Canada’s consumer carbon price (commonly known as the “carbon tax”) appears to be dead. No matter who Canada’s next prime minister is, he or she is unlikely to maintain the policy.
Yet the impending absence of the consumer carbon price reinforces the importance of Canada’s other carbon pricing system. Large-emitter trading systems (LETS)—also referred to as industrial carbon pricing systems—are Canada’s most important and least understood climate policy. And unlike the consumer carbon price, they go about their business quietly.
Done right, LETS are very good policy. Most provinces have already implemented their own industrial carbon pricing systems, tailoring them according to their own priorities. These systems protect the competitiveness of Canadian industry. They can insulate Canada against carbon tariffs. And they could drive more emissions reductions by 2030 than any other policy.
But LETS will only deliver on their promise if they are updated to make sure they are functioning as intended. New analysis suggests that several provincial systems in Canada are not performing to their full potential.
Fortunately, governments can adjust these systems to make sure they achieve both of their core objectives: protecting competitiveness and reducing emissions. Our analysis has identified five principles for well-functioning LETS. They should:
- Rely on well-functioning markets for credits;
- Create a level playing field for individual firms;
- Use revenue in ways that maintain incentives to reduce emissions;
- Be transparent; and
- Provide policy certainty.
We explore each of these principles in greater detail below. The Climate Institute has undertaken a comprehensive independent review of industrial carbon pricing systems across the country, including extensive consultation with provinces and territories. While the results of our review are forthcoming soon, that analysis informs our overview here of fundamentals for provinces and territories considering next steps to improve their industrial pricing systems.
1. LETS should rely on well-functioning markets for credits
LETS work by setting an emissions performance standard. Firms that reduce emissions beyond the standard generate credits they can sell. Facilities that do not meet the standard have to pay the carbon price or buy credits. Credits create cash flow for emissions-reducing projects. And all firms always have incentives to reduce more emissions—as long as those credits are valuable.
Our research, however, finds that not all provincial systems are on track to have credit markets that are working properly—and as result, the value of credits is at risk.
In provinces such as B.C., Alberta, and Saskatchewan, there is a risk that supply of credit will outstrip demand. This can happen if the emissions performance standards aren’t strong enough to incentivize change, or because other policies that overlap with LETS, allowing companies to generate extra credits, putting credit markets out of balance.
As a result, we project the value of carbon credits in these jurisdictions to be lower than other provinces—in some cases significantly so. If governments don’t tighten performance standards or tackle this problem in other ways, LETS might only be half as effective in reducing emissions, and much less helpful in attracting investment for low-carbon projects in Canada. LETS credits, for example, can help Canada compete with American tax credits in attracting capital for emissions reducing projects—such as carbon capture and storage projects—without additional fiscal costs.
2. LETS should create a level playing field for firms
One way of thinking about LETS is essentially as a combination of a carbon price and support for production. Together, those two components deliver on both emissions reductions and competitiveness objectives. Firms pay for their emissions above a threshold defined in terms of emissions per unit of production; they’re better off if they can sell more product with fewer emissions.
Alberta’s TIER system offers examples both of a challenge and a best practice in defining performance standards.
For most big emitters, TIER (like several other systems, including Ontario’s) uses mostly facility-specific performance standards, based on historical emissions for that individual facility. As a result, historically high-emitting facilities get bigger production subsidies, giving them a leg up on cleaner competitors, and creating more inertia in the system and slowing down decarbonization. That creates an uneven playing field that isn’t fair, undermines long-term emissions reductions, and also decreases the cost-effectiveness of the policy.
For electricity generation in Alberta, however, TIER has a uniquely different approach. TIER has a single standard for all electricity generators, which means that renewable electricity generators can generate credits without any disadvantage. That’s one of the reasons Alberta had been successful in growing its renewable sector and phasing out coal.
This stands in contrast to the federal backstop system (which applies in Manitoba, Prince Edward Island, Nunavut, and Yukon), which has unique performance standards for electricity generated from coal and gas. This approach creates different incentives for different sources of electricity, distorting the market.
3. LETS revenue should maintain incentives to reduce emissions
There isn’t one right way to use revenue from industrial carbon pricing. Different provinces and territories should be free to return revenue to the economy to fit their context.
There is, however, a clear exception: to maintain incentives to reduce emissions from the carbon price, the revenue returned to an individual firm must not be proportional to the emissions it produces (and therefore to the costs of carbon it incurs under the policy). This approach creates perverse incentives: Firms that emit more, pay more, but also get more revenue back, at least partly negating the incentives to reduce emissions.
Ontario, for example, is taking this approach to revenue recycling in its LETS. Firms can recoup all of the money they pay for their own emissions, as long as they commit to using that revenue to reduce emissions. That’s roughly akin to giving out a speeding ticket and then returning the full amount of the fine to the speeding driver, with the caveat they commit to taking action to reduce future speeding infractions.
4. LETS should be transparent
The problems in LETS credit markets are an open secret in industry and among credit traders. Behind paywalls, market intelligence reports project low future carbon prices, especially in the very large Alberta TIER system due to some of the problems outlined above.
Yet credit trades in practice are entirely private: neither governments nor the public know the volume or the price at which credits are being traded. As a result, tracking the scale of credit market problems—and the extent to which any potential solution successfully addresses them—is difficult to confirm without modelling, and impossible to track in real time.
5. LETS should provide policy certainty
It’s not just the current price of carbon that drives investment and emissions reductions in heavy industry; it’s also the expected future price of carbon. Investments that firms can make—whether electric arc furnaces in the steel sector, carbon capture and storage in cement, or cogeneration in oil and gas—last a long time and provide value over that period.
As a result, expectation about the future of LETS is critical. For LETS to work to their full potential, governments can and should signal carbon price trajectories well past 2030. Alberta, for example, has confirmed support for a carbon price that rises to $170 per tonne by 2030. Other provinces could follow this lead. They should also explore carbon contracts for difference to provide additional certainty.
Still, uncertainty remains about how LETS will be modernized over time. Most of all, provincial governments should commit to LETS, not just in the abstract, but in terms of the principles we’ve articulated here. That will increase certainty, which makes sense for emissions and for industry. Provinces should telegraph clear mechanisms and processes for adjusting and tightening systems over time, thus providing transparency and clarity about how LETS will be improved, while also signalling that functional markets are a priority.
LETS are smart policy. They’re worthy of a growing consensus across politics and sectors. But that’s only true if they are designed well.
