The Cost of Carbon

Rick Hyndman, the senior climate change policy adviser to the Canadian Association of Petroleum Producers in Calgary, has written this article in response to Michael R. King’s thoughts on carbon trading (“No Carbon Copy,” 34:6, 2008). That Canada should mimic the European Union and necessarily develop a carbon trading system is not the path to travel, according to Hyndman. Canadians must face up to what reducing emissions will cost, he warns, and resist allowing emission traders – rather than government – to set the price of carbon.

Rick Hyndman, the senior climate change policy adviser to the Canadian Association of Petroleum Producers in Calgary, has written this article in response to Michael R. King’s thoughts on carbon trading (“No Carbon Copy,” 34:6, 2008). That Canada should mimic the European Union and necessarily develop a carbon trading system is not the path to travel, according to Hyndman. Canadians must face up to what reducing emissions will cost, he warns, and resist allowing emission traders – rather than government – to set the price of carbon.

Communicating the need to put a price on greenhouse gas emission reductions is ridden with pitfalls, as Stéphane Dion recently found out and the BC government is discovering. It is a complex and confusing idea, and most Canadians have little appetite for it. But it would be a mistake to allow the Canadian government to let the need to put a price on the emissions that are causing climate change slide off the agenda as our focus moves to the world’s economic travails. Perhaps a better understanding of the multiple dimensions of greenhouse gas (GHG) emissions pricing will help us get a handle on what many consider to be the planet’s most pressing issue.

Many climate change policy specialists, economists included, agree that putting a price on greenhouse gas emissions should be a central element of Canada’s and other countries’ policies to tackle climate change. The common logic behind this idea is that in order for it to be effective, a price on GHG emissions needs to be high enough to make ways of doing things that emit fewer emissions more economical, and even modify consumer choices – more theatre, music and sports, fewer trips to the tropics in winter and Europe in the summer.

Since putting a price on GHG emissions necessarily imposes different costs on people in different circumstances, there is an argument for starting at a modest level and indicating that the price will escalate over time to the higher level required to achieve emission objectives.

Because carbon pricing is not prescriptive, it allows the millions of decision makers throughout the economy – business owners, university presidents, mayors and the general public, for example – to decide for themselves, given their particular set of conditions, in what manner and by how much they will reduce their emissions.

Two ways of pricing carbon to reduce emissions have been put forward. The labels commonly used are a carbon tax, for setting the price of carbon emissions directly ($/tonne of emissions), and cap-and-trade, when the price of carbon is set indirectly by fixing the total quantity of emission permits (tonnes of emissions) and then allowing the market to determine what the price of a permit will be. These labels are simplistic, but familiar.

In the recent federal election, the Liberals put forward a plan to introduce a carbon tax, thereby directly setting the cost per tonne of emissions, whereas the New Democrats favoured a cap-and-trade system. Over the past two years, the Conservative government has been developing a hybrid scheme that has characteristics of each. Meanwhile, the provinces of Quebec and British Columbia have introduced carbon taxes, though they differ in their design.

Despite the ability of regulators to set a price directly or indirectly for carbon emissions, the actual cost of reducing emissions is uncertain. We don’t know for sure if the last tonne of emission reductions will cost $75 or $100, though most analysts agree that costs will climb as we move from the easiest means of reducing emissions to more difficult ones. This uncertainty about costs can be depicted as an uncertain “emission reduction cost curve” .

As a result of this uncertainty, we also don’t know if a carbon tax set, for example, at $100 per tonne, will reduce emissions by 20 per cent, 30 per cent or more. The price may be certain, but the level of emission reductions it will generate is not.

Alternatively, if we use a cap-and-trade system, the number of emission permits handed out will determine the level of emissions. In this case, we know how much emissions need to be reduced by, but the cost of achieving this target is unknown. The targeted level of emission reductions is certain, but the price is uncertain.

A clear assessment of policy designs has not taken place in Canada because confusion over objectives has allowed alternative means of carbon pricing to overwhelm the dialogue. The debate has evolved into a choice between a certain low price with few uncertain reductions and certain low emissions (large reductions) and a very high, uncertain price. The result is neither clarity about the ambitiousness of objectives, nor assessment of the merits of alternative pricing systems.

To date, governments have presented their objectives for reducing GHG emissions as a target level of emissions in some year. These are most often expressed as a percentage reduction from some historical year. The current federal target, for example, is to be 20 per cent below 2006 levels in 2020. This seems like a simple and clear way to define objectives. There are, however, two problems with this approach.

First, when a target is expressed in this way, it does not clearly describe how ambitious the goal really is. Policies used to achieve the target must drive reductions, not from past emission levels, but from what emissions would otherwise be – a level referred to as “business as usual,” or BAU. Canada’s Kyoto target, to reach 94 per cent of 1990 emissions by 2010, is stated as a six-per-cent reduction target, but is in fact a 30- to 35-per-cent reduction from BAU in 2010.

Second, setting emission reduction objectives as a specified level of emissions in some year ignores the reality that the target Canadians will support depends on the cost of achieving it. Although most environmentalists and many policy analysts are adamant in their calls for a firm cap on emissions, any specific level would not reflect the balancing of costs and emissions that the public will actually support. The same applies to a specific price. It is more realistic to portray emission reduction objectives as an emission reduction demand curve, which embodies the reality that Canadians will be willing to make more reductions as the cost of achieving them declines.

When the uncertainty about emission reduction costs is combined with emission objectives defined in terms of both emissions and costs, we end up with a pair of curves: an emission reduction cost curve and an emission reduction demand curve. On one hand, the cost of achieving any particular level of emission reductions is uncertain. On the other, we find that the less it costs to reduce emissions, the more emission reductions Canadians will be willing to make, and vice versa. When we put these two curves together, we see that the policy choice for meeting emission reductions objectives provides neither price certainty nor emission certainty.

Emission pricing in North America is more likely to involve hybrid design elements than either a pure carbon tax or pure cap-and-trade. But whether the price of carbon is set directly or indirectly, the price of carbon will have to be adjusted at regular intervals in light of experience with the emitters’ responses to prices over time. The government will have to re-evaluate the timing of emission reductions that Canada can attain when its objectives for any period are defined in terms of both emission reductions and cost. Reductions may proceed faster or slower, depending on what we learn about costs.

Rather than choosing between price certainty (cost per tonne) and emission certainty (number of emissions permits) over the medium term, there will have to be some uncertainty in both until the costs of reductions are revealed.

Adjusting the price

At the end of each interval of five years, for example, the uncertainty that existed at the beginning will have been resolved, but new uncertainty will appear as we face an emission reduction cost curve with what is expected to be a more ambitious (higher price) policy.

While many policy specialists agree that emissions pricing is more efficient than administrative regulation, the debate about emission pricing has been viewed as a choice between price or emission certainty. This comparison, however, should be reframed from price certainty versus quantity certainty to policy efficiency. In this case, the important question becomes which is the more efficient way of setting the price of carbon: directly or indirectly?

The basic policy, most analysts agree, will set a rising price over time that will drive increasingly costly actions to reduce emissions. This can be done directly under a carbon tax or by setting a ceiling price under a cap-and-trade hybrid system. It can also be implemented indirectly by adjusting the total quantity of permits. (The price can also be set directly with a ceiling price, or a default compliance price under a hybrid cap-and-trade system.) If set directly, the question becomes one of how fast the price will have to be increased in order to achieve the emission reduction objectives defined in terms of cost and emissions. Here, there is short-term price certainty, but it declines in the medium-term. This approach, however, is clear and simple. It is the price level set by policy that drives action, not the manner in which it is set.

Setting the price indirectly by adjusting the volume of permits results in a volatile price that fails to send a signal to emitters about the cost of actions they should pursue over time. Furthermore, it requires that we create a complex and costly trading sector. The growing number of investment firms, many of them large and well-known companies, is testament to this need. These firms are pushing the government to allow the market to set the price of emission reductions, an approach that will reward these traders, and place costs on emitters, who will be left to deal with the resulting price uncertainty and volatility.

In his article “No Carbon Copy,” Alternatives, 34:6 (2008), Michael R. King points to the large size of the European Union’s trading system ($62-billion) as a sign of success. In reality, it demonstrates how complex and costly Canada’s system could become if the government turns to markets and traders to set the price of carbon.

Facing up to the task

Domestically, the government, be it Liberal or Conservative, seems unwilling to break the bad news about what it will cost to achieve the GHG emission reductions that Canadians indicate they support. As a result, governments consistently and seriously underestimate the cost of achieving the emission targets they set, and then fail to meet them.

In Turning the Corner, the Conservative government’s climate change plan released in 2007, Prime Minister Stephen Harper announced a goal of a 20-per-cent reduction from 2006 levels by 2020. The part of the plan pertaining to industrial emissions projected that this goal can be achieved if carbon is priced at $25/tonne starting in 2010 and then rises to $65/tonne by 2018-20.

Independent analysis by MK Jaccard and Associates, however, suggests that a more realistic estimate for industrial plus non-industrial emissions is in the order of $100 per tonne, unless “emission reductions” are to be achieved through the purchase of a large volume of offset credits from other countries (see figure 5). However, in the US policy discussion, hardly anyone is considering prices anywhere near $100 per tonne by 2020.

Canadians need to face up to the inconsistency between their stated desires regarding emission reductions targets and their willingness to incur costs or change their lifestyles to reach them. Industry has to cover its production costs. That leaves consumers and taxpayers to foot the emission reductions bill. It is not a huge expense, but it is more than Canadians have so far been willing to pay. Emission pricing, as described above, allows for a degree of flexibility that should minimize the costs of reductions, though we still must pay them.

Progress requires an intelligent discussion about what Canada aims to do over the next decade to improve the country’s performance, invest in technology and aid poorer nations so that they can develop cleanly. We need a policy that can be simply and clearly adjusted to reflect the country’s evolving objectives and align with efforts in other countries.

The resulting policy will necessarily involve medium-term uncertainty about both price and emission reductions. As we move along, the emission reduction cost curve, we will learn how to adjust our emission reduction demand curve. But we will continue to face uncertainty as we progress through each successive stage of the policy.

The trick is to choose policy approaches that avoid diversions, such as setting up a complex and ultimately costly financial carbon trading market to do what policy decisions could otherwise do simply and clearly.

The Carbon Dialogues do not end here. As Rick Hyndman suggests, understanding the various dimensions and options of the carbon pricing debate is an important step in finding an effective way of reducing greenhouse gas emissions. Read and comment on our free online articles on this topic (listed below). Join the discussion between readers, authors and our editors on the complex but urgent questions at the heart of our current energy crisis at