Linkages could also be restricted in order to ensure that a substantial number of reductions would occur within Canada; government could limit the quantity of permits from another system. If permits from different systems represented different amounts of emissions, government might also apply an “exchange rate” to permits from other systems. Finally, governments could impose conditions on accepting permits depending on the emission reduction measure.

A carbon tax system could also be linked to a tradable permit system by setting the price of carbon to the market price of tradable permits in the linked system. A linkage could be established between tradable permit systems and a carbon tax system by allowing emission reduction permits from the trading system to offset carbon liabilities within the tax system. That is, the emissions an emitter would pay taxes on would be reduced by the amount of emissions attributed to a purchased permit. This kind of linkage would not change the domestic price of carbon, set by the carbon tax.

6.1.1 Implications of Linkages

Linkages with other carbon pricing regimes have important trade-offs between different policy objectives. Linkages can have different implications for the effectiveness, efficiency, distribution, administrative feasibility, and political acceptability of a carbon pricing policy. Note that while implications of linking depend on the type of link as well as the nature of the carbon pricing systems being linked, two-way linkages between cap-and-trade systems is the primary focus of this discussion.

The implications of two-way linkages for a policy’s effectiveness in reducing greenhouse gas emissions depend on the nature of systems being linked. Linkages lead to a de facto harmonization of cost containment mechanisms such as banking, borrowing and price ceiling provisions. For example, if a price ceiling exists in one part of a linked system, permits can be purchased at the price ceiling and sold through the linked system. Cost containment mechanisms reduce uncertainty in the costs of achieving emission reductions, but increase uncertainty as to the total amount of emissions to be reduced in Canada. Linkages can also increase uncertainty as to the amount of emissions reduced globally if other systems have weaker standards for ensuring the quality of emission reductions. Thus linkages between a Canadian cap-and-trade system without cost containment mechanisms and a system with these mechanisms would decrease the overall effectiveness of the policy.

On the other hand, in the long run, linkages can help establish a global framework for emission reductions and facilitate a move toward an internationally unified carbon price. International reductions have the same effect on climate as reductions within Canada’s borders. Linked emissions trading markets could therefore provide such a policy framework. Further, Canada’s participation could improve the liquidity of an international market, increasing international reductions.

In linked systems, abatement effort will be focused in the regions and sectors that offer the lowest cost reductions. The regions and sectors with the lowest cost opportunities may be outside Canada. Where this is the case, prices will fall, and technological deployment in Canada may be delayed, as the incentives for innovation and deployment will be reduced.⁷⁴

Linkages could affect the political acceptability of carbon pricing policy in both positive and negative ways by altering the distributional impacts of the policy. If the prospective linkage partner system had a lower price of carbon, Canadian firms would have access to lower-cost reductions and thus lower costs of abatement. However, as a relatively small economy, Canada would likely be a “price-taker” if linked with larger systems such as the EU ETS or a forthcoming U.S. cap-and-trade system. The linkage could therefore result in either an increase or a decrease in the price of emissions: some buyers might become sellers or vice versa, and distributional impacts could shift. Linkages might reduce political acceptability because they could lead to flows of capital out of Canada. This issue is particularly critical if the linked system has a price ceiling; in that case, Canadian emitters could effectively be purchasing emission permits from a foreign government.

Linkages can complicate the initial administration of a carbon pricing policy. They require cooperation between the linked jurisdictions on some key policy design elements such as cost containment measures. In a multilateral linkage with multiple linked systems, complexity increases with the number of participants. The EU ETS systems is one example of a successful multilateral system. If policy differences do exist, an “exchange rate” may be required to ensure emission permits from one jurisdiction can be traded as equivalents in another. Finally, given the required cooperation between linked jurisdictions, linkages would reduce Canada’s ability to adapt and adjust its own domestic carbon pricing policy over time.

6.1.2 Linkages with the United States

For Canada, linkage with a U.S. system would be more significant than any other international linkage. Given Canada’s close economic ties with the United States, many NRTEE stakeholders suggested that Canada’s climate policy must align and the two systems must be linked. An assessment of the implications of such a linkage can therefore usefully inform design of a Canadian carbon pricing policy in several dimensions.

A linked North American system has several positive implications for Canada. First, it would reduce potential impacts on competitiveness. Given that the United States is Canada’s major trading partner, a harmonized carbon price resulting from the linked system would reduce competitive disadvantages for Canadian firms that could result from variation in the price of carbon across the border. Second, linking U.S. and Canadian systems could also substantially improve the liquidity of a carbon market. Trade of emissions proceeds more smoothly and market prices are more stable if there is a large supply and demand for tradable permits. Given that Canada is a relatively small market, linking with the US would result in greater liquidity.

Linking with the United States could have problematic implications as well. The large size of the U.S. market relative to the Canadian implies that the Canadian government and market would have substantially reduced influence over the price of emissions. A two-way linkage results in the convergence of market prices over time. Since the American market is large, substantial low-cost opportunities for emission reductions exist.⁷⁵ As a result of price convergence, the American market would experience small changes while the Canadian market would experience more significant ones, relatively speaking. The Canadian market would essentially be a “price-taker.” Canadian policy makers would thus be less able to set or influence the price of carbon. While linking would not affect the total quantity of emissions reduced, a significant drop in the price of emissions could decrease investment in new low-carbon technologies inside Canada and may have implications for the cost of future reductions.⁷⁶

6.1.3 Summary and Key Conclusions for International Linkages

Linking with the United States is the linkage that matters most for a Canadian carbon pricing regime, given the extensive trade between the two nations. The issue of a possible North American emissions trading system is thus worth addressing directly, especially given the Canadian government’s stated desire to implement such a system. A linkage between Canada and the United States could reduce competitiveness risks and increase the liquidity of a Canadian emissions trading market, smoothing out some market price fluctuations. Given that linkage likely requires some alignment of design instruments, Canada must be cognizant of U.S. pricing policy and seek to influence it favourably.

Following from the points above, Canada could consider two-way linkages with the United States (and with other international systems such as the EU ETS) as an eventual goal. Eventual alignment with international systems could help facilitate a more unified global price, thus enabling more efficient emission reductions globally. As stringency of a carbon pricing policy will likely increase over time, competitiveness issues will also be much more significant in the long term and would be partially mitigated through linkage. On the other hand, an un-linked Canadian system would allow initial flexibility for adopting domestic cost containment mechanisms such as price ceilings or banking, and would allow Canada to more easily adapt its approach to carbon pricing over time. This approach would also allow Canada to implement a carbon pricing policy immediately without having to wait for the United States to finalize its policy design and implementation. A staged approach, in which a unified Canadian system is first developed and then linked internationally, could be a viable option to meet the eventual goal.

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