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5.2 Point of Regulation
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Carbon fuels change hands along a supply chain from producers, to refiners and processors, to distributors and ultimately to final consumers. Carbon pricing can be applied at various points throughout the fossil fuel supply chain. For example, a carbon tax could be levied on consumers at gas pumps, or it could be levied on producers and importers of carbon-based fuels like oil and gas. The point at which carbon pricing is applied is known as the point of regulation.
As illustrated in Figure 11, downstream refers to the point at which emissions are finally released, typically where fuels are combusted. Upstream refers to the point at which carbon fuels enter the economy, such as oil wells and import terminals. Economic theory suggests that the point of regulation does not affect the economic efficiency or environmental effectiveness of carbon pricing policy – the price signal will be the same regardless of where it is applied in the fuel chain, because price increases are passed on to final emitters further downstream. However, other factors make this design choice important.
Carbon taxes can be applied with relative ease upstream or downstream. In upstream systems, a carbon tax is levied on importers and producers of fossil fuels, based on the carbon content of the fuels. The BC carbon tax is applied upstream. In downstream systems, the tax is levied on consumers at the gas pump and on fuel bills.
The choice of point of regulation for cap-and-trade systems is more complex than for carbon taxes. This is because the effective functioning of an emissions trading system is influenced by the number of participants. A trading system with many participants trading small amounts is administratively complicated; a system with too few participants can result in insufficient market liquidity and creates the potential for market manipulation. Several options are possible, each with strengths and weaknesses.
Downstream cap-and-trade among large emitters. In most existing and proposed cap-and-trade systems, only large emitters are included, typically electricity generators and industrial plants. Examples include the EU Emissions Trading Scheme and the Regional Greenhouse Gas Initiative (RGGI) in the US. The administrative burdens of a large final emitter trading system can be kept low, because of the relatively small number of regulated entities46, and such systems generally function well. However, such systems do not achieve broad coverage of all emissions in the economy, a central goal of efficient carbon pricing. This is because emissions from buildings and transportation are not affected by large emitter cap-and-trade systems. A large emitter trading system alone will not be sufficient to meet the Government of Canada’s targets at least cost.
Downstream cap-and-trade among small emitters. Buildings and transportation emissions could be included in a cap-and-trade system by capping the emissions of individuals and/or businesses. The UK is establishing a cap-and-trade system in its commercial and institutional sector, and has explored the feasibility of personal carbon trading.47,48 However, the administrative challenges involved in establishing cap-and-trade systems involving many thousands or even millions of participants are formidable. Personal carbon trading, in particular, is seen as prohibitively complex.
Upstream cap-and-trade systems. In an upstream system, the amount of fossil fuels entering the economy would be limited, with caps placed on importers and producers. Such a system has the advantage of achieving broad, economy-wide coverage of emissions, a central goal of efficient carbon pricing policy. In addition, an upstream system involves few regulated entities, and as a result is administratively more straightforward. However, a fully upstream cap-and-trade system has two principal disadvantages. First upstream carbon prices provide no incentive for carbon capture and storage, thought to be an essential technology to reduce emissions, or for process and fugitive emissions, which are important sources of GHGs. While additional rules could be developed to address these issues, they would add complexity to the upstream system. Second, the small number of regulated entities may enable market manipulation, since the actions of individual regulated firms could have a significant impact on permit prices.
Mixed cap approaches. The broad coverage benefits of upstream cap-and-trade can be combined with the administrative attractiveness of large emitter trading systems. For example, a national cap on emissions could be apportioned between large emitters and the suppliers of fuel for the rest of the economy (in particular heating and transportation fuels).49 This approach applies the most appropriate point of regulation to different areas of the economy. However, if a mixed cap is used, it will be important to ensure that prices are harmonized across the economy to the greatest degree possible, for the reasons laid out in Chapter 4.0.
Figure 12 illustrates one possible way in which a mixed cap system might ensure full coverage of the economy.50
Point of regulation is central to policy design. The administrative, political and institutional contexts of industrial emissions and household emissions are very different. As a result, there may be a case for regulating these emissions sources at different points in the fuel chain, or with different instruments. However, if different instruments are used, mechanisms to harmonize emissions prices between instruments will be necessary.
