Home / Parallel Paths – 4.1 Linking with a U.S. Cap-and-Trade system to Harmonize Prices

Parallel Paths – 4.1 Linking with a U.S. Cap-and-Trade system to Harmonize Prices

Canadian policy continues to envision the possibility of a continental cap-and-trade system.

In May 2010, Prime Minister Stephen Harper stated, “in the integrated North American economy, it’s difficult, if not impossible, to make progress on [a cap-and-trade system] without the co-operation of the United States.”³⁹ This section examines issues of linkage and what it means to Canada’s economic and environmental outcomes. In a linked trading system, emissions permits are traded between national carbon trading systems. If U.S. firms can use Canadian permits to comply with their carbon cap and vice versa, an integrated Canada-U.S. trading market is the result. Such an integrated, linked market would lead to a convergence of carbon prices for the two countries. Alternatively, in an unlinked approach, Canadian and U.S. markets are entirely independent with no trading and potentially different carbon prices.

Linking is thus one possible approach to harmonize carbon prices. Linking could benefit Canadian firms because U.S. permits will be available at lower cost than Canadian permits, thus lowering the price of carbon and the costs of meeting their GHG emissions obligations. Table 10 illustrates this point. The table compares the carbon price and GDP impacts between a scenario where Canada’s cap-and-trade system is independent of the U.S. — unlinked — and a scenario in which the systems are linked. The results show that Canada’s linked carbon price falls between the Canadian and U.S. unlinked price at $60, but closer to the U.S. price. Linking could therefore decrease the costs of policy substantially for Canada but raises it slightly for the United States. This result is consistent with other analyses of linkage: overall economic efficiency of the system is increased, though individual linkage partners could experience gains or losses.⁴⁰

The implications for Canadian industrial sectors of a linked Canada-U.S. cap-and-trade system mirror the overall positive national outcomes presented above. Some sectors, however, experience greater benefits from the lower, harmonized carbon price that would result from a linked system. As illustrated in Figure 19, sectors that might benefit most from linking – and a subsequently lower carbon price – include the oil sands and refining sectors, as well as those that benefit from a level playing field with carbon competitors in the U.S., such as cement and iron and steel.

Linkage comes with trade-offs — environmental and economic. Linked Canadian and U.S. cap-and-trade systems would result in lower costs for Canadian firms relative to a Canadaonly system, but linkage also means fewer domestic emission reductions would be realized. The lower price requires the purchase of U.S. permits by Canadian firms. Such permit purchases are effectively financial transfers from Canadian firms to American firms. NRTEE modelling shows this would total about $2 billion in 2020 in the scenario set out in Table 10. Money invested in the U.S. through permit purchases is money not invested in Canadian low-carbon technology and practices. Consequently, these transfers could impose opportunity costs. Figure 20 shows the difference in U.S. permit purchases required between linked and unlinked scenarios under NRTEE modelling. In each scenario, 20 % of total compliance is achieved through international permit purchases, amounting to around $1 billion in 2020, depending on the market price of international permits.⁴²

Compliance through domestic offsets, as shown in the figure, includes only reductions from landfill gas in Canada, which is modelled explicitly in the GEEM model. Other potential sources of domestic offsets, such as forestry and agriculture, are not explored in our analysis.

As noted, a lower carbon price would reduce costs to the economy in the short term, but also reduce incentives for innovation and deployment of the new, low-carbon technologies necessary over the long-term. Of particular risk for Canada is that prices contained in this scenario are below thresholds at which carbon capture and storage (CCS) becomes economically viable based on current costs of the technology. Recent studies suggest that CCS in Canada may not experience significant market penetration below a threshold carbon price of approximately $70–80 / tonne.⁴³ In the long term, CCS could be a critical technology for Canada’s oil and gas industries to remain competitive in a global lowcarbon economy. Previous NRTEE studies have demonstrated the important contribution CCS could make to achieve the scale of domestic emission reductions necessary to achieve Canadian targets.⁴⁴

A short-term barrier to linkage may reside in American public acceptability. A linked carbon trading system requires Canada to accept U.S. permits as valid, and vice versa.⁴⁵ Two issues emerge. First, a linked Canadian-U.S. system would likely increase the carbon price in the U.S. While the increase would be small given the relatively smaller size of the Canadian market, this outcome might still be undesirable in the U.S. as it would experience lower GDP growth under a linked scenario.

Second, current U.S. legislation⁴⁶ indicates that linking would constrain Canadian policy design choices. Both the Waxman-Markey and Kerry-Boxer bills admit the possibility that permits issued under a Canadian cap-and-trade regime could be treated as comparable to those issued under a U.S. system. As defined in both bills, the primary standard for using international emissions permits as compliance within the U.S. is imposing “a mandatory absolute tonnage limit on greenhouse gas emissions.”⁴⁷ Both a technology fund and intensity-based targets, as proposed under the original Canadian Turning the Corner plan,⁴⁸ would preclude linkage with the U.S. under these terms in both the House and Senate proposals. These mechanisms can constrain costs, but in doing so, create uncertainty in the absolute quantity of emissions to be reduced. Based on text in the proposed legislation, it seems clear that emissions permits will not be recognized from another country unless two conditions are met : a fixed number of allowances are available for every compliance period, and the implied level of emission reductions is at least as stringent as that imposed in the U.S.⁴⁹

Overall, while linkage could provide a means of addressing Canadian competitiveness issues by harmonizing the carbon price between Canada and the U.S., it remains problematic as a short-term solution, both because of timing and because it requires U.S. participation. Establishing a national cap-and-trade system within Canada in the interim would position Canada to link ultimately with the United States. It would also allow for piloting the system to “de-bug” it, and reduce the cost of fragmentation associated with different federal and provincial climate policy approaches, as the NRTEE noted in its Achieving 2050 report. The Western Climate Initiative cap-and-trade model being developed now could offer a solid foundation upon which to build.

[39] Clark, C., & Milner, B. (2010).
[40] Jaffe, A., & Stavins, R. (2007); Lazarowicz (2009).
[41] These scenarios show key outcomes with and without trade of emissions permits enabled between the Canadian and U.S. systems (linked and unlinked). In the first scenario set, Canada and the U.S. each implement a cap-and-trade system to achieve their 2020 target of 17% below 2005 levels, with 20% of its compliance through international permits. We model U.S. policy as this simplified economy-wide capand- trade system so as to have a common point of comparison across the Canada Lags, Canada Leads, and Canada Harmonizes scenarios. Permits to large emitters are allocated for free as output-based allocations in order to reflect trends toward free permits in the U.S. The rest of the economy is covered through an upstream cap with permit auction and revenue recycling 50% to corporate and 50% to income tax. This split reflects a neutral distribution; revenue is roughly distributed back to households and firms in the proportion in which it was collected.
[42] NRTEE modelling assumed a flat price of $25/tonne CO₂e for international permits if the U.S. does not implement policy (and thus does not compete for low-cost international reductions) and $50/tonne CO₂e if the U.S. does implement policy.
[43] Integrated CO₂ Network Group of Companies (2009).
[44] NRTEE (2009).
[45] For full “two-way” linking, both trading partners would accept the emissions permits from each other’s system. Under “one-way” linking, Canada could unilaterally accept U.S. permits as valid for compliance with a Canadian cap.
[46] H.R. 2454 (2009) and S.1733 (2009).
[47] H.R. 2454 (2009), section 728.
[48] The Turning the Corner plan included a “Climate Change Technology Fund” that is both a safety valve compliance mechanism that would allow firms to meet a portion of their compliance obligations by contributing to a fund, as well as a means of a revenue recycling in that it would return revenue to investments in emissions-reducing technologies. The plan included intensity targets in that it introduced emissions-intensity performance standards that would determine the right to emit for covered entities; with no change in output, each facility would effectively be given the right to emit 18% less than they did in 2006 and 2% less for each year thereafter. An increase in output would increase the level of allowable emissions for the facilities. See Environment Canada (2007).
[49] Also see Bramley, M., Partington, P.J., and Sawyer, D. (2009) for discussion of implications of cap-and-trade design for linkage.