Part II: Thinking about costs and policy design
By Brendan Frank, Canada’s Ecofiscal Commission
Climate policy is complicated area, and there’s a unique vocabulary to it. In the first part of this blog, we unpacked the basics of negative externalities, carbon pricing, non-pricing policies and cost-effectiveness. This week, we’ll discuss policy design and dive a little deeper on costs.
Thinking about costs
When it comes to cost-effective climate policy, we often talk about marginal abatement costs, which is the cost of reducing (“abating”) one additional tonne of carbon emissions in a specific part of the economy.
Carbon pricing, if it’s designed well, reduces emissions at the lowest possible cost. If the marginal cost of a given action is cheaper than the carbon price, better to take that action and avoid paying the carbon price. This can be anything from switching to a high-efficiency furnace to taking the bus instead of your car.
But non-pricing policies sometimes target emissions reductions that are pretty expensive. The Ecofiscal Commission found, for example, that Quebec’s electric vehicle subsidies reduce emissions at a cost of around $395 per tonne.
To optimize costs and benefits, policy should set the price of carbon equal to the social cost of carbon, which is equal to the damages to society resulting from one additional tonne of carbon. Environment Canada estimates the social cost of carbon dioxide at $40.70 per tonne, but also acknowledges there’s a good chance that it’s much higher (think $200 per tonne).
Other issues: leakage, competitiveness, and fairness
Well-designed carbon pricing avoids leakage. Leakage is the possibility that carbon pricing creates incentives for industries to move to areas where climate policies are less strong to avoid paying the carbon price. The overall result is that emissions are not reduced, they just shift to different parts of the world.
Leakage matters in particular for industries that produce lots of emissions per unit of output (they’re emissions-intensive) and compete in international markets (they’re also trade-exposed). Cement manufacturing, iron and steel, petroleum refining and oil and gas production are typical examples. Ecofiscal analysis estimates that about 5% of the Canadian economy meets both criteria.
Fortunately, well-designed policy can prevent leakage. In particular, we can use the revenues from carbon pricing for output-based allocations, which are temporary production subsidies for vulnerable sectors. Together with a carbon price, they create incentives for firms to improve their emissions performance and efficiency but not to reduce production.
Well-designed carbon pricing ensures fairness, which means that they don’t impose disproportionate costs on low-income households. Costs of carbon pricing—from heating and driving, for example—can make up a bigger share of low-income households’ total income. However, governments can recycle revenues in different ways to address these very important concerns. In Alberta, for example, households that earn less than $95,000 get cheques in the mail to help offset costs.
A complicated problem
The world of climate policy is complicated, and full of jargon and hard choices. At the Ecofiscal Commission, our goal is to show just how much these choices matter. Climate change is already costing us. Ensuring that our climate policies are cost-effective will save Canadians money now, and in the future.
