Reality bites carbon pricing scheme in Canada and beyond

If three key assumptions are not met, carbon pricing will always yield lower benefits than advocates suggest

By Jason Clemens
and Kenneth Green
The Fraser Institute

VANCOUVER, B.C. March. 9, 2017/ Troy Media/ – There’s a general, indeed a strong consensus, within the economic community that a properly designed carbon tax can both reduce emissions and improve the economy. We broadly agree with this academic analysis. The problem is that carbon taxes in the real world have to be implemented through a political system that deviates substantially from the academic ideal.

Economists tend to agree that the most efficient way to manage emissions is by placing a price on them that reflects the social costs of the emissions. By placing a price on carbon, emitting firms are incentivized to introduce emission-reducing technologies or change their production. In other words, the introduction of a price on carbon creates incentives for firms (and individuals) to respond to the social costs of emissions.

carbon pricing
Jason Clemens

Critically, however, there are several key assumptions necessary for this approach to be efficient. First, the introduction of a carbon price must replace, not be in addition to, existing regulations.

Second, revenues from carbon pricing (i.e. tax) must be used in their totality to reduce other more costly taxes such as marginal personal or business income taxes. The idea is that revenues from carbon pricing are used to reduce other more damaging taxes so there’s a net improvement in incentives for investment and entrepreneurship, which yield stronger economic growth.

Third, and related to the second, revenues from the carbon tax should not be used to subsidize substitutes (wind, solar or other alternative energies) for carbon-emitting activities since the whole point of introducing the price on carbon is to allow the market to determine the optimal substitutes.

No jurisdiction in or outside of Canada, including much-heralded British Columbia, meets these assumptions. No province or country has introduced an “ideal” carbon-pricing system and thus the benefits from it will necessarily be less than theory suggests.

No jurisdiction that introduced carbon pricing has eliminated the corresponding command-and-control regulations. Europe, California, and all of the Canadian provinces have retained most, if not all of their existing regulations after introducing carbon pricing.

carbon pricing
Kenneth Green

Moreover, no province or country has maintained revenue neutrality for carbon pricing. Perhaps the closest and certainly most talked about is B.C., which maintained revenue neutrality for the first five years of its carbon tax. However, beginning in 2013-14, B.C.’s carbon tax began generating revenues in excess of the legitimate tax offsets. Indeed, the government’s own projections indicate that the carbon tax will generate almost $900 million in net revenues over a six-year period.

Finally, many jurisdictions including Ontario specifically use carbon-pricing revenues to subsidize alternative energy sources such as wind and solar. Subsidizing energy substitutes such as wind and solar short-circuits the market process envisioned by carbon pricing advocates by having governments choose the “right” solution.

Further complicating the economics of carbon pricing are considerations regarding competitiveness and potential leakage. Specifically, adding a carbon tax means that the costs for firms in carbon-intensive industries such as agriculture, manufacturing, and resources are higher relative to their competitors with no such taxes. This creates incentives for firms to switch production from jurisdictions with carbon taxes to those without, which would damage the Canadian economy without providing any environmental benefit. This is made all the more poignant now that it’s clear the United States will not introduce a national carbon tax.

Our own federal government has mandated carbon pricing for all provinces by 2018. It’s imperative, therefore, that we understand the realities of carbon pricing as opposed to their theoretical possibilities. The politically altered carbon pricing observed in and outside of Canada including B.C.’s carbon tax will inevitably deliver lower benefits than the theoretical models predict or advocates suggest – and do real harm to the Canadian economy.

Jason Clemens and Kenneth Green are analysts with the Fraser Institute.

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