This article discusses why a cap-and-trade scheme, rather than a carbon tax, is the preferred carbon price policy for Canada. This is because a cap-and-trade scheme provides significant benefits of environmental effectiveness, cost effectiveness, effective revenue generation, geographic flexibility and political acceptability to Canada’s overall clean energy strategy. Indeed, this scheme will provide Canada with the greatest amount of carbon emission reductions at the least economic cost (Petsonk, Dudek & Goffman, 1998).
The evolution of Canada’s greenhouse gas (GHG) emissions profile reflects its emerging stature as a global producer and consumer of carbon-concentrated fossil fuels. Although its GHG emissions only contribute about 2 percent of annual global emissions, Canada’s total emissions on a per-capita basis have consistently ranked among the world’s top 10 emitters over the past 10 years (Mahoney, 2010). For Canada to effectively reduce its GHG emissions, it needs a national carbon price policy that achieves the greatest amount of carbon emission reductions at the least economic cost (NRTEE, 2009).
The two principal market-based instruments that are used to achieve this goal are cap-and-trade and a carbon tax. Under a cap-and-trade scheme, the government establishes a target quantity of emissions and issues tradable permits to companies that match the total target, thus enabling the market to determine the price for permits. Under a carbon tax, the government establishes a direct price on carbon emissions and allows the market to determine the resulting quantity of emissions (Canadian Chamber, 2008).
While there are trade-offs between those two market-based instruments, the preferred carbon price policy for Canada is cap-and-trade because of the 5 benefits that it provides:
1. Environmental effectiveness
A cap-and-trade system can achieve meaningful reductions in greenhouse gas emission levels due the cap it imposes on emissions (PWC, 2009). In contrast, a carbon tax does not guarantee reaching an emissions target (Stavins, 2008). Moreover, the political pressures on a carbon tax system will most likely lead to exemptions of sectors and firms, which reduce environmental effectiveness and drive up costs. In such cases, some low-cost emission reduction opportunities may not be pursued (Stavins, 2008).
2. Cost effectiveness
A cap-and-trade system may include the options of banking and borrowing, which allow firms to find the least cost compliance method over time. They provide firms with greater flexibility in compliance, which thus reduces price volatility. If the allowance price starts to rise, then borrowing for future allowances increases the supply of allowances to prevent a rise in price. Likewise, if the allowance price starts to fall, then firms can bank allowances to use in the future. This decreases the supply of allowances and creates a price rise (PWC, 2009). These compliance options effectively address the criticism that a cap-and-trade system produces price uncertainty and volatility, unlike a carbon tax that provides more price certainty.
3. Effective revenue generation
A cap-and-trade scheme that involves the auction of permits can also potentially generate the same revenue as a carbon tax (PWC, 2009). Auctioning sends out a price signal for allowances, which promotes price transparency. This increases information and certainty within the trading scheme and thus facilitates long-term investment decisions on whether a firm should take action to reduce its emissions or to buy allowances instead. Moreover, the government can use auction revenues to reduce personal and corporate income taxes (Canadian Chamber, 2008) or to fund research and development into green technology (PWC, 2009). Also, auctioning reduces distortions within a trading scheme because all participants, whether they are new entrants or incumbents, are required to buy their allocation of allowances (PWC, 2009).
4. Geographic flexibility
A cap-and-trade scheme provides a feasible means to participate in international emissions markets. It can be designed to easily link to other emission trading schemes around the world (Stavins, 2008). Linking effectively expands the market, providing even more opportunities for low-cost emissions reductions and a larger market for new technologies (Pew Centre, 2011). Market expansion takes place as countries and their private industries search for the lowest cost emissions reductions available anywhere in the world (Petsonk, Dudek & Goffman, 1998). It may be easier to get international agreement on a globally linked cap-and-trade scheme than on a global carbon tax (PWC, 2009).
5. Political acceptability
A cap-and-trade scheme is unlikely to be degraded, in terms of environmental effectiveness and cost effectiveness, by political forces (Stavins, 2008). Moreover, such emission trading schemes have a history of successful adoption and implementation in the United States and other parts of the world in the past two decades (Stavins, 2008). They also appear more politically feasible than a carbon tax, particularly when considered at the international level. This is because the public perceives a carbon tax as a revenue-generating instrument with potential environmental benefits. Juxtaposed against this is the cap-and-trade scheme that, because of its cap, is perceived as an environment-protecting instrument with potential for revenue generation (PWC, 2009). In a carbon tax scheme, government authorities will need to be courageous enough to make regular adjustments to the carbon tax rate to meet national emission targets, a scenario which may prove politically difficult (Pembina, 2008).
It is noted that a cap-and-trade system would require the creation of new administrative and legal trading infrastructures and a national electronic registry for issuing, holding, transferring and cancelling permits (Canadian Chamber, 2008). These are complex initiatives because they require much more time from government authorities to develop the necessary detailed regulations. They also entail increased transaction and administrative costs (Pembina, 2008). In contrast, a carbon tax can rely on existing administrative structures and thus can be implemented quickly (Pembina, 2008). Nevertheless, these trade-offs are far outweighed by the above significant benefits that a cap-and-trade scheme can provide Canada.
A cap-and-trade scheme, rather than a carbon tax, is the preferred carbon price policy for Canada. This is because it provides significant benefits of environmental effectiveness, cost effectiveness, effective revenue generation, geographical flexibility and political acceptability to Canada’s national carbon price policy. Because of these significant benefits, a cap-and-trade scheme effectively achieves Canada’s national carbon pricing policy of improved environmental quality at the least economic cost (Petsonk et al., 1998).
By implementing an economy-wide, well-designed cap-and-trade system that features allowance auctions as well as banking and borrowing, Canada will effectively put a transparent price on carbon and provide real market incentives for Canadian firms and households to change their technology choices and behaviour in order to reduce emissions (NRTEE, 2009). These will then transport Canada along the right path to achieving significant GHG reductions as it participates in the emerging low-carbon global economy.
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