Insights at UBC Sauder

Werner’s Blog: Canada's carbon pricing is continuing on the right track

Canada's carbon pricing
Posted 2020-12-23

In this excerpt from his latest blog post, Werner Antweiler, Associate Professor & Chair, Strategy and Business Economics Division at UBC Sauder, analyses the Canadian government’s newly announced carbon pricing policy and provides an argument in support of it.

After Canada's federal government made the announcement in mid-November to pursue net-zero carbon emissions by 2050, the question that arose immediately was: how do we get there? The answer came on December 11, when Prime Minister Justin Trudeau announced a bold strategy to increase carbon pricing from $50/tonne in 2022 (the current policy target) in $15/tonne annual increments to $170/tonne in 2030. This is great news for the environment and, once put into law, provides clarity for investment decisions for the entire decade ahead. The federal tax-and-rebate scheme is also smart politics with an eye towards the next federal election, as the Conservative opposition offers hollow promises with no concrete perspective towards reaching Canada's commitments under the Paris Agreement (30 percent below 2005 levels by 2030).

What is the proposed path of carbon price increases?

The federal government's proposal is meant to continue and accelerate the current trajectory of $10/year increments until 2022 with new $15/year increments between 2022 and 2030.

For most people this per-tonne price is not particularly informative because households pay the price on fuel purchases such as diesel and gasoline. To calculate the carbon price in cents per one litre of gasoline, divide the carbon price by 4.525. This means that the 2020 price ($20/tonne) amounts to just 4.4 cents per litre, due to rise to 11 cents per litre in 2022. Continuing on the proposed trajectory will raise gasoline prices by 37.6 cents per litre in 2030. This may sound like a lot, but it pales by international comparison. Germany's fuel tax is just over $1 per litre (and their value-added tax is higher too). If the German economy can thrive with fuel prices that are already higher today than in Canada by the end of the decade, it would be ridiculous to assert that Canada's economy and Canadian motorists could not adapt as well.

Is the $170/tonne target sufficient to meet our climate goals?

It was clear that leaving the carbon price at $50/tonne after 2022 was insufficient to meet the Paris Agreement target. Modeling carried out by Canada's Ecofiscal Commission calculated a carbon price of $210/tonne as adequate to reach the target. Results from other computable general equilibrium (CGE) models of the Canadian economy that I have seen over the past years all put the required carbon price over $150/tonne as well.

The beauty of carbon pricing is that the burden diminishes as people shift to cleaner modes of operation. Motorists who shift to driving electric vehicles (EVs) will not pay a carbon price for gasoline or diesel fuel. An effective carbon tax will eventually make itself mostly obsolete.

Carbon pricing also has another highly desirable effect: it will help make carbon-negative technologies commercially viable. Carbon-negative technologies include carbon capture and storage (CCS) and other methods that take carbon dioxide either directly out of the air or separate it from combustion processes. Carbon-negative technologies will play an important role in reaching "net-zero" emissions by 2050. Some industrial processes will not be able to capture all of their emissions, and some buildings will be too expensive to retrofit to become more energy efficient. To offset their emissions, it is necessary to develop commercially viable carbon-negative technologies.

How is the tax rebated?

Ninety percent of the revenue from the carbon tax is rebated to households through the Climate Action Incentive Payment on an annual basis. It is planned to shift these payments from annual to quarterly frequency in 2022 in order to make the impact more tangible for households. The rebates are not distributed on a simple per-capita basis but are differentiated by type of household. There is a 4:2:1 formula used for allocating the rebate to the first person, second person, and all other children in a household.

A family of four receives about $450 in Ontario, and close to $900 in Alberta. Carbon taxes are rebated on a provincial basis, so revenue raised in one province stays in that province. Because Alberta is more carbon-intensive than Ontario, the rebates are higher in Alberta.

How much households will receive back in future years depends, of course, on the effectiveness of the policy. The more effective the policy, the less revenue is raised and eventually less and less goes back to households as a result. After all, the goal of the policy is to make itself disappear (as carbon emissions approach net zero by 2050). However, at first the rebates will rise. The Ecofiscal Commission calculated that annual rebates on a per-capita basis could rise to roughly $1000 in Ontario, over $2000 in Alberta, and over $4000 in Saskatchewan.

Rebates will make most households better off. A study by the Parliamentary Budget Officer suggests that between 60% (Ontario) and 80% (Alberta) of households will be better off on balance. How is this possible? While lower-income households have a relatively small carbon footprint, the higher-income households have a significantly larger carbon footprint. This means that carbon tax-and-rebate systems tend to redistribute wealth from fewer rich and carbon-intensive households to many poorer but carbon-frugal households. In the end, a majority of household's benefit.

Won't rebates offset the beneficial effect of carbon pricing?

A common objection from opponents to carbon tax-and-rebate schemes is the idea that people who receive a rebate will not adjust their consumption behaviour. If you pay $100 in carbon taxes and get $150 back in rebates, won't you end up driving more? The answer is: very unlikely. This objection is a fallacy based on an incorrect understanding of economic principles. The point of carbon pricing is that it makes carbon-intensive activities more expensive, regardless of the rebate. Even if you get more money back than you pay, you will not spend it all on the carbon-intensive activity. The rebate, as general income, will also be spent on a variety of other activities. Even if your driving demand was completely price-inelastic (for example because there is no other option to commute to work than drive), the higher carbon price will eventually entice you to buy a more fuel-efficient car because driving a more frugal car will be more economical than driving a gas guzzler. Or your next car will be electric. Your purchase decisions will be influenced by the carbon price regardless of the rebate you get. So in short, rebates don't offset the beneficial effect of carbon pricing. Rebates will generate a small rebound effect, but won’t lead to a "backfire effect."

Could carbon pricing undermine the competitiveness of trade-exposed carbon-intensive industries?

The federal carbon pricing system is coupled with an Output-Based Pricing System (OBPS) that protects industries that would be vulnerable to international trade disadvantages. To keep industries competitive, they are subject to the full marginal carbon price but ultimately end up paying a much lower average price. This works by using an emission intensity threshold that is slightly below the average emission intensity for individual industries. Firms above the average (those that are more carbon intensive) pay the marginal price for emissions above the average, while firms below the average (those that are cleaner than average) receive a credit at the marginal price that they can sell to other firms. This is an ingenious system that decouples marginal from average carbon prices and creates the right incentives for reducing carbon emissions, while protecting industries from competitive disadvantages in international markets. In fact, the cleanest firms in an industry actually gain a small competitive edge because of the carbon credits. It pays to be a "green leader".

Why is carbon pricing superior to other policies?

Carbon pricing is a market-based instrument. This means that market forces determine the most cost-effective way to reduce carbon emissions. Government regulation (also known as "command and control") is less effective because of information asymmetry: governments cannot know the exact ability of each firm and each household to reduce emissions. However, the market mechanism makes firms and households reveal their ability through their purchase decisions. There is a broad consensus among environmental economists that market-based policies are the gold standard for achieving emission reductions. Economic theory tells us that putting a price on pollution is the "first-best" policy to reduce pollution.

Can provincial opposition undermine federal efforts to reach Canada's climate targets?

Several provinces have launched legal challenges that seek to overturn the federal law on carbon pricing. These provinces argue that the federal government lacks constitutional jurisdiction over the environment and thus cannot impose carbon pricing on provinces. Simply put, the argument is that Ottawa is overstepping its authority. However, the evolving interpretation of Canada's Constitution clearly recognizes issues of "national concern", and climate change is the ultimate transboundary concern—it is global. While the Supreme Court could in principle rule against the federal government of Canada, in my opinion, that is improbable. It would go against recognizing the already well-established role that the federal government has in matters of the environment that are transboundary in nature, and its role as partner in international treaties. In fact, the Trudeau government has proceeded with great caution and given provinces much leeway to choose its own methods of reaching the climate goals.

The federal government has broad powers under the Constitution for taxation as well as for "peace, order and good government" that encompass the notion of "national concern." The federal government also has criminal law power, and courts have recognized that federal criminal law can be used to influence behaviour in addition to prohibiting behaviour. All in all, the legal basis for federal carbon pricing appears to be robust and solid.