send a clear signal to the market about the costs of GHG emissions. If you know how much you have to pay, you can make informed decisions about the costs and benefits of taking steps to avoid it.

The problem is that Canada’s current approach to climate policy clouds that signal, creating numerous inconsistencies, uncertainties, and discriminatory impacts along the way.

For one, the federal government has a generous interpretation of what it considers an “equivalent” provincial carbon pricing system. While this was likely done to encourage provincial buy-in on carbon pricing, the result is a patchwork of carbon prices (and equivalents) across the country that, in practice, are not actually the same. For example, under Quebec’s cap-and-trade system, consumers in that province pay about four cents per litre of gasoline less in carbon taxes compared to provinces where the federal fuel charge applies. The gap had been even wider in Nova Scotia until this past summer when the province transitioned to the federal backstop. 

Second, the federal government has consistently layered additional rules and regulations on top of the carbon price. The Clean Fuel Regulations and Clean Electricity Regulations (CER) are two such examples. These regulations create new rules, timelines, and compliance costs that inherently change the relative cost of reducing emissions in some sectors compared to others. This adds uncertainty and tremendous complexity to the calculus on climate-related investments. The proposed emissions cap on oil and gas production (discussed further below) is another example of this trend.

A third example is the October 26th 2023, decision to provide a three-year exemption to the federal fuel charge on home heating oil. That move is aimed squarely at the Atlantic provinces where nearly 30% of households are heated with oil, compared to 5% in Ontario and less than 1.5% on the prairies. The exemption was intended to provide some price relief to beleaguered Atlantic Canadians in the face of soaring heating oil prices. A parallel increase in federal incentives was also designed to accelerate the transition to heat pumps.

However, the impact of that decision was to undermine the consistency and integrity of carbon pricing across Canada. Many argued that it made little sense to provide an exemption to heating oil and not natural gas when the former produces 40% more GHGs per unit of energy compared to the latter. Moreover, if providing tax relief on home heating oil truly increased the uptake of heat pumps, the same logic suggests that suspending the carbon tax on other fossil fuels would also accelerate the transition.

Finally, the federal government’s decision to impose an emissions cap on the oil and gas sector further distorts the carbon pricing system, imposing two distinct and discriminatory costs on the Canadian economy: one on the economic policy side and the other on the political/regional side.

On the policy side, the emissions cap discriminates against oil and gas production by singling it out while remaining silent on all other high-emitting industries; there is no equivalent cap proposed, or even considered, for industries like cement, steel, and fertilizer. To be clear, imposing a cap on these sectors would even further distort the functioning of a clear and transparent carbon price. But at least it would be consistent.

The overarching point is that when each tonne of carbon is priced consistently, markets will naturally remove the least expensive tonnes first. A sector-specific cap undermines this price signal and essentially directs the market to invest in more costly alternatives. It implies that a tonne of abated emissions in the oil and gas sector is more valuable than a tonne abated anywhere else. It would be like the federal government trying to cut back on commercial airline emissions by imposing a $50/seat tax on WestJet flights but only a $30/seat tax on Air Canada flights.

On the political/regional side, as Canada’s leading producer of fossil fuels, Alberta would be disproportionately affected by the proposed emissions cap. The federal government maintains that the cap is not intended to curtail production but, whether it ends up doing so or not, it will nevertheless subject Alberta to additional costs and damaging economic impacts while leaving many other provinces largely unaffected. In other words, the emissions cap is a policy that, like the Clean Electricity Regulations, effectively penalizes one part of the country simply because of its resource endowments (or lack thereof).

This policy stands in stark contrast to the fuel charge exemption for home heating oil. In the former case, the federal government is accommodating regional differences by conferring a targeted benefit. In the latter, it’s doing the opposite: recognizing differences by imposing a targeted cost.

Can a price on carbon co-exist with other climate policies?

A carbon price functions best when it sends a clear market signal to businesses and households about the cost of pollution. Policies like an emissions cap, sector-specific targets, carbon tax exemptions, and electric vehicle mandates only serve to distort that signal.

That said, not all climate policies interfere with carbon pricing; as long as they’re chosen carefully, some can be complementary. One example is policies to curb methane emissions. Methane is a potent greenhouse gas that is typically released into the atmosphere via leaks, accidents, and organic decay, rather than combustion. In this case, regulations can play an important role in reducing methane emissions without interfering with the carbon price signal.

Conclusion

When the federal government announced the exemption for home heating oil, some commentators suggested this could be the end of the fuel charge in Canada. Once the door to exceptions is open a crack, it’s hard to close it again.

That said, the federal government has been adamant that there will be no more exemptions. It even voted down a proposal to exempt farmers from paying the tax on the fuel they use to dry grain and heat their barns.

Even so, the fact remains that climate policy in Canada is scattershot at best. There are simply too many different policy tools at play, with new ones—like the emissions cap—coming along all the time. Each of these adds a layer of complexity and uncertainty to Canada’s business climate, ultimately deterring or even dissuading businesses from investing here.

The solution to this problem is not to scrap the consumer-facing price on carbon (it is generally expected that the OBPS would remain in place even if the fuel charge was abandoned). That would be throwing out the baby with the bathwater. Instead, the answer is to stop layering market-distorting policies and regulations on top of the carbon price.

How would we know if policies are distorting? One simple way would be for governments to calculate the implicit carbon price of any new action they considering. For example, a 2017 report by the EcoFiscal Commission calculated that Quebec’s EV subsidy would reduce emissions, but at an implied cost of about $395/tonne. Because that cost is far higher than the current (or planned future) price on carbon, it represents an inefficient and distorting policy.   

At the end of the day, carbon pricing may be unpopular but, done properly, it’s the simplest, clearest, cheapest, and least interventionist way to achieve Canada’s climate goals. Rather than trying to do too many things at the same time, sending mixed signals, or eliminating the best part of our existing climate policy, let’s have one set of rules for everyone, stay out of our own way and just let carbon pricing work.

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