Feel the Burn: Federal Policy May Complicate Nationwide Carbon Pricing

It’s becoming increasingly difficult to do nothing regarding climate change.  The impact is real, and the association with human-caused greenhouse gas (carbon dioxide or CO₂) emissions is widely accepted by the scientific community.  As a result, national governments are busy working on their own plans, and entering global agreements, in order to reduce carbon emissions.  One of the most effective ways to do so is to implement a price on carbon emitted, and the federal government has released several documents proposing a federal carbon pricing policy.¹  In addition, British Columbia, Alberta, Québec and Ontario have already enacted either a carbon tax/levy system, or a cap-and-trade program.  Whether a carbon tax or cap-and-trade system is a more effective approach has been the subject of several years of debate; and this article certainly won’t settle the issue.  However, the federal government’s proposal to effectively allow both systems may result in an administrative nightmare for many organizations.

How is Carbon Priced?

Proposals to put a price on carbon emissions have mainly consisted of two main approaches:  a carbon tax or a carbon levy; and a cap-and-trade framework.  In a carbon tax or levy jurisdiction, the regulatory authority, generally the taxing authority, sets the price of CO₂emissions directly, and requires organizations to collect and remit this tax on a per unit basis.² A cap-and-trade system is far more complicated. Generally, the regulatory authority determines the total allowable quantity of CO₂ emissions for the jurisdiction, and then provides carbon allowances to large emitters.  These allowances can be used, or traded in defined markets, which create or set a market price for CO₂ emissions.3

A third system, known as a hybrid, combines the elements of both a carbon tax and a cap-and-trade system. However, to date, no Canadian jurisdiction appears to have considered implementing one. Currently, Alberta and British Columbia have implemented a carbon tax, whereas Ontario and Quebec use cap-and-trade systems to price CO₂ emissions.⁴ Manitoba intends to implement its own carbon tax system, and Nova Scotia will launch its own cap-and-trade framework.  Every other jurisdiction in Canada, except for Saskatchewan, has agreed to implement the federal pricing platform, which uses a carbon tax approach to carbon pricing. Saskatchewan maintains that the federal government is overstepping its boundaries, and has requested the opinion of its own Court of Appeal on whether the federal plan violates the Canadian Constitution.⁵ In addition, after the Progressive Conservative Party won a majority government in the 2018 Ontario election, the new Premier of Ontario, Doug Ford, has indicated plans to scrap the province’s existing cap-and-trade system, and challenge the federal government’s authority to implement a carbon tax in Ontario.⁶ However, the federal documents make it clear that the “federal carbon pricing backstop... will apply in any province or territory that does not have a carbon pricing system in place by 2018.”⁷

Carbon Tax

A carbon tax, as defined by the Organisation for Economic Co-operation and Development, is defined as a tax levied on the carbon content of fossil fuels.⁸ It is generally priced per tonne, and then applied to purchases at smaller levels (i.e., as a dollar amount for every purchase of a particular motor vehicle or other fuel). Currently, British Columbia’s carbon tax is $35 per tonne of CO₂ emissions, but will increase to $40 per tonne by April 1, 2019. The tax will increase by $5 each year until April 1, 2021, at which point, it will be $50 per tonne of CO₂ equivalent emissions.⁹ Similarly, Alberta implemented a levy of $20 per tonne on January 1, 2017, and raised it to $30 per tonne in 2018, and has hinted that it will meet the future federal backstop requirements of $50 per tonne at a later date.¹⁰ The federal carbon price will initially be charged at $10 per tonne when implemented (likely in the fall of 2018), and is expected to increase to $50 per tonne by 2022.¹¹

The only other province to have committed to a carbon tax is Manitoba; however, it will be levied consistently at $25 per tonne, and it does not appear that this approach will meet future federal backstop requirements.¹² As will be discussed later, this could lead to some negative implications for emitters in Manitoba.

There are several advantages to a carbon tax versus a cap-and-trade system for emitters. First, the price of carbon is known at the time of purchase and, as a result, the price is usually known to most emitters.  While the price may be buried in the cost of the fuel for many consumers, it is effectively more transparent than the price incurred under a cap-and-trade system.  This is attributable to the fact that, while the specific tax amount may not be specified on a receipt for fuel purchases, it would be disclosed clearly in government publications.  It is also easier for emitters to budget for carbon costs in each period.

In addition, it is generally a less complicated system than the cap-and-trade approach. In most jurisdictions, it is typically levied like a fuel tax, in that a return is filed and the tax is remitted by a direct remitter. For the federal carbon pricing framework, this would be a “Registered Fuel Distributor”, which initially charges the tax to its customers, and the tax is then passed on in every additional sale. There are also self-assessment requirements when the carbon tax is not paid (i.e., when fuel is purchased from another jurisdiction and transported to and used in a carbon tax jurisdiction).¹³

Furthermore, the implementation of a carbon tax in some jurisdictions has historically been tied to some personal or corporate tax reductions.  For example, in Alberta, the carbon levy was offset by a rebate for households. As a result, if an Alberta consumer makes an effort to reduce their own emissions, they may end up paying less in tax, via the rebate.¹⁴ In addition, there have been attempts by jurisdictions implementing a carbon tax to make the tax revenue-neutral, although British Columbia has stepped away from this approach in its latest budget.¹⁵ The recently elected New Democratic government removed the “revenue-neutrality” requirement, with the intent of generating enough revenue to fund further climate change initiatives.

There are some disadvantages to a carbon tax, namely, it is still a cost of doing business or otherwise causing emissions. In addition, there are political implications to a carbon tax.  It wasn’t long ago when Stephane Dion’s Liberal Party was badly wounded in the 2008 federal election, after having campaigned on “The Green Shift”, a form of carbon tax that was not well received by voters.¹⁶

Also, there remain areas of concern with carbon tax implementation; in particular, where fuel is purchased, but not combusted.  A carbon tax framework, in order to be fair, should allow for the quick reimbursement of tax paid in such cases, or provide exemptions for such fuels when purchased under eligible circumstances. Currently, both provinces that implement a carbon tax address this issue with rebates for fuel not combusted in the province.

Finally, and perhaps most importantly, a carbon tax guarantees that carbon emissions are priced, but not capped. As a result, it can theoretically have a less significant impact on emissions than a cap-and-trade system. In fact, where an economy is growing rapidly, the carbon tax may not be an effective means to curb greenhouse gas emissions at all.

Cap-and-trade

A cap-and-trade framework is designed to set a hard cap on greenhouse gas emissions, while allowing businesses and large emitters to purchase or sell carbon allowances in a controlled market.¹⁷ The government essentially caps the emissions that a company is allowed in a given period, and if a company wants to exceed this cap, it can purchase allowances to meet its requirements. Similarly, if a company reduces its emissions, it can sell any unused allowances to other companies through a private sale, or via auction in a trading market. Currently, Ontario and Québec both have cap-and-trade systems, and have joined California in the Western Climate Initiative, Inc. (WCI), where allowances can be bought and sold in shared auctions for these jurisdictions. In addition, Nova Scotia has announced its own cap-and-trade program. However, the province has no current intention of joining the WCI marketplace.¹⁸

There are advantages to a cap-and-trade system over a carbon tax. First, it will almost certainly cap emissions, because there’s only a certain amount of carbon allowed to be remitted by certain sectors, as legislated by a jurisdiction.  The United States Environmental Protection Agency implemented a similar program with the intent of reducing acid rain, and pollutants causing acid rains drastically dropped since 1980.¹⁹ In addition, it is market-oriented, so the price placed on carbon may be a more accurate reflection of the cost of producing carbon emissions.

In addition, the initial and, potentially, continued sale or auction of allowances by a jurisdiction can provide a significant source of revenue. For example, Ontario’s first two cap-and-trade auctions provided the province with $2.8 billion in revenue.²⁰ Furthermore, a cap-and-trade system rewards carbon emission reductions by organizations because it allows them to sell unused allowances at market (or in some cases, privately brokered) rates. While an organization may initially have substantial capital costs to reduce its carbon emissions, it may be a worthwhile investment where a cap-and-trade system is in place for years to come, since the sale of allowances can result in added revenue.

There are, however, several disadvantages to a cap-and-trade system. First, there is no mechanism for a refund or rebate because the price of carbon is embedded into the cost of a product. As a result, interjurisdictional transfers may lead to paying tax twice on carbon. There could also be scenarios where fuel is purchased with no intent of combusting it, but the price of the potential carbon emissions has already been embedded into the cost. Consider a situation where an organization purchases fuel in Québec, but then transports it to British Columbia for use. In theory, there is already an indirect carbon price in the fuel purchase, since emitters may have purchased allowances to produce the fuel. There would also be, however, a requirement to self-assess the carbon tax in British Columbia, leading to a price on carbon being paid twice.

In addition, a cap-and-trade framework is not necessarily transparent. If one purchases fuel in a cap-and-trade jurisdiction, there is no obvious way to know how much is being charged for carbon emission. In contrast, carbon tax rates are readily available, so an individual or organization can determine the amount paid and assess whether it’s the correct amount.

Another issue is that cap-and-trade may hinder a jurisdiction’s economic output because it is linked to market prices. For example, as the Canadian dollar drops, manufacturing tends to increase. If manufacturing activity increases, the price of carbon credits should, theoretically, also increase, based on rising demand for the available allowances. What if the price for carbon allowances increases to a point where it becomes prohibitive to a manufacturer? In theory, where an organization has capacity in both a carbon tax and a cap-and-trade jurisdiction, it may be tempted to move production to the location where the cost of emissions is cheaper or more certain. Because a carbon tax is known before a period begins, it may be more favourable to an organization, especially where the trend in a cap-and-trade jurisdiction is that allowance prices are rapidly increasing.

Furthermore, a cap-and-trade system can be prone to political maneuvering. For example, if a jurisdiction wants to support a particular industry (i.e., automotive manufacturing), it may decide to allocate more allowances to organizations in that sector. Conversely, a province could technically punish a certain industry by allocating fewer allowances to those organizations. One potential deterrent to this type of political behaviour might be the recurring reviews by the federal government, which could declare that a cap-and-trade program is not meeting the requirements, and then impose the backstop.

Finally, the regulatory reporting for a cap-and-trade system can be burdensome. A review of Ontario’s cap-and-trade reporting regulations demonstrates that the tracking tools required in order to manage an organization’s compliance can be significant. Measuring greenhouse gas emissions rather than tax collected by large emitters can be arduous, and there is more room for error. As an example, in Ontario, the application for free allowances requires completed greenhouse gas emissions reports and verification statements.²¹

Potential Complications in Ontario

The election of a new Progressive Conservative government in Ontario is expected to lead to the cancellation of Ontario’s cap-and-trade program. This change will pose several challenges that need to be addressed. First, Ontario emitters have already purchased over $2.8 billion in allowances, either via auction, or through privately brokered transactions.²² The province may have to compensate these organizations, or face potential legal challenges, if the program is cancelled before the allowances have been used. In addition, on June 17, 2018, California and Quebec (through WCI) reacted to the announced change swiftly by closing the joint carbon market to Ontario allowances, thus preventing organizations from trying to recoup the cost of allowances already purchased by selling them in the WCI market.²³ Unfortunately, it will be Ontario consumers that ultimately pay for any unused or devalued allowances as emitters pass on these costs through higher prices.

Furthermore, while Ontario may mount a legal challenge to the federal backstop, historically, there’s little indication that it will succeed. As a result, the potential combination of legal fees, settlements with existing allowance holders, and a carbon tax eventually being implemented by the federal government could ultimately cost Ontario taxpayers more than keeping the existing cap-and-trade framework in place.

The Federal Backstop

The federal backstop was first proposed in October, 2016, with the purpose of ensuring that carbon pricing applies in every Canadian jurisdiction beginning in 2019.²⁴ There is little doubt that, with the backstop, the current government will achieve this goal. However, there may be some major issues to consider.

First, the federal backstop is a carbon tax, but it allows jurisdictions to keep their current or future cap-and-trade systems in place. Considering the two largest provinces in Canada currently use a cap-and-trade framework to price carbon, this approach could prove to be an administrative nightmare for multi-jurisdictional organizations. Annual reporting requirements exist for emissions in cap-and-trade provinces, which may be further complicated by Nova Scotia’s plan to implement its own cap-and-trade system. Currently, the carbon allowances need only be monitored by Nova Scotia’s 20 largest emitters; however, multi-jurisdictional organizations will have to account for emissions in this province separately, once the system expands to include additional emitters.

There’s also the possibility that other provinces will consider implementing a cap-and-trade system. New Brunswick has not ruled out a cap-and-trade system, but it has also not indicated that it would join with Nova Scotia in a common Atlantic marketplace.²⁵ Thus, it is possible that individual provinces will form their own cap-and-trade markets, further complicating compliance.

In addition, as previously mentioned, the use of both types of carbon pricing frameworks can lead to situations where a price is paid twice on carbon.  For example, the federal backstop will defer a carbon levy, where one is paid in another jurisdiction,²⁶ but under the proposed rules, it would not relieve an organization from the levy if it indirectly pays for the price of carbon in a cap-and-trade jurisdiction.

Another area of concern is in Manitoba, which will introduce its own carbon tax plan, where the tax will be $25 per tonne of CO₂ emissions starting in 2018, without any attempt to increase it by 2030, even though the federal government requirement will rise to $50 per tonne. In light of this fact, when there is a national review (starting in the fifth year of the implementation of the backstop),²⁷ what will happen? The federal government has indicated that it will use its framework to charge an additional amount to reach the desired goals (i.e., if the Manitoba tax remains at $25 per tonne once the federal requirement has reached $50 per tonne, there would be an additional federal tax of $25 per tonne). In essence, it is possible that Manitoba’s reluctance to bring the tax to $50 per tonne may lead to Manitobans paying two carbon taxes, and more tax overall, because the province’s initial tax rate will be much higher than the federal price. As a result, it is currently unclear what will happen in the event of that the federal government does not recognize Manitoba’s carbon tax plan as compliant with its pricing requirements. 

There are also concerns about provinces that have agreed to implement the backstop, but may create their own pricing policies going forward. As the backstop legislation is currently written, there is no clarity regarding transitional rules when a jurisdiction implements its own plan later on. To date, the federal government appears to be very lenient towards provinces implementing their own plans, especially if the provinces intend to switch to cap-and-trade systems.

Recommendations

It may have made more sense for the federal government to incentivize provinces and territories to harmonize with the backstop, rather than allowing them to maintain or implement their own carbon pricing frameworks. A harmonized system nationwide would simplify, if not eliminate, carbon tax self-assessment requirements, except for fuel imported into Canada, which could be dealt with at the border. It would also be easier to administer for multi-jurisdictional organizations. In addition, organizations that operate in several provinces would have fewer cash flow issues created by waiting for carbon tax refunds from various jurisdictions. Budget management would also be more fluid, as large operators would not have to worry about purchasing carbon allowances in different provinces. As the backstop intends to use the money raised for direct investment in the provinces where it is paid, negotiations with provincial governments to establish their own rates (approved by the federal government) may have been a compromise that provinces like Manitoba or Saskatchewan would have tolerated. 

At the very least, in lieu of harmonization, a federal backstop which discouraged cap-and-trade in lieu of a carbon tax may have been preferred. A cap-and-trade system may work well where it is the only system in place, but given the environment Canada presents for organizations, a carbon tax may ultimately work better, especially for those who operate across the country. A carbon tax is easier to budget and is simpler to administer than a complicated cap-and-trade system. While each system has its drawbacks, in a multi-jurisdictional environment, such as Canada, carbon taxes appear to be a more transparent, effective way of reducing emissions, with less headaches for both administrators and taxpayers.

George Tadross
Ryan
George.Tadross@ryan.com