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Introduction

Climate change remains one of the most urgent challenges facing the world. In a

document entitled 2007 Turning the Corner regulatory framework, Canada committed itself to

reducing its level of greenhouse gas (“GHG”) emissions to 20% of its 2006 level by 20201

(since then reduced to 17% from its 2005 levels, so as to align with the U.S. target)2. As will be

discussed by way of introduction, climate change policies can and often do draw on several

different mechanism to reduce GHG emissions. These include command-and-control

regulations, carbon taxes, cap and trade systems, emission reduction credit systems, clean

energy standards and the elimination of fossil fuel subsidies.3 Several of these methods have

proven successful in addressing other environmental problems, such as the U.S. sulfur dioxide

(SO2) cap and trade program in the 1990s, or the tradeable performance standard in the U.S. lead

phase-down of gasoline in the 1980s.4 However, economists agree that pricing carbon is the

most effective way to bring about the change. It is much less expensive for governments to

charge the private sector with finding the most cost-effective ways find to reduce GHG

emissions (and incidentally develop new technologies), than is possible under direct regulations

such as mandated technologies or performance standards.5 Debate remains as to which of the

two most widely used mechanisms is preferable: a carbon tax or a cap and trade system.6 After

briefly discussing regulatory instruments, this paper will provide an overview of both the cap and

trade and carbon tax policies, highlighting the advantages and disadvantages of each policy. The

1 Courchene, Thomas J. (2008). “Climate Change, Competitiveness and Environmental Federalism: The Case for a Carbon Tax”. Montreal QC, CAN: Institute for Research on Public Policy. Pg. 2.2 www.climatechange.gc.ca3 Aldy, Joseph E. and Stavins, Robert. (2011). « The Promise and Problems of Pricing Carbon : Theory and Experience » National Bureau of Economic Research. Working Paper 17569. ». Pg. 3. 4 Ibid. 5 Goulder, Lawrence H. and Andrew Schein. (August 2013). “Carbon Taxes vs. Cap and Trade: A Critical Review”, National Bureau of Economic Research, Working Paper No. 19338. Pg. 1. 6 Supra note 5, pg. 2.

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paper will then consider the question of whether one policy is more effective than the other, and

finish with a discussion concerning a “hybrid” cap and trade policy.

I. Regulatory Instruments

Regulatory instruments can vary based on compliance options and the reduction target.7

The traditional “command-and-control” regulations are the government prescribed use of either

technology based or performance based standards. Technology based standards require the use

of specified equipment, processes or procedures, such as energy-efficient motors, combustion

processes, or landfill-gas collection techniques.8 Performance based standards leave the specific

methods for achieving a specified allowable level of pollutant emissions up to the regulated

entity. Examples would be maximum allowable grams of CO2 per mile for cars and light duty

vehicles in the U.S. tailpipe emissions standards,9 or Ottawa’s 2008 policy update promising no

dirty coal electricity plants after 2012, as well as vehicle emission standards.10 While effective to

some degree, both technology and performance based standards can only be used in conjunction

with other measures. Criticism of both standards alleges that while the performance based

standard allows some flexibilty in meeting the prescribed outcome, both standards lead to

unsatisfactory cost outcomes where some firms end up reducing emissions in a highly non-cost

effective fashion.11 It is worth noting that more flexible regulatory models have recently been

adopted, for example in Alberta, which has regulated large final emitters since 2008. Alberta

provides four choices for annual compliance: direct emissions reductions, purchasing offset

credits, trading emissions credits, or contributing to a technology fund at a price of CAD $15/t

7 Sustainable Prosperity. (May 2011). “Managing Carbon Revenue: Institutional needs and models”. Ottawa ON, CAN: Sustainable Prosperity (University of Ottawa). Pg. 3.8 Supra note 3 at pg. 3.9 Ibid.10 Supra note 1 at pg. 2. 11 Supra note 3 at pg. 3.

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CO2e. Saskatchewan has also introduced legislation featuring regulation of major emitters,

offset trading and carbon compliance payment directly to a non-profit, third party technology

fund.12

It is also alleged that there is no incentive to improve once a firm has met the

performance standard, and technology standards, by definition, impose the use of a certain

technology, potentially at the expense of innovation through a more effective technology.13 For

all of the above reasons, as well as general cost-effectiveness, carbon pricing is the preferred

method of reducing GHG emissions.14

II. Cap and trade

A cap and trade system has been defined as an objective, the “cap”, usually enshrined in a

binding legislative provision, and which can be a quantified target (for example, a certain

percentage of electricity generated from renewable energy sources, or a number of previously

allocated quotas). These quotas represent a fixed volume of GHG emissions, which are to be

redeemed at a fixed time (an allowances system).15 Emissions trading creates a market where

firms can sell or buy carbon allowances (from the government, other firms, or approved “carbon

offset” sources as required), depending on whether they are above or below their allocated level

of carbon emissions. 16 Under a carbon tax, the price of carbon (or of CO2 emissions) is set

directly by the regulatory authority, and it is the tax rate. In contast, under a pure cap and trade

system, the price of carbon or CO2 emissions is established indirectly: the regulatory authority

12 Supra note 7 at pg. 4.13 Supra note 3 at pg. 3.14 Ibid.15 Banet, Catherine. “The use of market-based instruments in the transition from a carbon-based economy” in Donald N. Zillman, ed., (2010). Beyond the Carbon Economy – Energy Law in Transition. Oxford University Press. Pg. 209.16 Supra note 1 at pg. 21.

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stipulates the allowable overall quantity of emissions; this then yields a price of carbon or CO2

emissions through the market for allowances. Allowance trading is a critical element of a cap

and trade, as it promotes the emergence of a single market price for emissions faced by all

market participants at any given time.17 To fulfil the requirement or redeem the required

allowances, a trading system must be implemented.18 Initial allocations of carbon allowances to

firms can be through free allocation on the basis of historical measures (“grandfathering”) or on

an updated basis (such as output-based allocation), or auctioning (sale of permits).19

The main advantage of cap and trade systems is that the total amount of emissions is

“capped”, thus guaranteeing a positive environmental effect. Given that new taxes generally

generate ill-will among rate-payers, a cap and trade system is also a more politically attractive

option.

The main disadvantages of cap and trade systems are as follows: it stipulates aggregate

emissions, resulting in a general price uncertainty which can make business planning difficult.20

Many business groups argue that this price uncertainty hinders the ability of business to engage

in climate policy, because when future allowance prices are uncertain, it is risky to invest in new

technologies research or engage in fuel substitution.21 Also, cap and trade systems often leave a

significant portion of emissions unpriced (for example, emissions from cars, trucks, office

buildings and smaller industries),22 as they only deal with large emitters at the production end. In

comparison, a carbon tax would be required for the consumption level regardless.23 Cap and

17 Supra note 5 at pg. 4.18 Supra note 15.19 Supra note 7 at pg. 3.20 Canadian Chamber of Commerce. (December 2008). “A Carbon Tax vs. Cap-and-Trade”. Policy Brief Economic Policy Series. Pg. 2.21 Supra note 5 at pg. 16.22 Sustainable Prosperity. (2009). “ “Hybrid” Carbon Pricing: Issues to consider when carbon taxes and cap and trade systems interact”. Ottawa ON, CAN: Sustainable Prosperity (University of Ottawa). Pg. 4.23 Supra note 1 at pg. 16.

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trade systems are subject to lobbying by the big emitters. 24 As will be discussed later on,

transaction costs are higher compared to a carbon tax. This is attributable to the inevitable

requirement for a new institutional infrastructure, including an extensive tracking/administrative

system. There would also need to be a compliance and enforcement function, capable of

applying penalties for fraud and non-compliance.25

However, by far the greatest potential problem with cap and trade systems is the

possibility of extreme price volatility due to improper design. The European Union Emission

Trading Scheme, the world’s largest cap and trade system, was adopted in 2003. In the first

phase, each member state responsible for proposing its own national carbon cap and allowances,

subject to review by the European Commission. Inevitably, individual countries attempted to

protect their national competitiveness, and the result was an aggregate cap that exceeded

“business-as-usual” emissions by 4%.26 In January 2005, the price per ton was approximately

€8/tCO2; by early 2006, it had exceeded €30/tCO2, then fell by about half in one week of April

2006, before fluctuating and returning to about €8/tCO2. This volatility was attributed to the

absence of transparent, precise emissions data at the beginning of the program, a surplus of

allowances, energy price volatility, and a program feature that prevents banking of allowances

from the first phase to the second phase. 27 The issue of banking features in a cap and trade

system will be further expounded upon in the discussion of a “hybrid” cap and trade system.

A second example of extreme price volatility was the energy crisis in California in the

summer of 2000, which gave power companies in the Los Angeles area incentives to bring

online older generators. This led to a significant increase in the demand for NOx emissions

24 Supra note 1 at pg. 16.25 Supra note 20 at pg. 3.26 Supra note 3 at pg. 11.27 Ibid.

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allowances under the Regional Clean Air Incentives Market (RECLAIM) program, since

allowances were needed to validate the emissions produced by these generators. As a

consequence, NOx allowance prices rose from about $400 per ton to an average in the year 2000

of over $40,000 per ton (with the average allowance price reaching $70,000 in the peak month of

2000). 28 As with the European Union example, some have claimed that the volatility in this case

was also attributable to the absence of banking provisions.

III. Carbon Taxes

Some observers have noted that today most taxation is an arbitrary penalty on

employment, and suggest that taxation can instead be used to persuade enterprises and

individuals to consume differently: “A tax on carbon dioxide (CO2) would give everyone an

incentive to emit less of it. It would be simple, direct, transparent.”29 At its most basic, a carbon

tax is where the government levies a fixed sum on the carbon content of fuels, and the revenue is

collected through the existing tax administration infrastructure.30

The main advantage of carbon taxes is for businesses, which may prefer carbon taxes to

other carbon mitigation policies, because taxes provide a certain, long-term price signal that can

be incorporated into projections of operating expenses, whereas prices may not be as well known

with emissions caps.”31 Furthermore, energy-intensive industries or highly competitive

industries that compete with companies in jurisdictions without taxes have been allowed to pay

reduced rates.”32 Given that large emitters are often selling their products on an international

28 Supra note 5 at pg. 13.29 Blanco, Elena and Jona Razzaque. (2011). Globalisation and Natural Resources Law – Challenges, Key Issues and Perspectives. Edward Elgar Publishing Ltd. Cheltenham, U.K. Pg. 109.30 Supra note 7 at p. 3. 31 Sumner, Jenny, Lori Bird and Hilary Smith. (December 2009). “Carbon Taxes: A Review of Experience and Policy Design Considerations”. National Renewable Energy Laboratory. Golden, Colorado. Pg. 6.32 Ibid.

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market, they may find themselves at a disadvantage when competing with products from other

jurisdictions that are not so taxed. Carbon taxes implemented in European countries often apply

reducted rates or exemptions to large emitters.33

The primary criticism of carbon taxes is they stipulate the price of emissions, but do not

necessarily ensure a certain level of emissions reductions, unlike emissions caps.34 This is a fatal

flaw for some environmental groups, as it may ultimately defeat the purpose of the entire policy

in their eyes. Although carbon taxes can be designed so that tax rates increase automatically if

emission reductions are not met, this practice has not been fully implemented to date,35 which

may reflect the political challenges of passing a tax in the first place. The British Columbia

government has specified that changes to the tax rate will depend on whether GHG emissions are

being met. The B.C. government also intends to take into account the impact of other carbon

policies, the actions other governments are taking, as well as general advice being offered by its

Climate Action Team.”36

Carbon taxes are often seen as less politically acceptable than cap and trade systems

because they are perceived as lacking the ability to achieve a fair distribution of the policy

burden between polluters (firms) and consumers, and disproportionately penalize low-income

households. 37 As such, home heating is a social justice concern that should be considered in the

design of a carbon tax.38 Revenue-neutral policies and refunds to low-income consumers are

designed to make carbon tax policies more politically appealing.39

33 Supra note 22 at pg. 6.34 Supra note 31 at pg. 1.35 Ibid.36 Supra note 31 at pg. 21.37 Supra note 31 at pg. 1.38 Supra note 22 at pg. 7.39 Supra note 31 at pg. 7.

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Although a carbon tax is designed to meet the needs of the implementing jurisdiction, the

proper design of all carbon taxes require consideration of which sector to tax and what the tax

rate should be, how the resulting tax revenues would be used and how to ensure emissions

reductions goals would be achieved.40

Carbon taxes are usually placed on gasoline, coal and natural gas, and governments must

also decide whether to place the tax on a source of emission that is “upstream” (at the point of

production) or “downstream” (at the source of consumption). Taxing upstream sources may

provide an administratively efficient method of tax collection, while taxing downstream sources

such as electricity consumption may modify consumption patterns more strongly.”41

There is high variability of tax rates across jurisdictions that tax carbon. Higher carbon

tax rates, such as found in Europe, provide stronger signals to consumers to change behaviour.

Lower rates, such as espoused by California or various state and local governments, provide

funds for carbon mitigation programs or to supplement government budgets. As previously

mentioned, other carbon tax programs, such as in the U.K. and British Columbia, return tax

revenue to customers through other means such as income tax reductions. While these “revenue-

neutral” mechanisms do not raise money for government general funds, a price is placed on

goods that harm the environment and it is argued that lowered income taxes will generate new

employment opportunities.”42

IV. Which is a more effective climate change policy, cap and trade or carbon tax?

40 Supra note 31 at pg. iv.41 Supra note 31 at pg. 3. 42 Supra note 31 at pg. 4.

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The performance of the two approaches depends critically on specifics of design, which

may be as important as the choice between the two instruments.”43 Observers who have

compared the two systems dispel the following arguments which are sometimes advanced to give

one system primacy over the other. The first argument leveled against cap and trade is that any

free allocation eliminates the recipient’s incentive to reduce emissions. Even when allowances

are received for free, each additional unit of emissions carries an opportunity cost. According to

general economic doctrine, one more unit of pollution either reduces the number of allowances

the covered firm can sell, or it raises the number of allowances the firm must purchase to remain

in compliance. “The carbon tax and cap and trade thus offer equivalent incentives to reduce

emissions, regardless of whether the allowances are introduced through auction or free

provision.”44 A second argument, which the observers accept as true, is that emissions pricing

can lead to a very uneven distribution of costs across producing sectors, or between producers

and consumers. In light of this inequity, other observers have suggested that free allowances

should be used to avoid undesirable outcomes, stating that any distributional outcome under cap

and trade can be matched via a carbon tax.45 Finally, the use of offsets (which allow regulated

entities to offset some of their emissions with credits from emission reduction measures lying

outside the cap-and-trade or carbon tax system’s scope of coverage) can be included or excluded

with both a carbon tax or a cap and trade system, to the same effect.46

Although previously mentioned, it bears repeating that one area where a carbon tax may

be preferable to a cap and trade system is its adminstration. The regulator must establish a

registry for allowances and keep track of allowance trades and the associated changes in

43 Supra note 5 at pg. 2. 44 Supra note 5 at pg. 5.45 Ibid.46 Supra note 5 at pg. 10.

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ownership of allowances, in addition to monitoring emissions.47 The cost of administering an

emissions pricing policy is also a function of how many points of regulation there are to monitor,

and whether the system is introduced “upstream” (at or near the point where carbon first enters

the economy, which involves far fewer covered entities to monitor) or “downstream” (at or near

the ultimate point of combustion of the carbon-based fuels, which would potentially cover many

more entities). For example, the authors state that a fully downstream system – one that

considered only the ultimate emitters of CO2 – would involve millions of points of regulation

since it would need to include furnaces and automobile emissions of every household. Thus the

administrative costs associated with monitoring emissions can be considerably lower under an

upstream system. Both a carbon tax and a cap and trade system can be implemented upstream or

further downstream.48

V. The “hybrid” cap and trade

Emissions price volatility is not a problem for a carbon tax, as the tax rate is the

emissions price, and presumably policy makers would ensure relatively smooth changes rather

than sudden jumps. But as seen in previous examples from the European Union and California,

volatility can become a significant issue for a cap and trade system. In economic terms, under

the cap and trade system the supply of allowances is perfectly inelastic, therefore shifts in

demand can cause significant price changes.

Putting an effective price ceiling or “safety valve”, as well as a price floor or “price

collar” in the emission allowance market reflects a “hybrid” approach to climate policy: a cap

and trade system that transitions to a tax in the presence of unexpectedly high mitigation costs,

47 Supra note 5 at pg. 12.48 Ibid.

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and a price floor in the form of a minimum price in auction markets or a government

commitment to purchase allowances at a specific price.49 To enforce a price ceiling, the

regulator may also introduce into circulation additional allowances whenever the stipulated

ceiling price is reached so as to prevent allowance prices from rising further, or allow firms to

pay a set fee to emit instead of submitting allowances, if allowances reach a threshold (usually

set at the same price as the fee itself). 50 To enforce a price floor, the regulator may also buy up,

so as to remove from circulation, allowances whenever the floor price is reached, thereby

preventing prices from falling further, or set a fee that purchasers must pay in addition to the

allowance price when allowance prices drop below the stipulated floor level. Various cap-and-

trade programs, such as the one recently set up in California, use an auction reserve price.51

Other cost-containment measures to counter unexpectedly high or volatile allowance

prices and stabilize prices include offsets and allowance banking and borrowing, also known as

strategic allowance reserves, which permit emission trading across time and between compliance

periods by saving an allowance for future use, or bringing a future period allowance forward for

current use, as well as multi-year compliance periods. 52 For example, nearly unlimited banking

in the U.S. sulfur dioxide (SO2) cap and trade program in the 1990s is generally agreed to have

been a successful design feature of that program, as it mitigated issues of price volatility and led

firms to achieve SO2 reductions faster than they would have without banking.53

However effective intertemporal banking may be, it cannot prevent all volatility. SO2

allowance prices were particularly volatile in the late 2000’s as a series of court and regulatory

decisions changed expectations about the future stringency of the cap.54

49 Supra note 3 at pg. 6.50 Supra note 5 at pg. 14.51 Supra note 5 at pg. 15.52 Supra note 7 at pg. 3.53 Supra note 5 at pg. 14.54 Ibid.

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Furthermore, it should be noted that the hybrid policy also introduces uncertainty about

emission levels, because as previously noted, enforcing the ceiling may entail the introduction of

extra allowances, while enforcing the floor may imply removal of some allowances that were in

circulation. Some economists dismiss these concerns by suggesting that uncertainty about

emissions quantities under the hybrid model can be reduced if policy makers pledge to invest in

other, offset projects to compensate for whatever increase in emissions might otherwise occur as

a result of enforcing the price ceiling, for example. Revenues from emissions allowances sold

could be used to finance some or all of these offset projects.”55

An interesting dilemma has been advanced in the potential situation of a jurisdiction

having both a carbon tax and a cap and trade system in place. The two carbon pricing

mechanisms can be kept separate, with two different carbon prices. However, the two prices can

also be linked, with the carbon tax rate being the price floor or the price ceiling.56 There can also

be a carbon tax added to the cap, which might play out as follows: if emissions are only

sufficiently reduced when there is a cap at $40/tonne, for example, but the carbon tax is

$30/tonne, permit trading has resulted in an extra $10/tonne to the price, and volatility has been

reduced. However, if the carbon tax is set at the maximum trading price, there is no longer an

effective cap on emissions.57

Conclusion

By establishing a price for emissions of carbon dioxide, carbon taxes and cap and trade

systems (as well as the hybrid cap and trade system) encourage firms to innovate with their

55 Supra note 5 at pg. 18.56 Supra note 22 at pg. 5.57 Supra note 22 at pg. 5.

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technological processes so as to reduce emissions.58 Consumer behaviour is also modified by

causing the prices of carbon-intensive goods (for example, electricity, aluminum, and gasoline)

to rise relative to those of other goods.59 However, larger questions loom on the horizon, such as

the fact that these two systems are poised to interact. British Columbia and Quebec have already

implemented carbon taxes and are also planning cap and trade systems for large emitters, as are

other provinces.60 How will these two pricing systems function in tandem?61 Should the two

price mechanisms be kept largely separate, with modifications brought to the carbon tax rate on

an ad hoc basis?62 Should the two prices be linked?63 As discussed previously, there are several

ways in which such scenarios might play out.

As Canada and the provinces continue to develop their climate change policies, other

suggestions have been made, such as restructuring the federal fuel excise tax so that it includes

other sources of GHG emissions.64 Ultimately, the novel and untested nature of many climate

change policies suggest it would be prudent to learn from the experiences of other jurisdictions

who are grappling with this very global issue.

58 Supra note 5 at pg. 3.59 Supra note 5 at pg. 4.60 Supra note 22 at pg. 4.61 Ibid.62 Supra note 22 at pg. 5.63 Ibid.64 Supra note 20 at pg. 5.

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REFERENCES

Aldy, Joseph E. (2011). “The Promise and Problems of Pricing Carbon: Theory and Experience”, National Bureau of Economic Research, Working Paper No. 17569.

Banet, Catherine. “The use of market-based instruments in the transition from a carbon-based economy” in Donald N. Zillman, ed., (2010). Beyond the Carbon Economy – Energy Law in Transition. Oxford University Press.

Blanco, Elena and Jona Razzaque. (2011). Globalisation and Natural Resources Law –Challenges, Key Issues and Perspectives. Edward Elgar Publishing Ltd. Cheltenham, U.K.

Canadian Chamber of Commerce. (December 2008). “A Carbon Tax vs. Cap-and-Trade”. Policy Brief Economic Policy Series.

Courchene, Thomas J. (2008). “Climate Change, Competitiveness and Environmental Federalism: The Case for a Carbon Tax”. Montreal QC, CAN: Institute for Research on Public Policy.

Goulder, Lawrence H. and Andrew Schein. (August 2013). “Carbon Taxes vs. Cap and Trade: A Critical Review”, National Bureau of Economic Research, Working Paper No. 19338.

Sumner, Jenny, Lori Bird and Hilary Smith. (December 2009). “ Carbon Taxes: A Review of Experience and Policy Design Considerations”. National Renewable Energy Laboratory. Golden, Colorado.

Sustainable Prosperity. (2009). “ “Hybrid” Carbon Pricing: Issues to consider when carbon taxes and cap and trade systems interact”. Ottawa ON, CAN: Sustainable Prosperity (University of Ottawa).

Sustainable Prosperity. (December 2010). “Carbon Pricing, Climate Change, and Fiscal Sustainability in Canada”. Ottawa ON, CAN: Sustainable Prosperity (University of Ottawa).

Sustainable Prosperity. (May 2011). “Managing Carbon Revenue: Institutional needs and models”. Ottawa ON, CAN: Sustainable Prosperity (University of Ottawa).

www.climatechange.gc.ca