In the struggle against climate change, provinces are increasingly adopting cap-and-trade policies. They can succeed — but only if their policies include essential design features.

On April 13, 2015, the government of Ontario announced its commitment to joining Quebec and California in a cap-and-trade system under the Western Climate Initiative (WCI). Ontario is not at the front of the pack when it comes to pricing carbon, nor when it comes to choosing the specific approach of cap-and-trade. However, this does not diminish Ontario’s significant opportunity for leadership — quite the opposite. The province can leverage the tremendous advantage of learning from other jurisdictions’ systems — their strengths and weaknesses — to design a best-in-class policy straight out of the gate.

This article identifies four key cap-and-trade design principles as a guide for Ontario — or any province — in moving policy forward. While offered as a road map to provincial decision-makers, these recommendations can provide insight to all stakeholders — business, industry and everyday Ontarians — on what to expect and how to hold government accountable for implementing the most effective, fair and cost-effective system.

Carbon pricing, whether achieved through a tax or a cap-and-trade system, is an increasingly common policy being introduced by nations and regions across the world. Globally, the jurisdictions currently pricing carbon account for nearly a quarter of the world’s greenhouse gas (GHG) emissions.

Cap-and-trade systems, in particular, are a burgeoning force in world markets. In January 2015, the new South Korean cap-and-trade system became the second largest in the world, behind the European Union’s, which has been in place since 2005. China is currently running pilot markets in seven jurisdictions with the aim of launching a national cap-and-trade system in 2016. In 2008, nine US states joined together under the Regional Greenhouse Gas Initiative to create a market that caps emissions from the power sector. And in a few short months, when Ontario formally joins the WCI, three-quarters of Canadians will live in a province that prices carbon.

All of this can be considered meaningful progress toward establishing a broad, global price on carbon, a goal with a growing number of powerful advocates including the International Monetary Fund and the World Bank as well as major corporations and institutional investors across the world. Most recently, six of Europe’s top oil and gas firms publicly called for national political commitments to pricing carbon.

Committing to a carbon pricing regime is one thing.  Designing an effective, durable and economically sound policy is quite another. While it is possible to debate the inherent strengths or weaknesses of cap-and-trade systems versus a carbon tax, the fact is these instruments are more similar than they are different. Both can be effective at generating low-cost emissions reductions if they are designed well. And both instruments are vulnerable to poor design choices that could undermine their effectiveness as well as their credibility.

In June 2015, Canada’s Ecofiscal Commission released The Way Forward for Ontario, outlining key principles and recommendations addressing four major policy considerations: stringency, coverage, the distribution of allowances and linkage with other systems. A common theme runs through these principles: good governance and transparency. It is not enough to design a policy that is effective, cost-effective and fair. It must also be clear, predictable and immune to political interference. The confidence of Ontarians — everyday consumers and big emitters alike — is critical to the success of the province’s new policy.

Principle 1: On stringency. Stringency of policy should rise gradually and predictably over time in order to drive meaningful emissions reductions. A cap-and-trade system imposes a quantity constraint (the cap), limiting the total allowable levels of GHG emissions in a given compliance period. The cap reflects the total number of tradable emissions allowances (also known as permits) created by the policy. To comply with policy, emitters require a permit for each tonne of emissions. Critically, the cap declines over time, with deeper reductions required in subsequent compliance periods.

A lower cap represents a more stringent policy because it requires more action by emitters overall. Yet because the allowances are tradable, different emitters will generally reduce their emissions by different amounts. A carbon price emerges from the market created by these trades and the scarcity created by the cap. Not surprisingly, a lower cap generally leads to a higher carbon price. So the two key metrics to compare the stringency of different cap-and-trade systems — (1) the strictness of the quantity constraint and (2) the carbon price — are really just two sides of the same coin.

For Ontario’s cap-and-trade system to be effective, the total quantity of permits allocated must be equal to the provincial cap. This is not always simple, and errors can undermine the confidence in the system. In the European Union’s Emissions Trading System, for example, too many permits were allocated during the pilot phase (2005-07), partly due to limitations in emissions data, which led to a collapse in price.

This highlights another concern that policy-makers should account for: price volatility. A persistently low carbon price provides inadequate incentives for innovation and long-term investments in low-carbon technologies. In contrast, large and sudden spikes in the price could threaten business competitiveness and be detrimental to the economy. The aim should be to steadily increase the stringency of policy over time by tightening the cap gradually, but to avoid large and sudden swings in the price. This will avoid unnecessary shocks to the economy, but will nonetheless encourage households and businesses to change their behaviour as the price of carbon rises.

The volatility of the price can be managed by various mechanisms, including the establishment of a “price collar” that includes both a ceiling (an upper limit on the cost of allowances) and a floor (a minimum carbon price, which under the WCI is currently about $15 per tonne).

Finally, incentives under a cap-and-trade system work only if regulated entities have no motivation to cheat. The regulating authority must have the power to impose and enforce sufficient penalties on emissions sources that do not comply with the program rules. Under the WCI, for example, entities must surrender four allowances or offsets for each missing allowance.


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