3.1 The Essential Elements of Policy Design: A Unified Carbon Pricing Policy

To achieve stated reduction targets at the least possible overall cost, all emissions must be covered as fully as possible. This requires a unified carbon pricing policy that consciously takes into account all emissions across all sectors and all jurisdictions. If this does not occur, we believe that the cost of the current fragmented carbon pricing policy approach in Canada, characterized as a fragmentation of individual sector and jurisdictional GHG policies sending differentiated carbon prices across emissions, will only intensify adverse impacts. Overall costs rise and the ability to achieve our GHG objectives diminishes the more the current fragmented climate policy continues. A major conclusion of this advisory note is that the costs of a fragmented climate policy across emissions and jurisdictions are unnecessarily high and that the current approach will be an impediment to achieving deep, long-term emission reductions at a manageable cost.

To address this risk of fragmentation, our research suggests that the preferred carbon pricing policy must first seek to send a common carbon price signal across all emissions and jurisdictions using one pricing instrument, and then seek to expand coverage to emissions that are impractical to address with a carbon price alone. Finally, the policy must be consistent with that of our major trading partners and seek to contain the costs of domestic action with lower cost carbon abatement opportunities abroad.

3.1.1 Unify carbon prices across emissions, jurisdictions, and policies

The main driver of cost-effective emissions reductions is the carbon price. In order for the carbon pricing element of the policy to work cost-effectively, three objectives are essential. Carbon prices should be:

• aligned to deliver the reductions necessary to meet the targets,

• uniform across all emissions and jurisdictions, and

• unified through a single national cap-and-trade system.

Align carbon price to deliver the reductions necessary to meet the targets

The main advantage of carbon pricing is that it signals that carbon is valuable and should be managed. The carbon price signals the level of action desired by the policy, and behavioural and investment decisions are then made accordingly. However, a shortcoming of most current federal and provincial carbon pricing policies is that the carbon price signal does not align with the stated targets. This gap between what is required to achieve the targets and what influences technology decisions leads to both high cost outcomes, as technologies are chosen that do not account for rising carbon prices in time, and the risk of not attaining targets, as technology choices are made that are inconsistent with the targets.

A first element of our carbon pricing policy is to identify the carbon prices required to meet the government’s 2020 and 2050 targets. Our research suggests that economy-wide carbon prices will need to rise to $100⁸per tonne of CO₂e by 2020 and upward of $300 per tonne of CO₂e by 2050 to drive the behavioural change and technology deployment underlying the achievement of deep reductions (Figure 2). Note, however, that to contain domestic costs and improve the cost-effectiveness of the carbon pricing policy (one of our two main goals), an upper carbon price limit is set at $200 per tonne CO₂e in 2025. With this lower carbon price, domestic action falls short of the targeted emission reductions, requiring more steps.

Make carbon prices uniform across all emissions and jurisdictions

Covering all emissions, in all sectors as well as regions, becomes central to balancing costs while achieving reductions. A second essential element is to harmonize the carbon price seen by all in the economy. Practically, this means that sector-specific exclusions should be avoided so that the carbon price is broadly and uniformly applied across all emissions in Canada’s national GHG inventory. But, the current trend in federal, provincial, and indeed international GHG policies, is to exclude those emissions that are perceived to be more politically challenging to address.

Our research indicates that large industrial emitters⁹tend to face carbon pricing while transportation, light manufacturing, households, and buildings remain somewhat exempt, despite accounting for significant amounts of emissions. Excluding these emissions usually takes the form of differentiated carbon prices, where prices are either low, totally absent, or targeted through limited technology policy. But as Canada ramps up carbon prices to align with GHG targets, the continuation of these trends leads to two main risks:

• Costs rise significantly when carbon prices are applied differentially across emissions. If the current path of incomplete coverage of carbon pricing policy on all emissions continues, Canada can expect higher costs as low-cost abatement opportunities are not sought from all emissions. Our research suggests that if lower carbon pricing is applied in the non-industrial sectors, the carbon price in the industrial sectors must rise significantly—by 2 to 2.25 times, or $200/tonne in 2020 and $600/tonne in 2050—if we are to still achieve the emission reduction targets.
  
  
  
• With lower carbon prices in the household, transportation, and light industry sectors, there is a real risk that we will not hit our targets. While attaining the 2020 target appears feasible under differentiated carbon prices across emissions, we could have real difficulty in achieving the deep reduction targets for 2050, even with theoretical carbon prices at $600 per tonne. Based on our assessment, emissions do not appear reactive to increasing carbon prices beyond a certain point, and so additional reductions seem uncertain.

The broadly applied carbon price, however, delivers emission reductions uniformly across all emissions. Figure 3 shows sector and regional emissions “before policy.”

Figure 4 shows the relative contributions of emission reductions in 2020 across all Canadian emissions with the carbon price schedule outlined in Figure 2. While this figure seems to indicate Alberta and Ontario make disproportionate reductions relative to the other regions, in fact all regions and sectors make about the same level of reductions in response to the broad-based carbon price compared with their total emissions without a unified carbon pricing policy.

Just as the issue of unifying carbon pricing policy across sectors and emitters is important, the issue of fragmented policies across jurisdictions illustrates the importance of unifying policy in this area also. This rise of a fragmented or patchwork approach to carbon pricing now being observed across Canada poses risks (1) of notably higher costs for emitters if the targets are to be met, and (2) that overall prices will remain insufficiently low and targets will not be met.

To provide a sense of this risk, we explored the cost implications of each region in Canada attempting to reach the national reduction goals on its own. We determined the required emission prices for each region to reduce its emissions by Canada’s stated GHG objective of 20% below current levels by 2020 and 65% by 2050. We found that carbon prices would have to rise in the order of 25% above the unified approach, with increases in capital, operating, and energy expenditures 45% higher in 2020 and 25% thereafter (Figure 5). We also found that some jurisdictions, notably British Columbia and Alberta, would face significantly higher costs of achieving their share of Canadian emission reduction targets if they were to act independently. In Alberta, for example, carbon prices in our assessment would have to rise in the order of 300% beyond fast and deep prices in 2020, and 175% higher thereafter, if a fragmented policy were pursued without linking to a nationally unified system. In terms of economic impacts, the GDP costs of this fragmentation relative to an efficient unified policy are 7% greater than the unified approach in 2020, 20% in 2035, and 7% in 2050.

Unify carbon prices through a single national cap-and-trade system

The central design question for carbon pricing policy is the choice of a pricing policy instrument. At the outset, the NRTEE determined that in designing an effective carbon pricing policy we would not simply choose between the two principal instruments: carbon taxes and cap-and-trade systems. Each offers a benefit that carbon pricing policy seeks: price certainty through carbon taxes, emissions reduction certainty through cap-and-trade. Put another way, one offers price-setting certainty, the other offers quantity-setting certainty. In reality, price-setting approaches (taxes) can be blended with quantity-setting approaches (cap-and-trade) as we manage the trade-offs between the two. Figure 6 is a notional illustration of how existing and proposed carbon pricing instruments in Canada are neither a “pure” carbon tax nor a “pure” cap-and-trade system; rather, they blend aspects of one another to deliver on goals of price and emissions quantity certainty.

This consideration has important implications for the policy instrument the NRTEE is recommending based on our research. It implies that the carbon pricing policy must include design elements that enable costs to be contained (thus including features of a tax) and allow emissions to be driven down to levels consistent with the stated emission reduction targets (thus including features of cap-and-trade). Any carbon pricing policy must therefore blend design elements of both to enable costs to be stable within a predictable bandwidth, while allowing emissions to be driven down to levels consistent with the stated emission reduction targets.

But we did need to decide on a principal carbon pricing mechanism. In recommending a single, national cap-and-trade system for Canada, two main considerations influenced the NRTEE’s choice:

• First, most provincial, federal, and international carbon pricing regimes are actively considering or implementing some form of cap-and-trade for large emitters. Proposals in the US also seek to include other emissions from the rest of the economy. This is important since it points to an ability to ultimately contain the costs of domestic action alone through the ability to link and trade emissions permits across Canada and with other systems internationally.
  
  
• Second, given that cap-and-trade systems are proposed for implementation in multiple Canadian jurisdictions before 2015 (including Quebec, Ontario, Manitoba, Alberta, and British Columbia), it is simpler to transition these systems to one national cap-and-trade system shortly thereafter, thus quickly and effectively coordinating carbon pricing policies.

But with this choice of a national cap-and-trade system, issues remain. The federal Regulatory Framework is predicated on a cap-and-trade system for large industrial emitters representing some 51% of the economy’s emissions. A first question arises as to how to integrate the 36% of emissions from buildings, households, transportation, and light manufacturing within a single national cap-and-trade system.¹⁰Another issue is timeliness. An advantage of carbon taxes is their relative simplicity in design and implementation. A second question is therefore how fast a single, national cap-and-trade system can be up and running.

Our path forward is to design a carbon pricing policy that can balance these competing tensions. In this case it is to recommend a single national cap-and-trade program across emissions and jurisdictions, with definitive time frames for implementation. A national cap on emissions would be set for the economy at large. Large emitters would be covered with a portion of this national cap and the rest of the economy would be covered under the remaining portion. The large emitter portion of the cap would cover actual emissions and so address fugitive and process emissions, and provide a signal for carbon capture and storage. The remainder of the cap applied to the rest of the economy (buildings, transportation, and light manufacturing) would be apportioned on the carbon content of fuel purchased by these energy users.

Full trading of permits between large emitters and rest of economy emissions would be enabled under the single national system beginning before 2015. This option meets criteria of timeliness, coverage, and unification of the carbon price by 2015. The inclusion of a price floor and ceiling for permit prices we set out later in this report would ensure price certainty (an upper limit on potential costs) while a cap on emissions allows for quantity certainty. But such a system, with coverage of the non-industrial sectors, would need to be in place as soon as possible to minimize costs and get us started on a low-cost reduction pathway to unify prices across jurisdictions no later than 2020 and meet the government’s medium-term target.

3.1.2 Expand coverage and address barriers using complementary regulations and technology policies

Getting to 2050 and our subsequent research leading to this report show that carbon pricing is the most cost-effective single measure to drive the adoption of carbon abatement technology in Canada. Yet our research also illustrates that a carbon price alone is insufficient because of market barriers in some sectors of the economy and a reluctance on the part of government and others to impose steep carbon price rises, especially in the short term. Supporting technology innovation, adoption, and deployment will be necessary given the need for widespread deployment of low-carbon technologies required to meet Canada’s 2020 and 2050 targets.

As a carbon price alone does not achieve our emission reduction targets, we must look to other complementary regulations and technology policies to enhance the efficiency and effectiveness of the carbon pricing policy. Two types are necessary—one to ensure all emissions are targeted, and the second to address the specific technology barrier issues that impede carbon price signals.

• Targeted regulations to expand policy coverage to more emissions. Specific regulations can broaden the coverage of the carbon pricing policy by targeting emissions in certain sectors but do not respond efficiently to a carbon price signal alone.
  
  
  
• Policies that support technology innovation, adoption, and deployment. By addressing key barriers to innovation, adoption, and deployment of technology the price signal can have its full impact on the economy.

Carbon pricing is much less effective on its own in the key sectors of transportation, buildings, upstream oil and gas, and agriculture. Our research and analysis indicate that by covering these emissions with complementary policies, additional reductions can be gained while lowering total abatement costs. In modelling complementary policies to extend the coverage of the price signal, the national carbon price was reduced by about 30% from $300/tonne CO₂e to $200/tonne CO₂e to reach the same target.¹¹In effect, the highest cost abatement opportunities were avoided under the carbon pricing component of the policy when regulations expanded coverage.

Many opportunities to develop complementary policies already have precedents in Canada: regulations to capture and use landfill gas exist in several provinces, as do regulations concerning energy efficiency in buildings, and the handling of upstream emissions in the oil and gas sector.

The existing precedents for regulations in these areas suggest that such approaches are politically acceptable and administratively feasible. A recent NRTEE report on energy efficiency in Canada’s commercial building sector called Geared for Change: Energy Efficiency in Canada’s Commercial Building Sector demonstrates clearly the positive impact of complementary policies working with a carbon price.

The challenge is to ensure that these regulations impose costs that align with the broad-based carbon price so that costs across emissions are unified under both the pricing policy and the complementary regulations scheme. In doing so, governments and industry will need to address the difficult problems posed by institutional, financial, and other barriers within each regulated sector. Such barriers prevent the full impact of pricing and regulatory obligations from occurring, raise compliance costs, and hamper technology development and deployment.

3.1.3 Balance the cost of domestic action with low-cost international carbon abatement opportunities

As more reductions are sought in time, the importance of getting the carbon pricing right intensifies as increased costs are imposed on more and more of the economy. Our research indicates that there is a point at which additional domestic action does not deliver on our cost-effectiveness goal. The rationale for this is straightforward: the costs of abatement rise rapidly as deeper reductions are sought.

Figure 7 illustrates this point. As reductions are sought above 45% below 2006 levels by 2050, the incremental cost to move to our target of 65% increases from $200 per tonne to over $300 per tonne, and even higher to reach an 80% target. This observation indicates that at the target levels contemplated by the federal government, the cost of reductions rise faster than the quantity of emission reductions and each tonne reduced becomes more expensive.

Given the rapidly increasing carbon prices required to attain domestic reductions consistent with our long-term targets, a strategy that balances domestic action with real and verifiable reductions from outside Canada makes sense. Figure 8 highlights the benefits of such a strategy. This figure explores three possible scenarios to allow overall compliance costs to be contained: a domestic-alone strategy, a strategy allowing 10% of the government’s target to be traded, and a strategy allowing 30% of the government’s target to be traded. Most likely, international carbon purchases could be obtained at prices lower than Canadian domestic costs. Therefore, our compliance costs for the same target decline the more international trading is allowed.

Three immediate implications become apparent. First, if the integrity of the GHG targets is to be maintained, any shortcomings relative to domestic emission reductions will need to be made up by having either governments or emitters purchase reductions internationally. This implies either linking with international mechanisms under the United Nations Framework Convention on Climate Change (UNFCCC), or linking directly with other trading regimes in Europe or the US. Canada’s carbon policy framework therefore needs to be designed to facilitate such an occurrence. Second, these reductions need to be real and verifiable to ensure that they are not simply “hot air”¹²and that the overall global level of GHGs in the atmosphere is reduced. Third, Canadian firms can benefit by being able to sell domestic credits to firms in other markets.

The NRTEE’s carbon pricing policy is therefore designed with a view of eventual linkage to trading partner systems and of participation in global frameworks:

• Enable linking of trading systems. Our analysis suggests that Canadian carbon costs of reaching deep targets are likely higher than those of many trading partners. A move to allow trading permits with comparable international emissions trading systems will help contain costs domestically and align carbon prices across trading partners so that overall competitiveness concerns are reduced.
  
  
  
• limit domestic carbon prices by enabling international carbon purchases. Ideally, carbon costs faced by other major trading partners such as Europe and the US would inform the level at which we limit domestic carbon costs and the level at which we then seek international purchases. While international carbon prices are difficult to forecast, in all likelihood international real and verifiable emission reductions can be obtained at prices lower than the domestic carbon prices required to achieve Canada’s targets. In developing and assessing our carbon pricing policy, we limit domestic carbon prices somewhat below the levels required to achieve domestic action alone through to 2020 and then limit the prices to $200/tonne, approximately $100/tonne less than what would otherwise be required to achieve our targets.

This observation that our domestic carbon costs rise quickly while delivering limited additional reductions reinforces the need to consistently balance the costs of emission reductions with the attainment of the emissions reduction targets. As an exclusive domestic abatement focus does not deliver on our central objective of delivering deep emission reductions at least cost, real reduction opportunities will need to be sought internationally.

3.2 The Essential Elements of Policy Implementation: An Adaptive Carbon Pricing Policy that Sends a Credible Long-Term Price Signal

The second essential element of our policy is that it must send a price signal to the economy that is both certain and credible now, but also responsive and adaptive over the long term. It must be certain and credible to change behaviour and drive investment through clear “rules of the game” and responsive and adaptive to new economic and environmental circumstances and information. Policy design must find a way to link these two needs.

While policy adaptability and policy certainty are essential elements for any carbon pricing policy, there are trade-offs between the two criteria. If a policy has clearly been designed to be flexible or changeable at some future time, uncertainty as to the future nature of the policy follows. On the other hand, an attempt to fix policy in advance would imply a failure to adapt to new information, such as evolving climate science or the policies of Canada’s trading partners. Effective carbon pricing policy needs to find a balance between adaptability and certainty—it should be adaptable to changing and unknown future circumstances but certain enough to transmit a robust, long-term price signal to the economy upon commencement.

3.2.1 policy certainty is required to influence long-term investment decisions

Firms and households routinely manage risk and uncertainty when making investment decisions. Yet uncertain climate policy raises additional risks. It elevates the cost of capital and alters investment decisions. Policy uncertainty increases incentives to delay investments in emissions-reducing technologies in order to wait for additional information or clearer policy commitment from governments. This is a real challenge as many industry sectors, particularly power generation, oil and gas, and manufacturing, all face significant short-term pressures to invest in new capital stock for the long term. Firms and households both tend to avoid making investments in a climate of uncertainty, especially if there is a prospect that price signals and policy directions will change abruptly, or down the road.

Effective policy is one that clearly and consistently communicates the long-term nature of a carbon pricing policy. Policy certainty therefore suggests that the carbon pricing policy will be maintained and is defined through time. Put another way, policy certainty ensures the price signal is not diluted by uncertainty about the permanence or longevity of the pricing policy. Our research suggests that a clear communication of a government’s long-term commitment to a pricing policy is critical to achieving low-cost reductions aligned with the GHG targets. If consumers and businesses believe government might “backslide,” or soften pricing policy as a result of political pressure, the policy’s effectiveness is reduced.

In Figure 9, two scenarios are presented, one where investments are made with complete confidence in the carbon pricing policy and one where there is no confidence. With a lack of confidence, there is a lower level of overall investment that results in much lower emission reductions. With confidence in the carbon pricing policy, investments reflect the future value of carbon and so preferred long-term technology choices prevail. This illustrates the positive impact of certainty in carbon pricing policy.

3.2.2 Policy adaptability is required given the range of uncertainties

While policy certainty illustrates the importance of uncertainty from the perspective of firms and households, policy adaptability highlights the significance of uncertainty from the perspective of policy makers. Substantial sources of uncertainty complicate policy design, including the following:

• the carbon prices or caps implemented by Canada’s major trading partners;

• the urgency of emission reductions, as dictated by evolving climate science;

• the cost and effectiveness of domestic policies;

• the strength of the economy; and

• the distribution of impacts on stakeholders.

Because of these sources of uncertainty, governments face risks in implementing domestic carbon pricing policy, and must take these issues into account. If, for example, Canada were to implement a carbon pricing policy independent of its trading partners, it could subject Canadian industry to heightened competitiveness concerns. If the carbon pricing policy were set too stringently, and emission mitigation costs were unexpectedly high, the Canadian economy could suffer disproportionate disruptions. Similarly, if short-term Canadian emissions reductions were too shallow, Canada might be forced to move toward more aggressive reductions in the future that would have a higher cost.

These risks can be reduced if the policy is designed to be adaptable and flexible. Policy adaptability would allow a policy to respond to new information in the future and help it remain focused on delivering cost-effective reductions consistent with the targets. Principles of adaptive management are applicable here. An adaptive management framework would monitor results and adapt to uncertainties and adverse outcomes. Adapting to policy in time would be important given the complexity of the energy system and the underlying uncertainties described above.

3.2.3 Balancing policy certainty and adaptability

While policy adaptability and policy certainty are important objectives for a carbon pricing policy, there are trade-offs between the two goals. If a policy has clearly been designed to be flexible or changeable at some future time, uncertainty cannot be avoided. On the other hand, fixing policy for the long term implies that it cannot adjust to new information. Our research suggests that a carbon pricing policy should instead strive toward balancing certainty and adaptability; it should transmit a robust price signal to the economy upon commencement, but be adaptable in the future.

Achieving this balance is really an issue of governance: it involves the design of institutions and processes associated with implementing and managing the carbon pricing policy over time. This is particularly true for Canada as a federation with shared jurisdiction for the environment, provincial ownership of natural resources in the ground, and revenue-sharing agreements with provinces for resource extraction offshore. In order to achieve our deep, long-term emission reduction targets, we require an institution and process that can manage uncertainties from the policy makers’ perspective through an adaptive approach and manage uncertainties from the firm or households’ perspective by minimizing risks of investing in low-carbon technologies and keeping price signals constant and affordable. Further discussion of governance issues related to the implementation of an adaptive carbon pricing policy is found in Chapter 6.

3.3 The Carbon Pricing Policy Wedges

In order to meet our two main goals, we have translated these essential design elements into a workable carbon pricing policy consisting of “policy wedges.”¹³Together, the policy wedges address each segment of emissions in Canada’s national inventory. The carbon pricing policy also includes an implementation strategy to deliver adaptive policy and certain long-term carbon pricing. We use three policy wedges:

1. A Single National Cap-and-Trade System. This will unify carbon prices and policies across all emissions from all sectors and all jurisdictions, based on one national cap differentiated across emissions:

• Large emitters. This covers approximately 51% of emissions. By setting a maximum carbon price, we can include desirable elements of carbon taxes to enhance price certainty and contain costs while ensuring the cap on emissions works efficiently.
  
  
• Rest of the economy. For the 36% of emissions in buildings, transportation, and light manufacturing, a cap would be applied at a point in the fuel distribution chain to those that distribute or import fuel, thereby limiting the number of trading entities while broadening coverage throughout the economy.

2. Complementary Regulations and Technology Policies. Since market failures inhibit the carbon price from reaching all emissions, targeted regulations such as building codes, appropriate regulations, appliance and vehicle fuel-efficiency standards, and targeted public investment through technology development and deployment subsidies would help ensure that all sectors of the economy are contributing to emission reductions and that low-carbon technology deployment occurs in a timely manner. This would include regulations for some of the remaining hard-to-reach emissions.

3. International Carbon Abatement Opportunities. As carbon prices rise significantly from 2015 onward, we need to ensure the cost of domestic action alone is not prohibitive. Access to international carbon abatement opportunities will help align domestic carbon costs with those of our major trading partners and ensure that as carbon costs rise and further units of reductions become more expensive, we do not spend a disproportionate amount for fewer actual additional reductions. In time, international purchases could account for 20% of the targeted reductions in 2020 and less than 10% in 2050.

Figure 10 provides modelling results the NRTEE conducted for these three policy wedges and the contribution of each to the overall reductions in time. They demonstrate how individually and together they reduce carbon emissions and meet the government’s medium- and long-term GHG emission reduction targets.

The next chapter sets out the detailed design features—our “road map”—of the NRTEE’s recommended carbon pricing policy for Canada focusing on each of the policy wedges, showing how they will work. After, we turn to our consideration of the expected outcomes and impacts of the proposed policy on industry, households, and government and how we can mitigate adverse effects. Institutions and processes to manage the policy over time are as important as getting the design right. We therefore discuss important elements of the implementation and governance of a carbon pricing policy that provides long-term certainty but is adaptable to changing circumstances over time.

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