Devils, details and cap-and-trade

A year ago, I was firmly on the fence with regard to carbon taxes versus cap-and-trade systems. My internal conversation was around abstract, theoretical versions of what might happen, and at that point it was premature to consider how the two might play together as part of a hybrid system. Since that time, we now have some real models to consider: the BC carbon tax and the Western Climate Initiative cap-and-trade system. The latter has released draft final recommendations and is aiming to have final recommendations by September.

My preferences have steadily drifted in the direction of a carbon tax over cap-and-trade, and the more I hear about WCI the more I like the carbon tax. To be clear: I do not think a carbon tax alone gets us there, but should be one part of a broader strategy that includes standards, regulations, public investments, just transition programs and alternative technology development and diffusion. A rising price signal through either a carbon tax or a cap-and-trade system matters, but nor is it a Paul Hawken “get the market prices right and natural capitalism will rescue us” story.

The Sightline Institute has a series of overview posts on the emerging WCI that are worth reading as a primer to a very complex system that has many outstanding issues to be resolved between now and the final recommendations. Things may break perfectly and the resulting system could be workable, but I’m increasingly skeptical about getting there. The main point is that we may not like the final product, and it is troubling that some political parties have staked so much on supporting cap-and-trade.

The key advantage, in theory, of cap-and-trade is the cap. One serious shortcoming in WCI is the draft recommendation on offsets, which would allow for a substantial amount of the emissions “reduction” to be achieved by financing projects in the South or elsewhere outside the WCI region. This means that the system may not in fact reach its “cap”. And offsets are problematic in general: rather than moving ahead with bona fide projects that lower GHG emissions, these projects just end up validating unsustainable emissions. There are also huge issues in monitoring and enforcement to be sure that funds are actually delivering those GHG reductions.

Monitoring and enforcement issues also cloud a cap-and-trade system’s overall effectiveness. Assmmetries of information means ample opportunity for corporations to game the system or just plain cheat. In the EU’s Emissions Trading System, this is just what happened, as companies bulked up their reported emissions prior to the system coming into place. Related to this is how sanctions would be delivered: if a company exceeded its emissions and there were no permits to buy, it might have to pay a penalty per tonne above the cap, which is effectively a carbon tax. Again, in this latter example, we may not actually reach the cap.

Timing is also of the essence. The nice thing about the BC carbon tax was that it was able to cover 70% of domestic emissions simply by changing the Motor Vehicle Tax Act. The tax was announced in February, budget secrecy was maintained, and by July the system was in place. There is the matter of the remaining 30% of emissions and some action is needed to ensure the tax covers them, too, as was recommended in yesterday’s Climate Action Team report to the BC government (the CAT is an independent body tasked with filling the gap between the government’s current climate plan and the 2020 target of a one-third reduction in GHG emissions relative to 2007 levels; the report is rather underwhelming; see this post).

But compare this to the WCI, where the system will not even begin until 2012, and only starting in 2015 will a bunch of key sectors be covered. So we will not even know if it is working until 2020 or so. And it seems to me that we need more, sooner.

Another major issue, from a fairness perspective, is around how permits are allocated. If all permits are auctioned, this is roughly equivalent to a carbon tax and governments can use the proceeds to offset regressive price impacts on consumers, or fund other climate policy measures. In the previous draft of recommendations, it was suggested that 25-75% of permits could be auctioned; those numbers have been removed from the current draft final recommendations, meaning there could be very little or no auctioning at all. This would be bad, very bad, from a climate justice perspective.

One option for merging the two would be for the carbon tax to be a base paid by all emitters of GHGs, while a cap-and-trade system was imposed on top of that for large industrial emitters. For those included in the system, the price of permits would simply be net of the carbon tax, and the carbon tax would effectively set a price floor (hat tip again to Sightline, see here). But given that tax is a four letter word in most jurisdictions, cap-and-trade may be the second-best option. I just hope we do not waste a decade on a system that ultimately does not work.

All of that said, BC’s carbon tax is not perfect and could be even better. First, the tax must be high enough to be effective and should cover all emissions, including process emissions from cement and aluminum, oil and gas (leaks from pipelines, all flaring), and bioenergy production (one final outstanding area, emissions from landfills, is being covered by regulations). Wood burning and bioenergy (generating electicity from wood burning) is an odd loophole – these emissions are not part of the formal calculations in Kyoto because a tree over its lifecycle is technically carbon neutral. But emissions are emissions, and by including wood burning, we would avert a perverse situation where people stop using natural gas in favour of burning wood, potentially releasing more emissions but not having them count (the Climate Action Team also made a recommendation along these lines, though because they do not count, the government could safely ignore it as it would not undermine the 2020 target).

In order to be more effective, the carbon tax should be increased to $30 per tonne with annual increases to reach a level of $100 per tonne by 2020. These numbers may need adjustment, too, depending on how well we do towards meeting our targets – annual targets for emissions, a “cap” if you will, should be part of the system.

I would like to see people with low to middle incomes have real options for changing their behaviour, and they should be no worse off under any carbon pricing scheme as a central principle. Half of the revenues should go into either a per household transfer, or alternatively, an AFB-esque refundable green tax credit with fairly broad coverage (more like the Old Age Security or Child Tax Benefit model than the GST credit upon which the current green credit is based). I’m starting to lean more in favour of the per-household transfer as it essentially proxies the idea of carbon quotas, but with dollars instead of a bank account of GHGs and the added infrastructure that would require.

I would break with revenue neutrality, which is a political consideration above all else. The remaining half of carbon tax revenues should provide funds for major transit expansion, transition programs for workers, energy efficiency improvements for low- to middle-income families, and an alternative technology development program.

Similarly, I would break with “tax shifting”, a concept that has little traction with the public and is bad public finance because at some point in the future we want revenues to fall because we are doing such a good job a at reducing emissions. So while I would keep the transfer/credit system, no further PIT and CIT cuts would be financed by carbon tax increases. Write-offs of capital investments in emissions-reducing technologies, in lieu of existing Capital Cost Allowance, could be part of the package for the business sector. Similar write-offs could be contemplated for personal income taxes, though ideally with an increase in top rates and a new high-income bracket for income above $150,000.

[This post thanks to about 20 people who joined in yesterday for a CCPA workshop on carbon pricing. The discussions there have further shaped my evolving thinking on this topic.]


  • This is just about the best thing I’ve ever read on this subject. Imagine – taking politics out of it and just discussing carbon reduction initiatives on their merits. Kudos!

    I’ll be printing out a copy and handing it to Dion when he comes to Halton on the 20th.

  • Excellent post (as usual), Marc. You have accurately identified some of the many challenges that need to be addressed in establishing a well-functioning cap-and-trade system. For better or worse, the EU and US have embraced cap-and-trade as opposed to carbon taxes. If the western world is to succeed in reducing emissions, we will have to resolve the challenges associated with cap-and-trade. Whether it is our first choice or second best, cap-and-trade may be the only system that allows Canada to participate in an internationally coherent carbon-pricing regime that includes our largest trading partner.

  • William Nordhaus, who is probably the world’s most eminent climate change economic modeller and policy analyst argues that a cap and trade system has the flaw that prices may be volatile, and that quite likely initial permits will be distributed free of charge rather than sold or auctioned. He points to the price volatility of US SOx permits and their original distribution.

    I don’t think a carbon tax is immune for business shirking, especially where there’s a lot of self-reporting involved.

  • thanks for comments and discussion here.

    the questions around pricing and volatility, and self-reporting (vs. actual public monitoring) are important, particularly in the current global financial game, where it’s anyone’s guess at present which particular constellation of private players is going to emerge victorious. Some privateers did very well thanks to the Great Depression.

    The questions are central not only with respect to carbon issues, but intimately linked water issues as well. Of course the goal being the reverse- to reduce water use and diversion from watersheds, not actual water.

    Oil and gas companies, and financiers, need control of water, and have been funding and promoting policy to price water for many years already, with support from the Fraser Institute, and unfortunately some foundations which have funded self-described environmental groups.

    In the water sector, we need to hold firm to ‘caps’ on use, bans on diversion, and skip the ‘trades’ which would most definitely see water moved around from its natural courses.

    Pricing would put water under the control of financiers who have influence over prices, commodity exchanges, currencies, and monetary policy (or lack thereof).

    If we must avoid use of the harrowing term ‘tax’, then the term ‘price’ must be redefined to mean not price of the water itself, but a charge for use/service paid to public/social or Indigenous governance structures.

    In Ontario, the McGuinty government passed legislation regulating a ‘price’ for water, described in the same document as a ‘charge’, and studiously denied as a ‘tax’. Major water use industries were exempted, and simultaneous legislation was introduced treating containerized water as ‘product’ and exempted from bans of diversion. Containerization as a limit can be challenged by water traders and thus, under NAFTA, broader diversion bans challenged.

    With the province allowing foreign ownership and P3 management of water infrastructure, municipal servicing, hydro dam and canal systems, and particularly the sophisticated electronic systems used to monitor and manage water flows, with data protected under intellectual property rights, we are already in a situation where we don’t know where the water is going, or why, for example, the levels of many major lakes and river systems are dropping.

    It likely has to do with the facts of climate change and that major diverters stateside, and upstream from the Hudson Bay Basin, are taking more than is healthy, but none of this can be proven without public data collection and monitoring.

    To rely on a ‘market’-based ‘pricing’ regime to deal with these issues is ludicrous.

    It is my hope that economists in allied groups can be proactive in promoting caps on corporate water use, exemption of water from all investment deals, and if necessary, a tax/service rate on corporate profits for operations that use water, which is also indexed on a concave curve with increasing bulk volumes used. It needs to be reinforced that rates are for use, not prices for the water itself. This rate would be payable to public/participatory/social or Indigenous (ie. not P3) structures which are core funded with general tax revenues.

    It would be useful to develop a position so that we aren’t in a reactionary position when it comes to initiatives enacted in the US or EU, or pushed on us by Harper et al.

    thanks for any assistance you can provide,

  • It is not a moment too soon to be working on this.
    The Intergovernmental Panel on Climate Change has put out June ’08 recommendations that embody the worst options.

    Hundreds of progressive groups around the world signed a Polaris Institute initiative statement half a year ago that critiqued the UN’s CEO Mandate for water.

    It looks like the financiers and infrastructure corporations forces seeking to control water haven’t yet given up. Even though they did not succeed in getting global access via liberalized financial, ‘environmental’ and energy services in July’s WTO Doha Round, there is no doubt they will continue to push for the following destructive mechanisms under NAFTA and bilateral deals.

    By now we should be past-masters at decoding greenwash. The following will see more dams, ‘abstraction from water courses’ and ‘transfers’ ie) water diversion.

    Put that together with pricing and trade, black box metering and integrated electronic systems protected under privacy law, and we have a very big problem, from the point of view of the water commons, the public trust in water, and Indigenous values which hold water to be the sacred lifeblood of the earth.

    These will be sacrificed on the altar of climate change, to the financial and corporate interests whose greed caused the current crises, and who continue to push for resource use and control at all costs.

    We need to articulate a clear progressive economic and policy framework for water, and the sooner the better.

    thanks again for your help.

    “An expanded use of economic incentives, including metering and
    pricing, to encourage water conservation and development of water
    markets and implementation of virtual water trade, holds considerable
    promise for water savings and the reallocation of water to highly valued
    uses. Supply-side strategies generally involve increases in storage
    capacity, abstraction from water courses, and water transfers.
    Integrated water resources management provides an important framework to
    achieve adaptation measures across socio-economic, environmental and
    administrative systems. To be effective, integrated approaches must
    occur at the appropriate scales. [3.3]”

  • Elizabeth May did an interview this morning with Anna-Maria Tremonti on CBC’s The Current. In the context of a question regarding bulk water export, May stated that the Great Lakes St. Lawrence Basin Compact was ‘very good’.

    This is a serious mistake. May did properly condemn the outrageous Montreal Economic Institute proposal for bulk water diversion also critiqued last week by the Polaris Institute and others.

    However May and others should note that the MEI report explicitly quotes Quebec’s implementation of clauses in the Compact as legal loopholes which do not prevent, but rather ALLOW BULK EXPORT (quote below). A number of us have said this for years.

    It is time for environmentalists to be clear that the Compact and its provincial and state implementation plans are not ‘very good’ but in fact very bad.

    The MEI report tries to assuage fears around water trade by saying that water is not in NAFTA. Let us once again assert that water is indeed in NAFTA via reference to the HCCS of the GATT wherein ‘other’ natural water is explicitly listed.

    The call for water pricing and a trade system explicit in the MEI report underscores the urgency of efforts for progressive economists to develop arguments to the contrary sooner than later.

    Hopefully our formulations will be couched in 1) explicit elimination of water from trade deals; 2) explicit bans on export and diversion, and 3) a public tax on corporate profits from use of water in any form.

    Ideally we could achieve our goals using 1) and 2).

    But the reason for 3) is that many provinces including Ontario have already begun implementing rates for water use, and these need to be interpreted not as market-based pricing regimes which will put prices and water under the control of private finance in today’s casino, but as publicly controlled rates.


    “In Quebec, the Water Resources Preservation
    Act prohibits water taken in Quebec from being
    transferred outside the province. The act applies
    to surface water and to groundwater. The Quebec
    government nonetheless reserves the right to
    deviate from the law in certain cases such as: 1)
    the production of electric energy, 2) the
    marketing of water for human consumption, if it
    is bottled in Quebec in containers of 20 litres or
    less, 3) the supply of potable water to establishments
    or dwellings located in a border zone, and
    4) the supply of vehicles (Joint International
    Commission, 2000). It is also possible, in emergencies,
    for humanitarian reasons or for any
    other reason considered to be in the public
    interest, to lift the prohibition on water taken in
    Quebec being transferred outside the province.”

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