Strategy

Canada in 2020 – Tax: The carbon equation

Rejecting a carbon tax for cap-and-trade is just bad policy.

With the economy teetering, it is not surprising that environmental concerns took a backseat to economic issues during the federal election campaign. One striking outcome of the likely Conservative win (at press time, the election was just days away) will be the death of the carbon tax, at least for the foreseeable future, given its clear denunciation by the prime minister.

Instead, Canada will eventually pursue a cap-and-trade system, with targets and variable prices charged on greenhouse-gas emissions to businesses and consumers, relief for some industries, and the auctioning of credits yielding huge sums of government revenue. This could turn out to be highly interventionist. But, with certain restrictions, cap-and-trade could mimic many features of a carbon tax.

Let’s recap what Canadians have clearly rejected (assuming the Tories don’t somehow manage a surprise defeat). The Liberals’ proposed Green Shift plan would restructure the federal fuel excise tax by keeping the 10¢-a-litre gasoline tax unchanged, which is equivalent to a carbon tax of $42 per tonne of carbon dioxide. The Liberals would then have phased in the carbon tax over four years, by applying it to the consumption of other fuel sources of greenhouse gases, including diesel (already taxed at 4¢ per litre under the federal fuel excise tax), home heating oil, natural gas and coal products at the utility and refining stages. When fully implemented, the carbon tax would have raised $15 billion for government on top of the existing $5 billion revenue from the federal fuel excise tax, but that windfall would likely apply only in the short run. In the longer run, consumers and businesses would shift away from the use of carbon-intensive product, resulting in lower carbon revenues.

Under the Liberal plan, the carbon tax revenue would have been used to reduce personal and corporate income tax rates by one percentage point (or 1.5 percentage points for the lowest tax bracket), and to provide offsets for those living in rural areas and for low-income Canadians. About $600 million would be also spent on green technologies annually.

The Liberal plan would have had some positive economic and environmental impacts, although both are difficult to estimate precisely. With a carbon tax, the cost of coal used for electricity would increase relative to natural gas and nuclear power production. Utilities would therefore shift from coal to natural gas (reducing emissions), and incentives beyond the recent hike in energy prices would be created to reduce fuel consumption. Of course, more emission reductions could have been achieved if a bigger share of the tax revenues were spent on carbon-reducing technologies.

So, the economic net effects of the Liberal carbon tax might have been positive, by shifting taxes from income to the consumption of fuel. However, the plan would also have spent several billions of dollars on anti-poverty measures and refundable credits, so the package would include a substantial redistribution of wealth rather than reducing the economic cost of taxation. In particular, marginal personal tax rates would change little for many low-income Canadians, since increased clawbacks of income-tested programs, such as the child tax benefit and GST credit, would have offset the rate cuts.

Now, of course, this doesn’t matter much: the Liberal proposal fell flat on its face. Many voters were concerned about the run-up in utility prices, without understanding the benefits of the various personal tax reductions. Energy-intensive businesses were likely to pay more in tax even after benefiting from the corporate rate reduction. Alberta, Nova Scotia and Saskatchewan rejected the tax package as unfair. Ontario, with its coal-fired electricity generation, was lukewarm. New Brunswick — whose government has also proposed a carbon tax as a source of revenue to pay for its major income-tax-cutting package — also had most of its residents reject the idea.

So where do we go from here?

With the Conservatives’ return to power, their Turning the Corner plan will be central to federal climate-change policy. The plan is regulatory, with specified targets for emissions based on “intensity,” defined as emissions relative to output. Unlike the Liberal plan, which was more comprehensive, the Conservative strategy focuses on emitters in selected industries. To avoid criminal prosecution, businesses will need to comply with regulations by either reducing emissions below target or paying a price for excess emissions. If they go the pay route, they can either contribute to a technology fund (beginning at $15 per tonne, later rising to $20) or buy domestic or international offsets. This last bit effectively makes it a cap-and-trade system, since businesses can buy offsets from the market. And eventually (after 2017), if they exceed emissions targets they can only purchase offsets.

The price of carbon offsets? That’s an unknown, and will depend on their availability to companies with excess emissions. As the targets become more bining, effective prices for carbon will rise. They will still be variable, and that will impose risk to businesses — especially those needing to make technology investments that will take a long time to implement. That’s why many businesses would have preferred a carbon tax.

In the meantime, the provinces are pursuing their own pricing mechanisms — including the B.C. and Quebec carbon taxes, the Alberta intensity-target-based carbon tax (oops, “levy”), and a possible cap-and-trade system that Quebec and Ontario have agreed to in principle but as yet have no idea how to implement. Whether these efforts have much impact on emissions remains to be seen. Given the inefficiencies arising from multiple and complex schemes, with all their exemptions, allowances, offsets and technology slush funds, we already know they will impose substantial costs on the Canadian economy.

Those costs will be passed on to consumers and businesses, despite the heroic and misleading claims by some politicians that only “dirty” companies will pay. Fred Thompson — who disappeared from the U.S. presidential race as quickly as the Green Shift disappeared from Canadian voters’ minds — said it well during the Republican convention in September: people understand that when business pays higher taxes, they end up hurt by lower salaries or higher prices for goods and services. (I wish Jack Layton and John Baird had listened more carefully.) Given that consumers and busnesses will face higher prices, no offsets will be provided unless the government further reduces taxes. But since this is a regulatory regime, the government will receive no revenue, and it will have little money in the bank to provide relief.

Meanwhile, south of our border, the competing presidential candidates both promise to introduce a cap-and-trade mechanism for carbon pricing that will likely be fashioned after a proposal made by senators Joe Lieberman and John Warner. The cap-and-trade system they introduced is chock full of distortions, along with a difficult-to-implement carbon tariff and the partial auctioning of allowances — which would yield the federal government trillions in revenue over the next decade. Lieberman-Warner is expected not to pass, but it does illustrate how complex a cap-and-trade system will be in the United States, including price caps to reduce variability in carbon prices. With both the auctioning of allowances and price caps, the cap-and-trade system starts mimicking a carbon tax after all.

Perhaps North America will come up with a common approach to carbon pricing through a cap-and-trade system. But it would be particularly worrisome to get a system that is highly intrusive in the economy and accomplishes little to reduce worldwide emissions. Given that the United States, China, Russia, Japan and India are responsible for more than half of global greenhouse-gas emissions, it is clear that actions taken only by North America and Europe will not have great effect. In fact, international co-operation is the key to the climate-change file. It is hard to see Canadians carrying out a lone mission if the rest of world cares little about the issue.

So the carbon tax is dead, and we will likely end up with a cap-and-trade system. In policy terms, that’s not a good choice. Hopefully, we won’t end up with a lose-lose “solution” that imposes substantial costs on consumers and businesses, while showing little for it in terms of global carbon reductions.