Canadians increasingly agree that climate change requires action. Evidence continues to mount that melting ice packs and extreme weather events pose serious risks to Canadians and their economy. Other climate impacts, such as sea level rise and warmer temperatures, are of particular concern to Canada’s coastal and Arctic communities. The risks are even worse for other, more vulnerable countries.
Despite its relatively small population, Canada has a role to play in the global efforts to reduce greenhouse gas (GHG) emissions to avoid the worst of these risks. Canadians do not want to "free ride" on the actions of others. They want to do their part and contribute to these efforts.
Canadians are also moving closer to agreement on how we should tackle these challenges. Several large provinces have already introduced well-designed carbon-pricing policies. And the federal government is now committed to filling in the remaining policy gaps—by requiring every Canadian province and territory to put a price on carbon by the end of 2018.
That growing consensus around carbon pricing, however, is not yet universal. Various economists and policy experts have made the case for carbon pricing as the best way to reduce GHG emissions while maintaining a strong economy. Yet recently, others have questioned the extent to which carbon pricing will affect GHG emissions. And elections are on the horizon, both nationally and in several provinces, in which carbon pricing could be a source of debate and even a key issue.
Such policy debates are healthy and necessary. Historically, significant shifts in the consensus around policy emerged only after vigorous public discussion. While free trade and balanced budgets might now be broadly accepted, they were once controversial ideas.
But debates will support good policy decisions only if they are based on facts and evidence. And there is strong evidence, grounded in solid economics and policy experience, that carbon pricing works.
Part of the problem is communication. Governments and policy analysts (including here at the Ecofiscal Commission) haven’t always done a good enough job explaining carbon pricing to Canadians. This really matters because carbon pricing affects us all. How we design these policies will influence how we live and how we do business. We all want better understanding.
In short, we need a more informed conversation about carbon pricing. So let’s have that conversation. Let’s clear the air.
The many details of carbon pricing are important for governments to consider when they design good policy. The Ecofiscal Commission has undertaken extensive economic research exploring these details, some of it fairly technical. We’ve explored how to design policy for fairness, and how to design it to ensure Canadian businesses remain competitive. We’ve considered the best ways for governments to recycle revenues generated from carbon pricing. And we’ve looked at the other climate policies that work best with carbon pricing.
Done right, carbon pricing changes household and business behaviour, reduces GHG emissions, and drives the development and adoption of the technologies that will play a key role in a low-carbon economy.
The evidence is clear: carbon pricing shifts us away from "business as usual," changing our emissions trajectory. And higher carbon prices drive deeper emissions reduction.
In addition (and this point is also often overlooked), carbon pricing will achieve these outcomes at a lower economic cost than other policies.
Together, this means carbon pricing can support both a clean economy and a prosperous one. It achieves these goals by changing incentives and unleashing market forces. It lets businesses and individuals identify the best ways to reduce their GHG emissions and at the times and places that are right for them. And it doesn’t require governments to identify specific ways to reduce GHG emissions.
This essay unpacks the overall story. What does “working” mean for carbon pricing? Where has carbon pricing worked? Why does carbon pricing work? When does carbon pricing work? Who supports carbon pricing? How do policies put a price on carbon? We provide clear answers to these questions in simple, (mostly) jargon-free language.
WATCH: Carbon pricing is the solution to climate change that makes sense for both the environment and the economy.
What does "working" mean for carbon pricing?
We focus on two key outcomes that should drive Canada’s climate policy.
First, we should be aiming to reduce our annual greenhouse gas (GHG) emissions. Not just this year but every year going forward. Moving Canada toward deep emissions reductions over time contributes to global efforts to avoid some of the costliest and most uncertain impacts of climate change.
Note that GHGs aren’t just about carbon dioxide. They also include methane, nitrous oxide, and many other gases that collect in Earth’s atmosphere and act like the walls of a greenhouse to lock in heat, raising average global temperatures. Policies that “put a price on carbon” are really designed to put a price on all the major GHGs, wherever feasible.
Second, we should be striving to sustain a strong economy—with the good jobs and incomes that come with it. We can choose to reduce our GHG emissions by having a weak economy, with little production and income, but this is a very costly way to clean up the environment. Far better alternatives are available. Our objective should be to reduce GHG emissions significantly but do so at the lowest possible economic cost.
Can carbon pricing achieve these dual objectives? Yes. We’ll show how throughout this essay.
Carbon pricing isn’t the only option available to policy makers committed to reducing GHG emissions. In particular, command-and-control regulations are an alternative. This kind of policy requires businesses or individuals to adopt specific technologies or achieve certain levels of emissions performance.
For example, Canada has mandatory vehicle efficiency standards for cars and light trucks. These standards require car manufacturers to produce vehicles with a given average level of fuel economy for the vehicles they make, which lowers emissions per kilometre driven.
A central advantage of carbon pricing is that it works with market incentives by encouraging businesses and households to seek out the lowest-cost way to reduce emissions. Emitters are not all the same, and carbon pricing takes advantage of these differences to minimize the cost of reducing emissions.
In contrast, command-and-control regulations generally cost more than carbon pricing because they provide far less flexibility to businesses and households, and they typically ignore the important differences between them. Such regulations require specific actions or outcomes from specific firms or groups, regardless of their different abilities to achieve these outcomes.
Some carefully designed regulations might come close to carbon pricing by building in market mechanisms. For example, Quebec requires that automakers produce a certain number of zero-emissions vehicles (ZEVs). Car manufacturers receive tradeable credits for each ZEV they produce and need a certain number of credits to meet their quota. Firms that produce ZEVs cost-effectively can produce more than what is required by their quota to receive additional credits. They can sell these credits to other firms that cannot manufacture ZEVs as cheaply and are better off buying more credits than making more ZEVs.
WATCH: Carbon pricing gives people and businesses flexibility in reducing their emissions.
Where has carbon pricing worked?
Carbon pricing has a track record of success. There are two basic approaches to carbon pricing: carbon taxes and cap-and-trade. It’s also possible to combine them. We’ll get to the details of how they work later. The bottom line is that they all put a price on GHG emissions, which creates an incentive to produce fewer of them.
Here, we’ll explore outcomes in three different jurisdictions that have implemented different types of carbon pricing. None of these policies are perfect, but they all illustrate that carbon pricing works.
Isolating the impact of carbon pricing is critical. Changes in emissions that happen to coincide with new policy aren’t necessarily the result of that policy. In statistics jargon: correlation isn’t the same as causation.
Below, we focus on three case studies that explicitly isolate the impacts of carbon pricing. Using statistical or modelling analysis, these studies aim to answer the question: how would emissions or economic growth be different if carbon pricing policies hadn’t been put into place?
Case Study #1: British Columbia, Canada
British Columbia’s carbon tax started in 2008 at $10 per tonne of carbon emissions, rose by $5 a year, and then paused at $30 in 2012. The tax applied to the burning of fossil fuels, or about 70% of the province’s GHG emissions.
Initially, all revenues were used to finance income-tax cuts and selected tax credits — the carbon tax was “revenue neutral” for the government.
Starting in April 2018, BC’s carbon tax will start rising again by $5 per tonne every year until it hits $50 in 2021. The BC government will use the new revenues to finance initiatives such as public transit and home retrofits to drive further emissions reductions. It will therefore no longer be revenue neutral.
As a result of the carbon tax, annual emissions in BC are 5% to 15% lower than they would otherwise have been. This estimate draws from several analyses (see References for details) each of which isolates the impacts of the carbon tax from other factors.
Those reductions in GHG emissions were the result of various shifts, including:
- The fuel efficiency of BC’s entire vehicle fleet improved by 4% more than it would have without the tax. In other words, people invested in vehicles that would reduce their emissions and thereby allow them to pay less carbon tax by purchasing less gasoline.
- People also changed their gasoline consumption. Per-capita demand for gasoline would be between 7%-17% higher without the carbon tax by 2011. The carbon tax changed the way people drive.
- The carbon tax also affected natural gas use. One analysis suggests that tax reduced residential natural gas demand by 15% and commercial natural gas demand by 65%.
Still, the emissions news from BC isn’t completely rosy. In recent years, BC’s total GHG emissions have actually increased. Two main factors are at work.
First, the tax was “frozen” at $30 per tonne in 2012 after steady increases for the previous few years. As a result, businesses and individuals had a weaker incentive to make long-term investments to reduce emissions than they would have had with a slowly rising carbon price. For example, gasoline consumption fell between 2008 and 2013 when the carbon price was rising but rose by 7% between 2013 and 2016 when the price was frozen.
Second, even though BC’s total GHG emissions have increased in recent years, they are almost certainly lower than they would have been in the absence of the tax. BC’s strong economic (and population) growth has contributed to more overall energy use and therefore GHG emissions.
Similarly, declines in energy prices over time encouraged energy use, partially offsetting emissions reductions from the carbon tax.
The $30 per tonne tax caused emissions to grow less quickly than they otherwise would have. But a higher carbon price will be required to drive deeper emissions reductions in the future.
The BC carbon tax appears to have had at most a very small impact on economic growth. Some analysis finds no significant economic impact, while other studies suggest that the economy grew only slightly more slowly as a result of the carbon tax than it otherwise would have.
Growth nonetheless remained strong. Indeed, since 2008, British Columbia’s economy has outperformed the rest of Canada. This difference doesn’t mean that the carbon tax is the reason for BC’s higher growth — indeed, it almost certainly isn’t — but it does reinforce that the tax likely wasn’t a significant barrier to BC having a strong economy.
In addition to relatively strong economic growth, BC’s carbon tax has not negatively affected its overall job market. One economic analysis (again, a study that carefully isolated the effects of the carbon tax) found that while some emissions-intensive industries did see job losses between 2007 and 2013, the carbon tax also led to the creation of 10,000 jobs in less emissions-intensive industries (for example, service industries) that would not have otherwise existed.
In other words, BC’s carbon tax didn’t lead to fewer jobs—it shifted jobs to different industries, with a slight overall increase. As part of a necessary long-term transition away from carbon-intensive energy systems, this shift is exactly the pattern that carbon pricing is designed to produce.
WATCH: Carbon pricing is changing behaviour in British Columbia and California.
Case Study #2: California, United States of America
California introduced a cap-and-trade system in 2012. Under the program, the state sets a cap on how many GHGs its largest industrial emitters can produce and gives them permits, or “allocations,” that allow them to produce GHG emissions.
The minimum price for emissions permits started at $10 per tonne (around $13 Canadian) and will increase at a rate of 5% per year until 2020. Over time, the emissions cap, and therefore the number of permits, will decline, so permit prices will likely increase. The carbon price (permit price) is currently just over $15 per tonne (around $19 Canadian).
The cap initially applied only to electricity producers and manufacturers. In 2015, the cap-and-trade system expanded to include fuels like gasoline and diesel and now applies to 85% of California’s GHG emissions.
The cap falls every year, as required by legislation. From 2015 to 2020, the cap fell just fast enough to allow California to meet its target of reducing GHG emissions to 1990 levels by 2020.
In 2014, California linked its cap-and-trade program with Quebec’s, so companies in the two jurisdictions can trade permits with each other. In 2018, Ontario joined this linked cap-and-trade system.
Is the system working? Yes, but modestly, at least in the short term. From 2012 to 2015, California’s emissions fell by only 2%. A few factors help explain this outcome. First, the cap initially applied to only a few sectors. Second, the cap did not initially need to fall very fast for California to meet its 2020 emissions targets. Starting in 2020, however, the cap will start to fall faster, so we expect that GHG emissions will also start to fall more quickly.
The system’s challenges have offered lessons. Some observers worry, for example, that there are too many permits in the system, especially in the longer term. But the design of the California system at least partially addresses this concern by establishing a minimum permit price. Even if there is a glut of permits in the market, the price of carbon won’t fall below this threshold, thus maintaining the economic incentive for households and businesses to reduce their emissions.
Again, there is no evidence that cap-and-trade has harmed growth in the Sunshine State, which has remained robust. Since the 2008 global economic crisis, California’s economy has consistently outperformed the rest of the American economy, a trend that continued after 2012, when the cap-and-trade system was implemented.
Case Study #3: United Kingdom
The United Kingdom uses a hybrid carbon-pricing system, with elements of both cap-and-trade and a carbon tax.
Since 2005, the UK has participated in the European Union’s cap-and-trade system, which has a current permit price of less than £10 per tonne (around $18 Canadian). Since 2001, the UK has also had a domestic “Climate Change Levy,” which is a tax on electricity, gasoline, and other fuels supplied to firms. In 2013, the UK started increasing its domestic carbon tax to support the EU’s cap-and-trade system. The UK’s carbon tax differs from BC’s in a few key ways. For example, different sectors in the UK pay different levels of carbon taxes, whereas BC’s carbon tax is economy-wide.
The UK’s domestic carbon tax is now £18 per tonne (around $33 Canadian), and creates incentives additional to those created by the EU’s cap-and-trade system. In other words, domestic industries pay both carbon prices. For example, if the EU permit price were £8 per tonne, UK industries would pay a total carbon price of £26 per tonne (around $47 Canadian). If the EU permit price were to fall to zero, UK industries would still pay £18 per tonne for their GHG emissions.
Since 2000, the UK has seen a sharp decline in its total GHG emissions, and the drop has become steeper over the last few years.
As Figure 1 illustrates, the UK’s emissions have fallen faster than those in the rest of the EU, which has a cap-and-trade system but (for most countries) no additional carbon tax.
One sector in which the UK’s climate policies, including the carbon tax, have been particularly noticeable is large-scale electricity generation.
Electricity emissions have fallen by more than 30% over the last ten years. The carbon tax has played a key role.
According to one estimate (which isolates the effect of the carbon tax), production facilities that paid the UK’s Climate Change Levy reduced their electricity consumption by 23%. In addition, the tax was far more effective at reducing emissions than other programs that companies had the option to adopt instead of paying the carbon tax.
Carbon taxes also affected the way in which electricity is generated in the UK. Though other policies have also affected these outcomes, several recent studies cite carbon pricing as the main cause for the rapid decline of coal-fired electricity. Figure 2 shows the data: faced with a carbon tax, large electricity producers have begun producing more electricity from renewables and less from fossil fuels. As a result, the UK is producing fewer GHG emissions from electricity (and also less electricity overall).
The UK case also highlights some challenges. The UK is slowly decarbonizing its electricity sector but is now more reliant on imported electricity. In 2016, 5.8% of the UK’s electricity was imported, mostly from France and the Netherlands. While France uses mostly nuclear power, the Netherlands is still largely reliant on fossil fuels. Therefore, while the UK has reduced emissions significantly from its electricity sector, some of these emissions simply shifted to the Netherlands as a result of their weaker climate policies.
In the years following implementation of its carbon tax, the UK’s economy performed very well by current European standards. In per capita terms, the country’s economy grew faster than in similarly sized European countries, including France, Italy, Germany, and Spain. In the last decade, however, the UK’s economic growth has been slower than in many of its neighbours, due in large part to the financial crisis of 2008, and more recently, to the economic uncertainty created by the prospect of the UK’s exit from the European Union.
Why does carbon pricing work?
Why do higher carbon prices lead to lower GHG emissions? The underlying logic is based on an essential economic truth: prices influence behaviour.
Prices affect choices throughout the economy
First, think about prices of other goods and services. If the price of cauliflower increases, many people choose broccoli instead. If the price of parking increases, many people choose instead to take the bus or subway to work. If the price of winter beach vacations increases, many people choose instead to have local holidays. An increase in cigarette taxes helped to reduce the number of smokers. The same kind of response holds for choices all through the economy.
Here’s a specific example from history: in the 1970s, the world price of oil spiked significantly on two occasions, both of which led to sharp increases in gasoline prices in Canada. In response, drivers’ choices changed. In the short term, people drove less. In the medium term, fuel-efficient vehicles became more popular, so people might have driven the same amount, but they used less gasoline while doing so. The reason was simple: buying a more fuel-efficient car meant saving money. People (and businesses) like to save money when they can and when they have options to do so. Prices influenced behaviour.
Carbon pricing affects many different choices. It increases the costs of any activity (driving, flying, heating, etc.) based on how much carbon dioxide it produces. But that doesn’t mean that anyone and everyone simply pay a higher cost. After all, individuals and businesses have choices. Those choices give them ways to avoid paying the carbon price. And in fact, that’s exactly the point.
An example: carbon prices affect driving choices
To illustrate why carbon pricing works, let’s consider our choices around driving and how carbon pricing can affect them. The carbon price will make gasoline a little more expensive. How might your driving behaviour change as a result?
Most drivers have options in how they respond. Some seek opportunities to carpool. Others take the bus or train to work instead of driving. Others take more dramatic action like buying a smaller car—some even get rid of their car altogether (thus saving money on fuel plus many other car-related expenses). Others move closer to work. Some people might not change their behaviour at all, choosing instead simply to pay the carbon price on their unchanged gasoline usage.
Evidence shows that these kinds of decisions actually happen. Two UBC economists found that BC’s carbon tax reduced demand for fuel by 7%, and that a little less than half of those reductions were from changes in driving habits. Similarly, evidence from Denmark finds that a 10% increase in the price of fuel causes the average driver to reduce driving by 3%. In other words: prices influence behaviour.
Why do drivers make these choices? Because of the relative costs of the various options available. If making a different choice is easy (perhaps because a driver lives close to public transit) then it has low costs (for example, in terms of the time required).
By letting drivers choose how to respond (or not), a carbon-pricing policy lets individuals—rather than governments—identify the most preferred approaches to reducing GHG emissions.
Carbon prices can also affect vehicle choices
Changes in driving behaviour probably aren’t the only — or even the most important — way drivers respond to a higher carbon price. Over time, the policy will also affect the vehicles they purchase.
Let’s consider four Canadians in very different circumstances who share the need to buy a new car:
Different vehicles have different fuel economies. This means they produce different amounts of GHG emissions, so they also have different carbon costs under a carbon price.
Our four individuals have choices when it comes to buying a new vehicle. The carbon price can affect which vehicle they choose and thus the GHG emissions they ultimately create while driving that vehicle.
To unpack these vehicle choices, let’s consider the four options for a new vehicle in Table 1. We can see that different vehicles have their own advantages and disadvantages, both financial and non-financial (precise numbers will vary; think of these rankings as illustrative).
Which vehicles do our four drivers prefer? Let’s think about that question in three different contexts.
Begin in the situation without carbon pricing, in which case producing GHG emissions is costless to the individual. In this case:
Now consider the choices under a carbon price that rises over time. Emitters will therefore pay for the carbon emissions they produce. In this case: