Selling Clean Air: Market Instruments for Climate Protection A Discussion Paper prepared for West Coast Environmental Law Research Foundation’s Selling Clean Air: market instruments for climate protection workshop October 15-16, 1998 Blue Horizon Hotel, 1225 Robson Street (at Bute) Vancouver, BC Prepared by Chris Rolfe, West Coast Environmental Law Research Foundation Table of Contents Executive Summary Introduction The Science and Economics of Climate Change What Is Climate Change and the Greenhouse Effect? What are the Benefits and Costs of Reducing Emissions? How do we reduce greenhouse gas emissions? How do we make all those changes happen? Introduction to Market Mechanisms for Greenhouse Gas Emission Reductions What are ‘market mechanisms’ for reducing greenhouse gases? How does a cap and emission allowance trading system work? How Does Credit Trading Work? How would a carbon tax or carbon allowance trading system work? How Would Municipal Trading Work? Combining Program Designs What do different programs mean for profits, competitiveness and community stability? The Greenhouse Gas Emission Reduction Trading Pilot Concluding Notes Executive Summary Human-induced climate change is one of humanity’s greatest challenges. Scientists predict that over the coming century climatic changes caused by our emissions of greenhouse gases will have drastic environmental consequences, yet these emissions are closely tied to much of our economic activity. On October 15 and 16, 1998, West Coast Environmental Law Research Foundation will host a workshop in Vancouver, BC, to discuss market instruments for climate protection. Day One will be a primer on climate change, emissions trading and other market instruments for reducing greenhouse gas emissions. Day Two will focus on how municipalities, environmental groups and independent power producers can generate greenhouse gas emission reduction credits and can potentially profit from carrying out emission reduction activities that have multiple social and environmental benefits. Human activities – especially the burning of fossil fuels – have increased concentrations of greenhouse gases in the atmosphere, and the balance of evidence suggests that human activities are having a discernable influence on global climate. This influence is predicted to grow steadily, causing major ecological and economic upheaval if major emission reductions are not made. In choosing the tools to combat climate change, it is important to understand the dimensions of the problem. First, over the long term we will need tools that can yield massive emission reductions. Under the Kyoto Protocol, Canada ¾ along with other industrialized nations ¾ agreed to reduce its greenhouse gas emissions. Canada agreed to a six percent reduction below our1990 emission levels during the period 2008 to 2012. While this target represents a substantial reduction from business as usual emissions for Canada, it is likely that Canada will need to pursue even deeper cuts over the longer term. Stabilization of atmospheric greenhouse gas concentrations at anywhere near today’s levels would require cuts in global emissions of over 60%. Ideally, the tools we develop to reduce greenhouse gases should be capable of realizing continual reductions. Second, the costs of reaching Canada’s Kyoto commitment are uncertain, but they will depend on government’s ability to choose tools that lead to low-cost reductions or reductions that are worth doing for reasons unrelated to climate change. Some studies suggest that Canada could reduce emissions by twenty percent below 1990 levels by 2010 through measures that would yield net economic benefits to society (known as no-regrets measures). Other studies suggest costs could be higher, with economic growth being slowed slightly (for instance, some of the most pessimistic studies suggest that, by 2020, the economy would only grow by 64% compared to 71% if we did nothing). A central difference between these studies is an assumption in the more pessimistic studies that all emission reductions have net costs compared to the assumption in other studies that many measures will have no net costs. The latter studies assume that emission reduction measures are often worthwhile because they reduce waste, improve air quality or increase efficiency. The extent to which these studies (i.e. major emission reductions at no net social cost) are borne out in reality will depend on the extent to which we can develop measures that reduce emissions and are worthwhile doing for other reasons. Finally, the tools chosen to reduce greenhouse gas emissions must affect a wide variety of behaviors and technologies. The measures necessary to reduce greenhouse gas emissions range from changes in how we produce electricity to changes in cattle feed; from home energy retrofits to more transit and more efficient cars. Almost all sectors of the economy have a part to play in climate change solutions. Most economists believe that market instruments are among the tools best suited to reducing greenhouse gas emissions. Market instruments to reduce greenhouse gases are mechanisms established by government which use market forces to encourage reductions in greenhouse gas emissions. A single instruments can create incentives throughout the economy to reduce greenhouse gas emissions through innumerable changes to technologies and behaviours. Market instruments can be designed to encourage continuous reductions in emissions. The theory of emissions trading assumes that by placing increased choice of control measures in the hands of emitters, emissions will be reduced at the lowest cost. While economists generally support market instruments, some economists warn that if market instruments focus purely on reducing greenhouse gas emissions at lowest cost, and do not cure existing problems in the marketplace, they may not lead to as many no-regrets emission reductions. For instance, the lowest cost greenhouse gas emission reduction measure for a specific company may be planting trees that absorb carbon dioxide, but another measure might be better from a societal viewpoint (because it not only reduces greenhouse gas emissions but also reduces local air pollution). Unless there are incentives to reduce local pollution, the company is more likely to choose the tree-planting option. Similarly, market instruments can be developed to discourage vehicle use, but they will not necessarily work well if there are few alternatives to the motor vehicle. Market instruments may be important, but few economists believe they are the complete solution. There are a number of different market instruments for reducing greenhouse gases. The attributes of these instruments are summarized in Table 1. The instruments include: * Carbon taxes. A tax is placed on the carbon content of fossil fuel. The tax would be highest per unit of energy for carbon intensive fuels such as coal and non-existent on renewable energy sources. The tax revenue collected could be used to reduce other taxes, to reduce the debt or fund programs that will help reduce emissions. Revenue could also be directed to ease the transition of companies who have the greatest difficulty in reducing their emissions or to communities that are adversely affected by the tax. Although a tax is a simple measure for government to implement and involves low administration costs, the political climate for new taxes (even if they involve no increase in the overall tax rate) is cold. * Cap and emission allowance trading. The government establishes a cap on total allowable emissions from defined sources during a defined time period. It then allocates allowances to emit greenhouse gases, with the total emissions permitted by all allowances being equal to the cap. Those sources that expect to emit less than permitted by their allowances may sell their surplus allowances to other sources whose emissions would otherwise exceed the allowances allocated to them. Over time, the number of allowances in circulation can be reduced and thus total emissions are reduced. Allowances can be auctioned or distributed free of charge based on historic emissions or some other formula. Allocating emission allowances is a contentious political process requiring significant government resources; however, once it is established, emission allowance trading creates a fairly certain way of reducing emissions with low administration costs for government and industry. The existence of a scheduled cap of emission reductions also creates momentum toward environmental goals. On the other hand, unless combined with credit trading, emitters will be unable to exploit many low cost emission reductions. * Credit trading. Credit trading is a means of reducing the costs of meeting regulatory requirement or voluntary target. If the owner of Source A is required by regulation to reduce emissions from that source by x tonnes/day, the owner can instead use credits generated by having Source B reduce its emissions by x tonnes/day below a projected baseline. Sources A and B may be different emission stacks within the same firm or completely different facilities with different owners. There are a number of advantages to credit trading. Credit trading theoretically allows all cost effective emission reductions to be exploited. The ability to generate and sell credits creates an incentive for third parties like municipalities and environmental groups to undertake no-regrets emission reduction projects and profit from selling credits. For instance, both municipalities and environmental groups have energy retrofit programs to reduce both emissions and energy bills. Finally, credit trading is an easy initial step for government. However, there are negative aspects to credit trading: reductions are likely less certain under a credit trading program; there are much higher administration costs involved in measuring emission reductions; and, unless credit trading is combined with a cap and trade system, reductions are dependent on government constantly increasing the stringency of regulatory standards. * Cap and carbon allowance trading. This program is similar to cap and emission allowance trading but acts in a manner similar to a carbon tax. Rather than trading an allowance to emit a given unit of greenhouse gases, allowances represent licences to produce or import carbon in fossil fuels. Since carbon in fossil fuels is a very close proxy for the carbon dioxide emitted by burning those fossil fuels, the limitation on carbon in fossil fuels reduces greenhouse gas emissions. In order to match demand for fossil fuels with a limited supply, importers and producers will charge a premium on carbon-based fuels. Because the premium amounts to a windfall profit from higher consumer fuel prices, for it to be socially acceptable, government will need to tax the premium back or auction allowances. Carbon allowance trading is relatively simple to implement and would likely achieve environmental goals with reasonable certainty. However, it creates no direct incentives for third parties to implement projects that realize no-regrets measures. * Municipal Allowance Trading. It is also possible that a nation such as Canada could allocate responsibility for greenhouse gas emissions among different sub-national governments. In particular, local governments could be responsible for greenhouse gas emissions from local residences, commercial buildings and urban transportation. Such a system would likely be combined with carbon or emission allowance trading so that municipalities which successfully reduce emissions from houses or urban transport could then sell allowances. Making municipalities responsible for emissions from buildings and transport is attractive because local governments – whether they be municipalities, regional governments or transportation authorities – are often in the best position to realize the no-regrets emission reductions from these sources. On the other hand, they are not able control some technologies and behaviours that affect these emissions. The final choice of market instruments for reducing greenhouse gas emissions will likely involve a mix of these basic program designs. Many studies have shown that industries seldom shift locations to jurisdictions with less stringent environmental standards, and some economists believe that environmental regulations may make industry more competitive. Nonetheless, climate policies may have negative as well as positive impacts on Canadian industry. The impacts of market instruments on the competitiveness of Canadian industries depends less on the type of instrument chosen (e.g. carbon tax or emission allowance) and more on how an instrument is implemented. For instance, a carbon tax or auctioned emission allowances will inevitably lead to higher costs for large greenhouse gas polluters, but how the revenue from a tax or auction is spent will determine the overall costs faced by a firm. Revenue could be used to reduce income taxes (encouraging clean industries to locate in Canada) or pay for investments in transit, but a portion of revenue could be used to compensate industries that have no low-cost way of reducing emissions. If a credit trading program is not combined with stringent emission standards for all polluters it may lead to windfall profits for those companies who can reduce emissions cheaply and higher cost burdens on those companies or sectors that cannot reduce emissions easily. But the credit trading program may be more equitable if all companies are subject to relatively stringent standards. Market instruments could affect decisions of industry and business regarding whether to locate in Canada. If revenues from a carbon tax or allowance auction are used to reduce income taxes or payroll taxes they could encourage businesses to expand production here. On the other hand, these same instruments might make energy intensive industries uncompetitive if a portion of the revenue isn’t redirected to them. For faltering companies or plants, these policies may be enough to cause them to shut down. Allocating allowances on a historic emissions basis could also have an effect on energy intensive industries – essentially rewarding companies for decisions to shift production elsewhere. As Canadian climate change policy evolves it is important for the public to understand and participate in the choices being made. The purpose of West Coast Environmental Law’s workshop is to raise awareness about market instruments and the issues surrounding the choice of instrument. Table 1. Summary of Trading Systems Cap and Emission Allowance Trading What is traded? Emission allowances. Allowances represent a licence to emit a given tonne of carbon dioxide (or equivalent). May be tradable with emission allowances or municipal allowances. Cause of emission reductions? Cap on total allowable emissions. What determines distribution of costs? If allowances are auctioned distribution of costs determined by manner in which tax revenue is used by government. If allowances are allocated free of charge, distribution of costs determined by who receives free allocation. Cap and Carbon Allowance Trading What is traded? Carbon allowances. Carbon allowances represent right to import or produce a tonne of fossil fuel carbon. May be tradable with emission allowances or municipal allowances. Cause of emission reductions? Cap on total fossil carbon used. What determines distribution of costs? Manner in which tax revenue is used by government. Municipal Allowance Trading What is traded? Municipal allowances. Allowances representing right of local government to permit emissions from their residential, commercial or transportation sector. (May be tradable with carbon allowances or emission allowances). Cause of emission reductions? Cap on total emissions. What determines distribution of costs? If allowances are auctioned distribution of costs determined by manner in which tax revenue is used by government. If allowances are allocated free of charge, distribution of costs determined by who receives free allocation. Credit Trading What is traded? Credits for an emission reduction from a projected baseline. Cause of emission reductions? Stringency of emission reduction standards, threat of regulation; corporate voluntary commitments. More stringent regulations needed to maintain cap. What determines distribution of costs? Stringency of emission reduction standards. Carbon Tax What is traded? Tax represents price of right to emit greenhouse gases, right traded from government to fossil fuel distributors to consumers. Cause of emission reductions? Increased price of fossil carbon based fuels. Increases in tax necessary to maintain cap. What determines distribution of costs? Manner in which tax revenue is used by government. Introduction On October 15 and 16, 1998, West Coast Environmental Law Research Foundation is hosting a workshop in Vancouver, BC, to discuss market instruments for climate protection. Day One (October 15) will provide participants with a broad overview of market instruments and the issues surrounding the appropriate choice of market instruments. A series of speakers from across Canada and the US will provide an overview of the climate change issue, and an introduction to market instruments. The workshop will examine trading in the real world and discuss the implications of different instruments on competitiveness and communities. Day Two (October 16) is focused on credit trading, Canada’s Greenhouse Gas Emission Reduction Pilot, and the potential for businesses, municipalities or environmental groups to profit from projects that reduce greenhouse gas emissions. After a general discussion of credit trading, speakers will discuss the nuts and bolts of generating emission reduction credits. Participants will be given an opportunity to discuss their own emission reduction project ideas with other participants and experts. A separate paper describing the Greenhouse Gas Emission Reduction Pilot will be provided to those participants registered for Day Two. The following groups will be interested in attending Selling Clean Air: * interested citizens; * municipal politicians and local government staff; * environmental groups; * independent power producers; * social activists and labour groups; * industry and large scale service providers; and * university and college students. This discussion paper has been prepared by West Coast Environmental Law Research Foundation for workshop attendees and will be made available on the internet. It is intended to be a frank and objective assessment of different trading systems. The views represent the views of the author and are not shared by all those involved in these issues. The Science and Economics of Climate Change What Is Climate Change and the Greenhouse Effect? Life as we know it is dependent on the "greenhouse effect" created by the earth’s atmosphere. Solar radiation passes through the atmosphere and heats the earth’s surface. This heat is then re-radiated in the form of infrared radiation. Some of it escapes to space. Some of it is captured by greenhouse gases such as carbon dioxide, methane, water vapour, and nitrous oxide. Without the greenhouse effect, the earth would be far colder than it was at the height of the deepest ice age. However, human activities – especially the burning of fossil fuels and deforestation – have increased the concentrations of greenhouse gases in the atmosphere. According to the international body of scientists that advises the UN, the balance of evidence suggests that human activities are having a discernible influence on global climate. The earth’s average temperature has already increased by between 0.3°C and 0.6°C since the late 19th Century. Scientists predict that, if strong policy actions are not taken, average global temperature will increase by between 1°C and 3.5°C between 1990 and 2100 with the best estimate being a 2°C increase. These numbers may seem low, but the Earth today is only four degrees warmer than at the height of the ice age 20,000 years ago, a time when glacial ice covered Vancouver along with most of Canada. Climate change means not only warming, but also sea level change, increased storm activity, more extreme droughts in some areas and more extreme floods in others. Climate change’s predicted impacts include massive changes in ecosystems, extinction of many species that cannot adapt to rapid climate changes, impacts on agricultural production (especially in countries where most of the world’s poor and hungry are located), inundation of large areas of some countries, and the spread of diseases such as malaria far beyond their current ranges. But isn’t the science of climate change uncertain? Predictions of future climate change are based on models that reflect the best scientific understandings, but climate is the product of a bafflingly complex array of factors that scientists do not fully understand and will not fully understand for many decades. The uncertainties associated with climate change do not justify inaction, but instead provide compelling reasons for reducing the risks we are imposing on ourselves and the globe. Scientists’ predictions of climate change are based on ‘linear models’ where climate reacts to increased greenhouse gases in a relatively predictable manner. But climates in the past have switched radically from one system to another in very short periods. There is a possibility that increased greenhouse gas emissions could trigger such a radical "surprise event" once again. Surprise events could occur with little or no warning and could have devastating consequences for human societies and nature. Perfect knowledge of impacts will only exist after we have, through inaction, committed ourselves to those impacts. What needs to be done to reduce the risk of climate change? Under the international climate agreement negotiated in Kyoto, Canada is required to reduce emissions by six percent below 1990 levels during the period 2008 to 2012. Most other industrialized countries are subject to similar targets. The US is required to reduce emissions by seven percent and the EU by eight percent. While these targets represent substantial reductions from business as usual emissions, it is likely that Canada and other industrialized nations will need to pursue even deeper cuts over the long term. Because climate change is caused by the total pool of greenhouse gases in the atmosphere (atmospheric concentrations), and because humans are adding to that atmospheric pool at a far higher rate than nature is removing greenhouse gases, stabilizing the climate will require emission reductions far below the targets set for developed countries in the Kyoto Protocol. Immediate stabilization of greenhouse gas concentrations at today’s levels would require an immediate 60% reduction in global emissions. Given the impossibility of reducing emissions immediately by 60%, our goal must be to work toward an acceptable atmospheric concentration level. But global emissions might nonetheless need to be reduced to less than half of 1990 levels. Canada is one of the world’s highest per capita emitters of greenhouse gases, and we will likely, as part of any reasonable global strategy, be required to reduce emissions much more than the global average. This means that the emission reductions required by Kyoto are just a beginning for Canadians and we will need to continue to reduce greenhouse gas emissions after 2012. The instruments to reduce greenhouse gas emissions must be developed with the need for major long term emission reductions in mind. What are the Benefits and Costs of Reducing Emissions? Aside from the benefit of reducing the risks posed by climate change, many of the measures that will reduce greenhouse gases are worthwhile pursuing for reasons unrelated to climate change. For instance: * Measures to improve energy efficiency can, by reducing energy costs, save consumers and businesses money. * Many measures to reduce air pollution also reduce greenhouse gas emissions. * Measures that spur development of energy efficient and renewable technologies in Canada can contribute to Canadian exports. * Removal of subsidies to energy intensive industries and fossil fuels can make the economy more efficient and reduce the tax burden on other industries. * Measures to reduce greenhouse gas emissions by decreasing reliance on automobiles are often worthwhile because decreased traffic congestion can improve the quality of life in urban areas. The Canadian Options for Greenhouse Gas Emission Reductions (COGGER) report, prepared under the auspices of the Royal Society of Canada, concluded that Canada could achieve a twenty percent reduction in emissions by 2010 through measures that would yield net economic benefits to society (no-regrets measures). The COGGER report was based largely on ‘bottom up’ analyses which consider the myriad of market failures – consumers not having necessary information, failure of prices to reflect environmental costs, businesses’ lack of access to financing for profitable energy efficiency changes, preferences of politicians and industries for inefficient megaprojects over relatively mundane energy efficiency, etc. – that prevent no-regrets emission reductions. Bottom up analyses assume that market failures can be cured and no-regrets measures realized through changes to government policy and programs. Other economic analyses – so called ‘top down studies’ – assume there are no no-regrets measures, and, not surprisingly, often suggest that greenhouse gas emission reductions could be relatively expensive. For instance, one economic model developed for the American Petroleum Institute predicts that the Canadian economy would decline below projected baseline growth (growing only by 64% rather than 71%) by 2020 if Canada and other industrialized nations reduce emissions ten percent below 1990 levels. Other studies suggest that climate change policies may slow economic growth during a five to ten year transition period but the economy will be stronger in the long run. The existence of market failures and the potential for no-regrets measures has relevance in the choice of instruments for greenhouse gas emissions. Some policy instruments may be better suited to achieving emission reductions through no-regrets measures, and may thus be best able to achieve emission reductions that have the greatest net benefits to society. How do we reduce greenhouse gas emissions? The sources of greenhouse gases are ubiquitous: carbon dioxide from burning logging slash; methane from rotting garbage in landfills and cattle production; nitrous oxide from fertilizers; perfluorocarbons from aluminum smelting; and carbon dioxide from cement manufacture. But Canadian and global emissions are dominated by one source: fossil fuel combustion and its inevitable byproduct, carbon dioxide. In Canada, 85% of our emissions are from fossil fuel production and consumption. Because the greenhouse gas carbon dioxide is an inevitable byproduct of fossil fuel combustion, reducing dependence on fossil fuels in essential to curbing greenhouse gas emissions. To effectively reduce greenhouse gas emissions will require myriad changes in behavior and technologies: use of more efficient engines and motors in industry, homes and automobiles; switching from carbon intensive fossil fuels such as coal to low carbon intensive fuels such as natural gas or renewable energy sources such as wind; improved insulation in homes; and, greater use of transit. How do we make all those changes happen? There are numerous steps that governments can take to cure market failures and help ensure adoption of no-regrets measures. For instance, government can adopt energy efficiency standards that overcome consumers’ poor understanding of the cost savings from energy efficiency; invest in transit; require municipalities to curb inefficient urban sprawl; and, educate municipalities on the benefits of capturing methane from landfills. However, most economists agree that market based policies are essential to reducing greenhouse gas emissions. Introduction to Market Mechanisms for Greenhouse Gas Emission Reductions What are market instruments for reducing greenhouse gases? Market instruments for reducing greenhouse gases are mechanisms established by government which use market forces to encourage reductions in greenhouse gas emissions. A single instrument can create incentives throughout the economy to reduce greenhouse gas emissions through innumerable changes to technologies and behaviours. The theory of market instruments assumes that by placing increased choice of control measures in the hands of emitters, emissions will be reduced at the lowest cost. Market instruments for climate protection include emissions trading and carbon taxes. Under emission trading programs, individual polluters are given flexibility in how to reduce their emissions. Where an emitter can, at a low or negative cost, reduce emissions or energy use beyond what is required by regulation they can sell an emission reduction credit or an emission allowance to a polluter who cannot reduce their emissions as easily. The purchaser of the credit or allowance is then allowed to emit more. Trading is not intended to reduce emissions, it is intended to reduce the cost of meeting a government imposed limit on emissions or a voluntary corporate commitment. Under a carbon tax, a tax is placed on the carbon content of fossil fuel. The revenue can be used to reduce other taxes, to reduce the debt or fund increased program spending. The tax would be highest per unit of energy on carbon intensive fuels such as coal and non-existent on renewable energy sources. Changes to the prices of energy will be reflected in prices for products. Energy providers have an incentive to switch to renewables, manufacturers to switch to more efficient production processes, and consumers to switch to products which consume less energy, especially fossil fuel energy, in their manufacture and use. Why are market instruments important? Market instruments – whether trading or carbon taxes – are essential to the long term reduction of greenhouse gases for a number of reasons: * Reducing costs. Theoretically, market instruments should reduce emissions at the lowest possible costs. The market will often be more effective than government regulators in locating least cost emission reductions. * Achieving greater reductions in the long run. While the advantages of market instruments are often described as being purely economic, they are also environmental. Reducing the costs of emission reductions is essential to overcoming political opposition to further emission reductions. * The incentive to innovate. Market instruments can create an economy wide economic incentive to innovate in ways that reduce greenhouse gases. This is particularly important in the context of greenhouse gases, where there is a need for technological innovations across the economy and where technological change and innovation are essential to dramatic reductions in emissions over the next century. * Responsibility for finding solutions is shifted to those closest to the problem. Strategies to reduce emissions through regulations that prescribe a particular technology or emission rate encourage businesses to exaggerate the cost of emission reductions so that they can avoid stringent regulations. Government is usually at a disadvantage in determining whether a business can cost effectively reduce its emissions. It does not have the same understanding of an emitters’ needs and opportunities as does the actual emitter, and it cannot easily separate gross exaggerations from valid concerns. Market mechanisms shift the onus of finding most cost-effective emission reduction measures from government to the private sector. * Flexibility in who pays for reducing emissions. Market instruments separate the issue of who pays for emission reductions and where they occur. Carbon taxes and some forms of emissions trading can be designed to reward non-polluting industries so that they are more competitive. Or they can spread the cost of emission reductions equitably across many sectors even if reductions are concentrated in a few areas. How would an emissions trading system work? There are innumerable permutations in how an emissions trading systems could be designed, but there are essentially four basic forms of trading that could be used to reduce greenhouse gas emissions. Any actual program is likely to combine these forms. The four forms are: * Credit trading. Credits are an alternative to complying with a prescriptive standard. If the owner of Source A is required by regulation to reduce emissions from that source by x tonnes/day, the owner can instead use credits generated by having Source B reduce its emissions by x tonnes/day below a projected baseline. Sources A and B may be different emission stacks within the same firm or completely different facilities with different owners. Credit trading can also be used to reduce the costs of companies meeting voluntary emission reduction commitments. * Cap and emission allowance trading. The government establishes a cap on total allowable emissions from defined sources during a defined time period. It then allocates allowances to emit greenhouse gases, with the total emissions permitted by all allowances being equal to the cap. Those sources that expect to emit less than permitted by their allowances may sell surplus allowances to other sources whose emissions would otherwise exceed the allowances allocated to them. Over time, the number of allowances in circulation can be reduced and thus total emissions are reduced. * Cap and carbon allowance trading. This program is similar to cap and emission allowance trading but acts in a manner similar to a carbon tax. Rather than trading an allowance to emit a given unit of greenhouse gases, allowances represent licences to produce or import carbon in fossil fuels. Since carbon in fossil fuels is a very close proxy for the carbon dioxide emitted by burning those fossil fuels, the limitations on carbon in fossil fuels reduces greenhouse gas emissions. In order to match demand for fossil fuels with a limited supply, allowance holders will charge a premium on carbon based fuels. This could mean added costs to consumers and windfall profits for fossil fuel producers. In order to be socially acceptable, government would need to either tax this windfall back from allowance holders or auction allowances, and use the revenue to reduce other taxes or invest in government programs and transition strategies. * Cap and trading between governments. It is also possible that a nation such as Canada could allocate responsibility for greenhouse gas emissions among different sub-national governments. These governments could then use their own regulations and planning powers – possibly even their own economic instruments – to limit their emissions under their jurisdiction. Although it is possible that this could be used to allocate responsibility among provinces, this paper considers only one scenario – making local governments responsible for greenhouse gas emissions from local residences, buildings and urban transportation. Each of these programs represents a distinct approach to emissions trading, and each has its distinct advantages and disadvantages from both economic and environmental perspectives. Before discussing possibilities for combining these basic approaches we will discuss each of the above separately. Why would a company want to trade? Emissions trading is not intended to reduce emissions. It is intended to reduce the cost of achieving a particular environmental goal. The main driver for emission reductions is the existence of regulations which require emission reductions. A company’s incentive to purchase credits or allowances is that the buyer can use the credits or allowances as an alternative to complying with relatively expensive regulations. In several pilot credit trading programs (such as the Greenhouse Gas Emission Reduction Pilot Project) the incentive to trade is the likelihood that credits approved under the program will be useable in future regulatory programs. Because greenhouse gas emissions are currently unregulated, emission reductions in a trading system will depend on the perceived threat of future regulation and the development of new regulatory standards. Just a license to pollute? Emissions trading is sometimes criticized as involving "licenses to pollute." This is true. Allowances in a cap and emission allowance trading system are licenses to pollute. Allowances in a cap and carbon allowance trading system are licenses to sell polluting substances. Valid credits in a credit trading system are licenses to pollute above regulated levels. However, in a cap and trade system, there is only a limited number of licenses to pollute. In comparison, greenhouse gas emissions are currently unlimited: no licenses are necessary. Moreover, our current methods for preventing other types of pollution -- government regulations or government-issued waste management permits -- are also licences to pollute up to a certain amount. The difference in a trading system is that the licenses can be traded. How does a cap and emission allowance trading system work? Under cap and emissions allowance trading programs the government establishes a cap on total allowable emissions from defined sources during a defined time period. For instance, government might cap emissions from large industrial and power generation sources at 190 megatonnes for the year 2003, 188 megatonnes for 2004, gradually reducing the cap to 160 megatonnes by 2012. Because of difficulties including small sources and sources which can not be easily measured, a cap and allowance trading program would likely be restricted to power generation and carbon dioxide from large industrial sources, thus capturing about 30% of Canadian emissions. Who receives the right to pollute? Once government has set a cap on total emissions it must either give or sell emission rights to polluters. The total emissions permitted by all allowances must be equal to the cap. Allocation is an inherently contentious political process with significant economic implications. The rules for allocating allowances will determine how the costs of emission reduction are shared. Indeed, the difficulty of settling allocation issues in a cap and emission allowance trading program is a major drawback to allowance trading. There are a variety of different methods by which allowances could be allocated. Three of the most commonly discussed methods are allocation based on emissions in a historic year, allowance auctioning, and allocation based on annual production levels. Giving away emission allowances based on how much a company emitted during a particular year is generally popular with large emitters because they are given a valuable asset (a license to emit) free of charge. The companies overall cost of emission reductions will likely be far less. However, it also punishes companies who have invested in energy efficiency and renewable technologies. For instance, BC Hydro would receive very few emission allowances because most of its generation is from hydro sources. If it meets future energy requirements by using natural gas (likely the lowest cost source of new generating capacity) it will need to buy allowances from other sources. On the other hand, a large emitter who is able to reduce emissions cheaply would enjoy a windfall profit. For instance, a coal fired utility might be able to shift from coal to less carbon intensive natural gas at very low cost allowing it to sell excess emissions. Allocating emission allowances based on historic emissions is also problematic as it will create barriers to establishment of new industries (if they have any emissions) and could encourage large emitters to close and relocate to other jurisdictions. Auctioning allowances to emitters would allow government to raise new revenues which could be used to reduce taxes. This may in turn make some sectors of the economy – those with low emissions per unit of output – more competitive as their taxes can be reduced. However, unless the auction revenue is recycled back to industries who cannot easiliy reduce emissions, the revenue will make large emitting facilities less profitable. Another method of allocation is to give allowances away based on how much a company produces in a year. Government would require large emitters to estimate their production levels in the next year. Emission factors would be applied to the estimated production levels to determine the firm’s allocation for that year. For instance, a steel mill might receive an allocation of two tonnes of carbon dioxide for every tonne of steel it expects to produce. If the combination of emission factors and estimated production levels result in emissions that are higher than the overall cap, all emission factors would be reduced by an equal percentage in order to maintain the cap. At the end of the year a "reconciliation" of estimated and actual production levels would be necessary, so that firms would have no incentive to overestimate or underestimate production levels. Such a system could apply across many sectors or might be limited to a few sectors with high emissions per unit of production (e.g. steel, oil refining, pulp, smelting etc.) This system would have the advantage that firms are rewarded for increasing rather than decreasing or closing down production, and there are no disproportionate barriers to new facilities starting production. On the other hand, it would be very hard to develop emission factors that do not result in transfers of wealth from one industry or firm to another, and the more emission factors reflect differences in energy needed to produce different products, the more they will tend to reduce incentives to shift industrial production to less carbon intensive products. Monitoring and enforcement An emission allowance trading programs would require changes to the Canadian regime for enforcement of environmental laws. A combination of continuous, tamper-proof monitoring systems and automatic penalties for non-compliance can create a system that, once established, is extremely efficient and puts few demands on government resources. In the absence of these measures, a cap and emission allowance trading program may prove less environmentally effective and require greater government enforcement resources. Has emission allowance trading worked elsewhere? Cap and emission allowance trading programs have been used in several US jurisdictions for reducing local or regional pollutants. The US trading program for sulphur dioxide has been successful in significantly reducing sulphur dioxide emissions from utilities at a much lower cost than was initially anticipated. The sulphur dioxide program was difficult to establish, but once established, it proved to be very cost effective. A major drawback to emission allowance trading programs is that, in order to appease competing firms’ demands for allowances, government may initially create a cap that is significantly higher than actual emissions. This can delay the timing of real emission reductions. In the Los Angeles area a cap and emission allowance trading program was established for oxides of nitrogen and sulphur dioxide from major point sources. Because of the political desire to appease various polluters, the cap was initially set at a level higher than actual emission levels from the sources within the cap. Critics believe emission reductions would have been faster if the local air quality district had stuck to its plan to reduce emissions through prescriptive standards. Supporters of the trading program believe that improvements to air quality from prescriptive standards would have likely been delayed by lobbying from industry. They argue that the momentum toward emissions reduction is greater under the allowance trading program. Pros and cons of allowance trading Although many of the pros and cons of emission allowance trading programs depend on the details of program design, their advantages and disadvantages can be summed up as follows: Pros * A definitive cap is established on emissions from sources within the scope of the program. * A schedule of cap reductions creates a momentum in favour of reducing emissions that is far greater than exists in a program dependent on perpetually making a wide variety of regulatory standards more stringent. Experience shows that the speed of cap reductions can be accelerated in allowance trading programs. * If cap and emission allowance trading programs use automatic monitoring and enforcement mechanisms they are likely to be very effective. * Once established, the costs of running an allowance trading system, both for government and participants, are very low. Cons * The design of an allocation method will be politically contentious and, depending on what method is used, may require considerable administrative resources and time. * Many low cost projects cannot be used to reduce emitter’s compliance costs because they fall outside the range of a cap and emission allowance trading program. How Does Credit Trading Work? Although credit trading programs can be designed in a number of different ways, most proposals for greenhouse gas credit trading are along the following lines: generators of credits (i.e. implementers of emission reduction projects) make estimates of business as usual baseline emissions and then measure actual reductions from those baselines. Credits are denominated in tonnes of pollutants reduced. A company that exceeds government imposed limits on its emissions can stay in compliance with the law by applying one or more tonnes of credit against every tonne of excess emissions. In a credit trading program emission reductions occur because government sets emission limits on companies. This contrasts with a cap and emission allowance trading program where emission reductions occur because of the cap on emissions. Improvements in emissions require government to set a variety of performance standards or corporate emission limits. Industry in Canada has also argued that voluntary commitments can propel emission reductions if government makes a clear commitment to crediting early emission reduction actions. The environmental community has been generally skeptical of this claim, noting the general failure of current voluntary challenges to reduce emissions. How is the validity of credits checked? Programs can be designed in a number of ways to ensure credits represent real emission reductions. In some programs, emission reductions can only be based on detailed government approved protocols and credits must be approved before they are used. While this ensures some government oversight, there is also a very real risk that short staffed government agencies will approve credits that might not stand up to more rigourous analysis. The alternative is to give generators flexibility in developing their own protocols and not require approval of credits prior to use. Instead, credits can be audited after they are used. In such cases it is essential that audits be a meaningful threat. There must be a mechanism whereby credits based on defensible but not sufficiently conservative protocols can be invalidated. Are all emission reductions equal? The need to measure emission reductions and set baselines with a reasonable degree of accuracy may place limits on what emission reduction activities are attractive under a credit trading program. For instance, a municipality might be able to establish bicycling infrastructure, adopt land use measures that support energy efficiency, and establish waste reduction programs. All of these measures will have greenhouse gas emission benefits. But quantifying these benefits is difficult and it may be impossible for a buyer or government agency to independently verify the quantification. So long as emission reductions are difficult to quantify or verify they will be worth less than other reductions, thus placing a real limit on the attractiveness of such reductions. Setting baselines and additionality One of the most contentious aspects of baseline setting is how to reflect the chances that a credit generating emission reduction project would have occurred without the incentive of being able to sell credits. An emission reduction project is additional if the incentive of being able to sell credits from the project was essential to making it happen. Use of credits for compliance will only be as environmentally effective as strict compliance with regulations if the credits represent emission reductions from additional projects. The problem of baseline setting is particularly acute in credit trading systems because there are no limits on who can claim a credit for an emission reduction. A company wanting to exceed its emission limits can shop the world looking for emission reductions that would have occurred anyway and use these to meet their limits. In comparison, under a cap and emission allowance trading system, there is a good chance that some emitters will be able to sell allowances due to non-additional emission reduction projects. However, the number of non-additional projects is limited by the number of sources in the trading program. Unfortunately, it is very difficult to definitively determine whether or not a project would have occurred in the absence of trading (some groups such as Pembina Institute for Appropriate Development are grappling with this issue). The problem is that there are many greenhouse gas emission reduction projects that are not happening even though they are worthwhile for reasons unrelated to climate change. Rejecting all projects which are profitable or should be happening for other reasons would lead to the rejection of many of the projects that society should be focusing on. Alternatives to determining additionality are to either discount credits, recognizing that some credits will come from non-additional project; set very stringent baselines that reflect best within a sector; or, set more stringent emission limits where credit trading is an option to compliance. Leakage Measuring emission reductions will often be difficult because of leakage – the indirect effects of a project on emissions elsewhere. Switching a pulp mill from using coal to electricity will lead to an easily measured reduction in emissions at the pulp mill. However, it will also be necessary to consider how new, additional demands for electricity are met (i.e. what is the marginal source of electricity). This is often a difficult question as the marginal sources for electricity might be very different from the average source of electricity. In turn, if the electricity is produced by natural gas combustion it will be necessary to consider emissions associated with increased production of natural gas. Considering these sorts of factors is difficult but essential for the effective working of a credit trading system. Pros and cons of credit trading Credit trading has a number of distinct pros and cons: Pros * Easily implemented. Credit trading is easily implemented as an interim measure, before government decides on an overall strategy. Regulatory standards — the driver of environmental improvement in a credit trading program — can be implemented piecemeal. Although many basic issues will need to be settled early on, acceptable protocols for setting baselines and measuring leakage can be developed and refined over time. * Most adaptable to different regulations. Credit trading can give added flexibility to a broad variety of regulations. For instance, automobile manufacturers could use credits to reduce costs of complying with fuel efficiency standards. For some types of regulation, credit trading may be the only viable way of giving industry flexibility. * Potential to realize lowest cost emission reductions is theoretically larger. Credit trading may have greater cost saving potential than its alternatives because, theoretically, any possible emission reductions may be used to generate credits. For instance, while it would be difficult to include landfill gases in the scope of an emission allowance trading program, a landfill methane recovery project could easily be a generator of credits. * Incentives for third parties to overcome barriers to no-regrets solutions. Credit trading programs create incentives for third parties to overcome the barriers to no-regrets emission reduction measures. Under some market mechanisms there are few direct incentives for a third party to cure market failures. For instance, a carbon tax would encourage car pooling or home energy retrofits by increasing energy costs, but there would be no direct incentive for a third party to set up car pooling systems or energy retrofit programs that help overcome barriers to these no-regrets measures. Under a credit trading program, a third party that sets up car pools or energy retrofits may be able to sell credits that flow from their emission reduction projects. Cons Credit trading also has a number of drawbacks. * May reduce environmental effectiveness of a particular regulation. Credit trading can reduce the effectiveness of a particular regulatory standard if credit is given for non-additional projects; if emission exceedances or emission reductions are estimated inaccurately; or, if a credit generation projects lead to leakage. Uncertainty as to the additional emission reductions achieved by a specific project is inherent in credit trading. * Higher transaction costs. Administration, enforcement and transaction costs are higher in a credit trading program than its alternatives. This may negate some or all of the cost effectiveness provided by a potentially unlimited range of emission reduction opportunities. * Difficulty quantifying or verifying emission reductions may limit emission reduction activities. While the sources of credits are theoretically unlimited, they may often be limited by the need to verify or quantify reductions. For instance, the emission reductions from trip reduction programs, involving numerous sources and numerous individuals’ behaviour, are difficult to quantify. * No cap on emissions is created and emission reductions are dependent on constant increases to the stringency of regulation. Reducing emissions requires government to continually make emission standards more stringent. Even if caps are placed on existing polluters, new emitters will come into being. This will require ongoing political will to impose tougher standards. There is the risk that governments will defer the political pain of increasing the stringency of standards, choosing instead to believe in overly optimistic projections as to the efficacy of its trading program. This could lead to Canada defaulting on its emission targets. * Large numbers of non-additional emission reductions may slow progress. Progress in achieving reductions may be slowed because of credit for non-additional projects. If a sufficiently large number of credits from non-additional projects are available, initial regulatory actions to reduce emissions may be less effective in achieving Canada’s reduction targets. * Emission reduction burden more likely to shift unfairly to some sectors or companies. All market instruments have distributional impacts, affecting some companies or sectors negatively and others positively. However, in systems other than credit trading, fair "burden sharing" tends to be a part of overall system design. This is not the case with credit trading where burden sharing is dependent on setting standards that are developed piecemeal. Large emitters who can reduce emissions cheaply and are not subject to stringent standards may be able to make windfall profits by selling emission reduction credits. Under other forms of trading the issue of burden sharing is part of an overall strategy, and it is more likely that burdens and benefits will be shared equitably among sectors. For instance, in carbon allowance trading system government can decide to use auction revenue to ease transition of some companies or to ease the challenges of reducing passenger transportation emissions. In an emission allowance trading program, government can decide on allocations that they expect will be fair to all sectors. * Enforcement very difficult. Where credits are generated by a third party working to overcome barriers to no-regrets emission reduction and aggregating a number of small emission reductions (e.g. through trip reduction programs, home energy efficiency programs), enforcement becomes difficult. While it is relatively easy for an enforcement officer to verify that an industrial plant does not exceed maximum allowable rates, it may often be more difficult to verify credit generating activities at a variety of remote locations. * Current enforcement system not suited to making difficult judgments. Our current enforcement system for environmental laws is suited largely to making determinations of non-compliance where someone is clearly breaching a legal standard. In the case of credits, the validity of a baseline is a difficult matter of judgement. New mechanisms need to be in place for ensuring that baselines are the best estimates possible and for ensuring that credits can be discounted or invalidated where there is a reasonable doubt as to the baseline. How would a carbon tax or carbon allowance trading system work? Both cap and carbon allowance trading and carbon taxes work by increasing the prices paid for fossil fuels – especially high carbon fuels like coal – and thus provide an incentive to reduce energy use, switch to renewable energy sources or low carbon sources like natural gas. How would a carbon tax work? A carbon tax works by placing a tax on units of carbon contained in fossil fuels. Because some fossil fuels contain more carbon per unit of energy, they would be relatively more expensive sources of energy as compared to energy from renewable sources or less carbon intensive sources. For instance, if the tax were set at $25 per tonne of fossil carbon, natural gas consumers would pay an additional $338 for every terajoule (about $13 per thousand cubic metres), while consumers of sub-bituminous coal would have to pay $638 per terajoule, or about $12 per tonne of coal. Consumers of wind based energy would pay no premium. How would carbon allowance trading work? In a carbon allowance trading system participants trade in rights to distribute, or rights to produce and import, fossil carbon. A cap and carbon allowance trading program would capture emissions from millions of small emitters who are hard to include within other trading programs. While an emissions allowance trading program for large point sources can probably only capture about a third of Canadian emissions, a cap and carbon allowance trading program would directly control over 74% of Canada’s greenhouse gas emissions, indirectly control many non-carbon dioxide emissions associated with fossil fuel combustion. And, as noted below, it could be expanded to cover a number of other sources. The limited supply of carbon allowances would allow producers and importers to charge a premium to their customers so that demand for fossil fuels does not exceed the limited supply. The premium will be higher for more carbon intensive fuels. To be socially acceptable, most or all of the windfall revenue from the premium would need to be captured by government. Government can capture the premium by auctioning allowances or taxing allowance holders. The effect of a carbon allowance trading program is very similar to that of a carbon tax or an emission allowance trading program in which allowances are auctioned. The essential difference between a carbon tax and carbon allowance trading is the parameter regulated by government. In a carbon tax government places a set tax on fossil carbon, and the market sets the emission reduction. In a carbon allowance trading system government specifies the emission levels and the market sets the premium. The carbon allowance trading system has the advantage of avoiding a series of politically difficult adjustments to carbon taxes and is less complicated than an emission allowance trading system. Who owns the allowances or pays the tax? If a carbon allowance trading program were used to control all carbon dioxide emissions from fossil fuel combustion it would be best applied to production and import because this captures fuels used by fossil fuel producers. However, it is possible that a carbon allowance system could be used as an adjunct to an emission allowance system for large emitters. Distributors of fossil fuels to small emitters (e.g. gasoline refiners) could be required to hold allowances reflecting the emissions from the fuel they sell. Where does all the money go? The revenue from a carbon tax or carbon allowance system could be recycled into the economy in a variety of ways. Most proposals for carbon taxes assume that the revenue will go to reduce taxes, especially taxes that have negative impacts on job creation (for instance, the employment insurance premium collected by the federal government). Labour has stressed the need for using taxes to aid coal mining towns and other communities adversely affected by climate change policy. Some economists have suggested that it would be most efficient if carbon taxes were spent on government programs to help consumers and industry reduce their greenhouse gas emissions (e.g. home retrofit programs or transit). Revenue could also be used to provide tax credits to industries that compete internationally and have the greatest difficulty reducing their emissions. Expanding the cap A carbon allowance trading system could be expanded to cover a number of emissions other than carbon dioxide from fossil fuels. Allowances could also be required for large point source non-fossil fuel emissions, (for instance, carbon dioxide from cement plants), and allowances could be used to cover nitrous oxides from fertilizer use. These steps would ensure that an allowance trading program is effective in reducing greenhouse gas emissions from almost all Canadian sources. Pros and cons of cap and carbon allowance trading The pros and cons of carbon allowance trading and carbon taxes can be summed up as follows: Pros * Both are simple ways of covering the vast majority of Canadian greenhouse gas emissions. * Carbon allowance trading could be counted on to deliver a known environmental effect. * Transaction costs and government administration costs would be very low under either system. * If revenue is used to reduce general taxes, carbon taxes or carbon allowance trading may make Canada’s clean, low carbon intensity industries more competitive. * Carbon allowance trading may be politically easier than a carbon tax because it is clearly tied to an environmental goal. * Government has control over the distributional impacts and can adjust tax credits to ensure fair burden sharing. Cons * Price signals alone are not very efficient mechanisms for achieving the emission reductions in some of the sectors (e.g. urban transportation) affected by carbon allowance trading or carbon taxes. Other policies will be needed to help ensure efficient reductions in these sectors. * In the absence of tax relief for carbon intensive industries that cannot easily reduce their emissions, carbon taxes or carbon allowance trading may make Canada’s carbon intensive industries less competitive. * Carbon allowance trading’s unknown impact on fuel prices may make it politically difficult. * Public may be skeptical that a carbon tax will lead to reductions of other taxes. How Would Municipal Trading Work? Municipalities are likely to be involved in a credit trading system because they are able to generate emission reductions from measures ranging from energy efficiency programs to landfill methane recovery projects. In a cap and trade system municipalities might be involved by being given responsibility for some of the emissions in their area. Potentially, municipalities could be required to hold allowances covering the greenhouse gas emissions from homes and buildings in the municipality, and regional governments might be responsible for urban transportation emissions. If local governments introduce programs that reduce emissions, they could sell allowances to industry or other municipalities. If their emissions increase they would be required to buy allowances from other sources. New opportunities for local government Including local governments in a cap and trade system means that local governments would have new responsibilities. However, it also creates greater opportunities than exist in a credit trading system. In a credit trading system, municipalities’ ability to profit from generating and selling credits is limited by the difficulty of quantifying emission reductions against baselines. Often emission reductions will not be counted in a credit trading program because they are uncertain. In a cap and trade system, municipalities will be able to benefit from the ability to sell allowances from all their reductions. Why make local government responsible? Why place the responsibility for these emissions on local governments? Clearly municipalities have control over emissions from their own buildings and vehicle fleets, but it is homeowners and drivers that determine the emissions from the residences and urban passenger transportation? It is true that an individual citizen’s choice has a large impact on emissions from homes, commercial buildings and urban transportation. However, often homeowners and car drivers are not in a good position to make the right choices. Homeowners do not have the knowledge to judge the impact of different insulation standards on their energy bills. Suburban commuters may have no practical alternative to the car. Giving municipalities the responsibility for reducing emissions from home and commercial establishments has the advantage that municipalities may be in the best position to reduce emissions from these sources. Municipalities can control emissions through building standards, establishment of efficient district heating systems, zoning that allows for more efficient housing, and locally operated programs to retrofit inefficient homes. As long as they are given a power to impose taxes on fossil fuels, municipalities would be able to share responsibility for these emissions with consumers. Large municipalities, regional governments and regional transportation authorities may also be in the best position to control emissions from the motor vehicle fleet. Although they do not have control over the efficiency of new cars, local governments typically control transit, roadway construction and whether or not new developments are built in a way compatible with transit. Care would need to be taken to ensure that local governments are only tasked with controlling urban transportation emissions where they have control over the policy decisions that affect vehicle use. Allocating emission allowances As with cap and emission allowance trading, there are a number of ways emission allowances might be allocated to different municipalities. Municipalities might be given allocations based on estimated emissions from residential, and commercial buildings during a historic baseline year. However, this would tend to penalize municipalities that are growing quickly. A fairer method might be to base allocations on a mix of factors such as population (with annual allocations going up if population grows), climate and a municipality’s historic starting point. Pros and cons of municipal allowance trading The pros and cons of municipal allowance trading can be summed up as follows: Pros * Allows the extension of a cap on emissions to residential, commercial and urban transportation sources. * As long as local governments can use taxes to encourage reductions, municipal trading places responsibility for residential, commercial and urban transportation on the individuals and entities that have most control over emissions from these sources;. * Provides incentives for municipalities to invest in infrastructure and regulate urban growth in way that is compatible with greenhouse gas emission reductions. * Allows municipalities to profit from emission reduction initiatives without difficulties inherent in setting baselines etc. Cons * In some cases, existing municipal institutions are not suited to controlling urban transportation emissions. * Urban transportation emissions may be difficult to measure. * It may be difficult to enforce against municipalities. Combining Program Designs If the evaluation of different instruments could be summed up in a sentence it would likely be "there are many instruments that can be used to reduce emissions cost effectively, but there is no panacea." A number of program designs combine attributes of different instruments. For instance, a carbon tax or carbon allowance trading program could be combined with tax credits for reductions in net emissions not covered by the carbon tax. Thus, a large point source might reduce its carbon tax bill by financing a project to capture methane from a municipal landfill. If an allowance trading program is established, producers of fossil fuels may be able to increase production by purchasing or generating credits from projects that reduce emissions at sources not covered by the tax. In such a program the range of credit generating activities is limited. To avoid double counting of tax benefits or to ensure the integrity of a carbon trading program, credit generating activities would need to be limited to emission reduction projects outside of Canada; projects to sequester carbon in trees; and, forests or projects that reduce emissions which are not caught by the carbon tax or allowance trading program (e.g. reducing landfill methane emissions or nitrous oxide emissions from fertilizer use). Use of a hybrid carbon allowance/credit or carbon tax/credit program combines the advantages of a carbon tax or carbon allowance system with the ability to use low cost greenhouse gas emission reductions from sources outside the scope of a carbon tax. Another alternative would be to require large point sources to hold emission allowances for their emissions, require municipalities to hold allowances for emissions from commercial and residential sources, and require distributors of fuel to hold carbon allowances for the carbon content in the fuel distributed to sources not covered by allowances. Carbon allowances could be traded with emission allowances, and credits could be used as an alternative to allowances. Once again, credits would only be generated by a narrow range of activities in Canada. Such a system would combine the advantages of emission allowance trading for industrial sources, municipal trading, carbon allowances and credits. The list of possible combinations goes on. It is likely that any greenhouse gas emission trading system adopted in Canada will be a hybrid of different designs. What do different programs mean for profits, competitiveness and community stability? What do different program designs mean for different industries and the communities on which they depend? While most analyses show limited impacts on the overall size of the economy, climate policies may impact significantly – both positively and negatively – on some industries and communities. The impacts of climate measures on industry should not be exaggerated. Energy costs represent only about four percent of production costs for most Canadian industries and less than one percent for most manufacturing industries. While some globally competitive industries have higher costs, often these industries rely on sources of energy that will be unaffected by climate policy. For instance, while seventeen percent of the pulp and paper industry’s production costs are energy, this is mostly provided by renewable woodwaste. Similarly, some aluminum smelters have their own independent hydro sources. Despite the relatively low portion of industrial production costs accounted for by energy, other jurisdictions have been reluctant to adopt carbon taxes (and presumably might be equally reluctant to adopt carbon allowance trading or auction emission allowances). A number of trade-dependent nations in Europe have adopted carbon taxes, but provide exemptions for export oriented industry. Sweden, for instance, charges a tax equivalent to about $57 Canadian per tonne of carbon or fourteen cents per litre of gasoline; however, the tax is only applied to the export-oriented industrial sector at a quarter the rate charged to households. While the Swedish experience suggests carbon taxes are difficult to impose because of competitiveness concerns, they may be easier to impose in the post-Kyoto world where many of Canada’s competitors in industrialized nations will also be faced with carbon taxes. Nonetheless, climate policies may affect decisions of industry and business regarding whether to locate in Canada; may encourage them to expand production here; or, encourage them to shut down. How climate policy affects these decisions depends less on the type of instrument chosen and more on how it is implemented. For instance, in a cap and emission allowance trading system: * Historic allocation of emission allowances will disadvantage high emitting companies wanting to locate in Canada, while at the same time encouraging marginally economic high emitting facilities to close down and reap profits from the sale of allowances. * Auctioning emission allowances and using revenues to reduce general taxes would also encourage-shut downs of inefficient energy intensive firms but would also encourage clean industries to locate in Canada. * Allocating emission allowances based on annual production of energy intensive goods would avoid any incentive to close down production in Canada and would encourage the location of new efficient energy intensive industry here. (However, it will reduce incentives to restructure the economy to less energy intensive industries.) In a cap and emission allowance system the choices between different allocation systems are obvious. But similar choices exist in any system. Table 2 discusses the different effects mechanisms could have on the competitiveness of industries, incentives to locate in Canada, and incentives to move. It is often assumed that the revenue derived from carbon taxes or allowance auctions will be used to yield a double dividend, reducing taxes on jobs and encouraging clean industries to locate in Canada. It is also often assumed that these measures will inherently make energy intensive industry uncompetitive. However, these impacts can be negated or reduced by offering carbon transition tax credits to energy intensive, internationally competitive industries. Transition credits would reduce the short term potential for a double dividend but may avoid unnecessary disruption. The essential difference between credits or free allocations of allowances versus auctions or carbon taxes is not their effects on different sectors’ competitiveness, but government’s control over the effect. Where government is controlling the distribution of revenue through the tax system it can make adjustments that mitigate windfall gains or transition costs. In a credit trading or allowance trading system the distribution of gains and losses is an artifact of emission standards and allowance allocations. With an auction, government can adjust the tax system to provide relief to a hard struck sector or spend money on transit to help the passenger transportation sector. In a credit trading system the allocation of emission rights is implicit. Emission rights are implicitly given to greenhouse gas emitters up to the level of either their historic emissions or regulatory limits on emissions. If regulatory limits are very stringent for new sources (for instance, requiring them to offset all new emissions) and weak for existing sources, the allocation is similar to a historic emission allocation. Under a credit trading system, there is no opportunity to generate revenue for government or allocate rights that exceed a source’s actual emissions. Thus, in a credit trading system there is little opportunity to realize the double dividend of using carbon tax or allowance revenue to reduce overall taxes. The Greenhouse Gas Emission Reduction Trading Pilot Day Two of the Selling Clean Air workshop is focused on the Greenhouse Gas Emission Reduction Trading Pilot Project. The GERT project is a voluntary credit trading program which is intended to encourage early reductions in greenhouse gas emissions, give participants familiarity with trading and test the feasibility of credit trading. The pilot is lead by a steering committee with membership from industry, government, environmental groups and labour. Under a Memorandum of Understanding the federal government and participating provinces have agreed to recognize credits (referred to as Registered Emission Reductions) under the pilot as "progress towards possible compliance obligations." Experience to date suggests this ambiguous promise of recognition may not be sufficient to encourage significant amounts of trading. An agreement has been negotiated establishing general rules for generating credits although many issues have not been resolved. Workshop participants will find more information on the GERT project in their registration package and copies of the GERT Rule, Memorandum of Understanding and Terms of Reference will be available at the workshop. TABLE 2: Program Effects on Profits, Competitiveness and Community Stability Potential to decrease taxes on jobs, income. Revenue raised for community transition, curing market failures. Encourages new low carbon intensity industries. Creates incentives for existing relatively efficient but carbon intensive industries to close and relocate. Rewards historically efficient, clean producers/imposes relatively higher costs on historically inefficient producers. Government ability to ensure equity (i.e. fewer windfall profits, less chance of disproportionate burden being carried by few players). Creates barriers to the establishment of new relatively efficient but carbon intensive industries. Carbon tax/carbon coupon/auctioned allowance trading. Revenue recycled to government programs for community transition; easing transition for carbon intensive industries; reducing greenhouse gas emissions; reducing taxes. Yes Yes Yes Possibly (depending on amount of tax/auction revenue use to ease transition for carbon intensive industries). Yes No chance of windfall profits; Revenue (e.g. carbon transition credit) can be used to ease burden on carbon intensive industries. Possibly (depending on use of tax/auction revenue to ease transition for carbon intensive industries). Cap and Emissions Allowance Trading. Allocation based on historic emissions. No No No Yes No. Rewards historically inefficient producer. Windfall profits likely. Potentially high burdens for carbon intensive industries without low cost emission reduction options. Yes Cap and Emissions Allowance Trading. Allocation based on production levels. No No Yes (if industries receive allocation) No Yes Windfall profits likely. Potentially high burdens for carbon intensive industries without low cost emission reduction options. No Credit Trading. None or weak limits on existing emitters/relatively strict limits on new emitters. No No No Yes (if credit given for closure) No. Rewards historically inefficient producer Windfall profits likely. Potentially high burdens for new carbon intensive industries. Yes Credit Trading. Relatively strict emission limits on all emitters. No No No Yes (if credit given for closure) Neutral Windfall profits less likely if emission limits reflect ease of reducing emissions. No Concluding Notes It will take at least several years before Canada has a fully established cap and emission allowance trading program or cap and carbon allowance trading program. However, it is clear that market instruments – carbon taxes or emissions trading – are important tools for averting climate change and they may be essential to minimizing the costs of emission reductions. Currently, the only market instruments for greenhouse gas emission reductions are credit trading with the demand for credit being generated by the threat of future regulation. However, beyond these initial steps we are beginning to embark on the process of making choices between different market instruments. The choices among different market instruments are far from being academic issues of public administration. The choices may involve shifting taxes from jobs and income to greenhouse gas polluters. Some choices will impose a high cost on government. The choices may affect how sure we can be that we will reach an environmental target and who will be responsible for achieving it. They involve choices that may affect the shape of Canada’s industrial development and the decisions of businesses to locate here or elsewhere. One of the first steps towards making choices between economic instruments is to begin experimenting in the use of different instruments and gain experience with them. The purpose of West Coast Environmental Law Research Foundation’s workshop is not to identify the single best market instrument or hybrid of instruments. Instead, it is to raise awareness of the need for market instruments and the issues surrounding our choices.