The Pros and Cons of Carbon Taxes and Cap-and-Trade Systems

Abstract

As part of Canada's effort to meet its commitment to the 2015 Paris climate accord, the provinces must establish their own carbon pricing policies or the federal government will impose a policy on them. When choosing among the various policies, provincial governments should first determine how much a particular policy will negatively affect economic competitiveness in their jurisdictions. When the negative impacts are judged to be low, a carbon tax on each tonne of greenhouse gas emissions (GHG) is the preferred choice. A cap-and-trade policy allocating tradable permits under a market price, or a hybrid combination of carbon tax and cap-and-trade, is best when the negative impacts could be high. These three policies can all satisfactorily achieve emissions reductions. However, other variables must be taken into consideration, including the provision of price certainty, how strongly each policy promotes innovative research into cleaner technologies, the complexity and costs of set-up, the policy’s salience, or visibility to consumers, and the amount of revenue it can raise. A carbon tax has a major advantage over cap-and-trade and a hybrid version because it allows for carbon price certainty, is less costly to administer and is a substantial source of revenue. However, a cap-and-trade policy offers its own advantages in that emissions allowances can be allocated so as to minimize the policy’s negative effects on competitiveness and prevent emissions leakage. The latter is the term used when companies leave one jurisdiction to operate in another jurisdiction that has either fewer or no rules around carbon pricing. A hybrid policy, also known as output-based pricing, allows for some permits to be allocated freely based on a facility’s or industrial sector’s emissions and output. It also offers more carbon price certainty than a pure cap-and-trade system. Research shows that a hybrid policy almost completely reduces the impacts on competitiveness and emissions leakage. And while a carbon tax is more visible to the public, the advantages of higher visibility are debatable. Such a policy may be favourable because a lower price is required to achieve the same GHG reductions, but it might also be unfavourable because politically it is less palatable. British Columbia has a carbon tax, while Quebec uses a cap-and-trade system. Alberta has a hybrid policy that covers large industrial emitters and a carbon tax for smaller ones. Other provinces remain without a carbon pricing regime, while Ontario’s newly elected Progressive Conservative government is set to dismantle the province’s cap-and-trade policy. Those provinces that wait for the federal government to impose carbon pricing on them can expect to get a hybrid policy much like Alberta’s. For provincial governments wishing to establish their own policies, choosing one that is the right fit involves weighing the advantages and disadvantages of each. Ultimately, a given jurisdiction should examine its own economic and emissions profile in order to make the best choice for achieving the combined goal of reducing GHGs without negatively impinging on industry’s competitiveness.