Intergovernmental Relations and Carbon Pricing: Carbon Taxes vs Cap and Trade by

1. Intergovernmental Relations and Carbon Pricing: Carbon Taxes vs Cap and Trade by Thomas J Courchene And John R Allan IIGR Queen’s Power Point Presentation to the Conference Carbon Pricing and Environmental Federalism October 17-18, 2008 Four Points Hotel, Kingston, ON iigr@queensu.ca TC-083

2. Story Line • In both Canada and the US it is the sub-national governments that are driving the carbon-pricing agenda while their respective national governments are either politically or ideologically unwilling to assume leadership on this file. • While this creativity on the part of the provinces is welcomed, the reality is that for reasons relating to constitutionality, efficiency, equity and preserving the internal environmental union (IEU), Ottawa needs to assume the mantle of leadership. • The analysis will attempt to buttress this assertion which, in turn, will elaborate on what federal leadership might mean. • We then assess how C&T and carbon tax regimes can accommodate an increased federal presence while still respecting the reality that the provinces cannot and should not be left out of the picture. • Finally, we focus on the Western Climate Initiative (WCI), i.e., the proposed C&T system embracing several Western US states and four Canadian provinces (BC, MB, ON, QB) and whether this has the potential to keep the provinces in the driver’s seat. TC-083

3. Role of Provinces in Climate Change • Great source: Building on our Strengths (Jillian Bollinger and Kari Roberts: Canada West Foundation 2008). • Emission Reduction Targets (see chart at end of deck • Carbon pricing: • C&T: (Alberta; and 4 provinces in WCI: BC,MB,ON, QB), • Carbon tax: (BC, QB) • Carbon sinks and carbon capture (all provinces) • Alternative Energy (Barry Rabe captures this with RPS –Renewable Portfolio Standards); all provinces, especially as this relates to electricity and biofuels • Other: command and control mechanisms, e.g., appliance standards; conservation, etc • Bravo! • But our focus here will only be on carbon pricing TC-083

4. Carbon Pricing and the fed-prov tug-of-warHeading for a re-run of the NEP? • While the provinces deserve our thanks for their creative proposals for reducing GHGs, there is a potential downside: e.g., with Alberta imposing an origin-based emissions charge (essentially a tax on production of carbon) and with BC among others imposing a destination-based carbon tax (essentially a tax on consumption), and with Ottawa likely apply to a centralized scheme, the stage is set for a repeat of an NEP-type federal-provincial and inter-provincial donnybrook. • The issues in play are highly explosive: • Political/Constitutional: Who can (ought to) tax/regulate carbon? • Competitiveness: Who can we level the playing field for industry, domestically and internationally? • Fiscal/Financial: Who should receive the revenues from carbon abatement? • Unfortunately for the provinces, they may have to reconcile themselves to three inconvenient truths relating to these three challenges ...... TC-083

5. The First Inconvenient Truth:Constitutional Jurisdiction • S.92A gives the provinces primary control over their resources, but pricing carbon may not be viewed by the courts as equivalent to pricing/taxing resources. • Provinces can also rely on s.92(2) “direct taxation”: and s.109 (“ All Lands, Mines, Minerals and Royalties ...shall belong to the several provinces”); and s.125 (essentially, the crown cannot tax the crown). • Peter Hogg (2008 C D Howe Backgrounder) notes: • It is clear that [the provinces] have the constitutional authority to regulate emissions from industries within their borders. All provinces have in fact announced plans to introduce controls on greenhouse gas emissions, and Alberta has actually enacted a regime of control. • However, he then adds: But it is obvious that air is not confined by provincial borders, nor is competitive economic activity, so some form of national regime is required, which does not necessarily exclude a role for the provinces. • The conference papers by Elgie and Chalifour provide corroborating and convincing evidence that Ottawa has the right of way in terms of carbon pricing, both C&T and carbon taxation • But Ottawa may have to tolerate some form of joint occupancy TC-083

6. The Second Inconvenient Truth:Competitiveness • There are at least two aspects to competitiveness – levelling the playing field in terms of free riding, domestically and internationally, and ensuring the internalenvironmental union (IEU). • Since provinces cannot levy “tariffs” they may not be able to deliver export-import neutrality or even cross-province neutrality. Beyond competitiveness concerns, this will likely lead to “emissions leakage” as production moves to avoid provincial carbon pricing regimes • C&T systems that limit trading and offsets to occur within-province create further inefficiency issues, and may not be constitutional. • Perhaps the provinces, acting together (via the Council of the Federation or with a federal imprimatur) could mount a national C&T or latch on to an international C&T. • Whereas the previous slide agued that Canada can tax and regulate carbon, the above analysis of the concerns relating to preventing Balkanization of the IEU and to securing efficiency and competitiveness (x-m neutrality and a single national price for carbon) provides the case that Ottawa oughtto tax/regulate carbon emissions TC-083

7. The Third Inconvenient Truth: Who Should Get Carbon-Abatement Revenues? • The costs of GHGs are allocated rather equally across all citizens. • The revenues arising from carbon abatement should also be shared rather equally across all citizens (or perhaps all consumers since they will presumably bear the carbon price). Therefore revenues should be allocated broadly, probably on the basis of consumption • If one used production, rather than consumption, as an allocator, this would mean that not only would the energy provinces be receiving huge rents/royalties, but they would also receive the bulk of revenues from carbon abatement policies. Since the monies involved are large, this would dramatically exacerbate the already huge fiscal imbalances across provinces. Again, a potential argument for federal leadership. • This is not meant to be a federal revenue grab. For example, under a national carbon tax, there is no reason for Ottawa not to share carbon tax revenues with the provinces (on, say, an equal-per-capita basis) who can then use them as they wish (e.g., to make their portions revenue neutral via tax cuts or incentives for low-GHG technologies) TC-083

8. Interim Conclusion: • We have attempted to show • That Ottawa has a constitutional right to pursue carbon pricing • This is necessary in order to level the playing competitive playing field (e.g., X-M neutrality and for preserving and promoting the IEU) • This implies a single national carbon price (either via a carbon tax or C&T) • Revenues from a carbon tax should be allocated on a consumption, not production, basis. • It seems appropriate for a significant portion of these revenues to be shared with the provinces on an equal per capita basis. • Two Questions/Issues arise and will be the focus of the remainder of the presentation 1. How do the various carbon tax and C&T regimes accord with the above presumed principles? and relatedly 2. How can C&T and carbon tax regimes be altered to accommodate an increased federal presence while still respecting the reality that the provinces cannot and should not be left out of the picture? TC-083

9. Carbon Taxes:A Carbon-Added Tax/Tariff (CATT): I • From Courchene & Allan (Policy Options, March 2008) • A CATT is the carbon equivalent of our GST (i.e.,VAT) ) • Would be a tax on the carbon emissions added at each stage. As the product moves through the supply chain, the carbon taxes accumulate. (At each stage, the carbon tax on inputs is rebated, so that the net tax to the agent at this stage will only be on the carbon added.) • When the product reaches the final stage, the tax is on the cumulative value of carbon emissions. • This is identical to the way in which the GST works. • The full carbon tax is ultimately paid largely by consumers • As with the GST, the tax accumulated at the point of export is rebated, so that the CATT is export neutral. Continued... TC-083

10. Carbon Taxes:A Carbon-Added Tax/Tariff (CATT): II • A carbon tax will be assigned to all imports, equal to the accumulated carbon footprint. • Therefore the CATT is export-import neutral, it does not affect our domestic or international competitiveness • Since a CATT would be an indirect tax, Ottawa has jurisdiction, and in any event the provinces could not manage (practically or constitutionally) the interprovincial and international entries required of a VAT or CATT (except via delegation). • The resulting revenues can be shared with the provinces, as with the Atlantic HST. • The CATT should be WTO compatible in the same way as the VAT. CATT is a tax on carbon, not on imports, per se. • Achilles Heel? – measurement challenges. But much is afoot here. The Carbon Disclosure Project has the support of 3,000 of the world’s largest corporations, Loblaw’s is undertaking carbon labelling, Japan has told us that there are 75 grams of carbon in a small bag of chips TC-083

11. CATT : IIIAssigning Carbon Footprints • Suppose Alberta produces X barrels of oil, which creates 1 tonne of GHGs, and then it exports this to China? • Whose carbon footprint is this 1 tonne of GHGs? • Kyoto says it is Canada’s . Canada also says it is ours! • But this is surely wrong. The footprint should be China’s • In other words, the locus of consumption (demand), not production, should be the allocator of the carbon footprint. • Under Kyoto, if country A imports its energy/resources while country B produces its own, country A will have a much lower GHG footprint. • Thus, resource exporters like Australia and Canada are allowing importing countries to appear to be better environmental citizens than they actually are: the UK GHGs would be above its Kyoto target under a consumption assignment. This is going to be an enormous problem for Canada, domestically (fed-prov) and internationally. This is especially so if the developing countries expand rapidly • CATT would assign this carbon footprint to China! • energy TC-083

12. Carbon Taxes;Non-VAT Versions • The dominant version of carbon taxes (Mintz-Olewiler model, BC tax, QB tax, Green Shift) are non-VAT and more like sales-type taxes on fossil fuels or taxes targeted on big emitters of GHGs • They should be made X-M neutral, although this is more problematic in the WTO context than it is under a CATT • The revenues can be made revenue neutral (typically including funding for low-carbon research and renewable energy). • The huge advantage here is on the implementation front, especially if the tax is on producers and distributors since both collection and measurement issues are much less problematic than for a CATT. • Relatedly, it is much easier for provinces to become players here (because of implementation ease), as BC and Quebec have revealed. • Revenue sharing with the provinces becomes rather inevitable since it is difficult (politically and even constitutionally) to prevent the provinces from imposing carbon taxes, as Green Shift has realized when it offered to integrate the BC tax into it plan (with obvious but unmentioned implications for Green Shift’s revenue neutrality). TC-083

13. C&T Systems:Pros and Cons • A pure C&T system would: i) set the cap; ii) auction this amount of emission permits; and iii) allow permit trading which would set the carbon price. Efficiency would increase the larger is the trading area. • This pure system is probably a null set. Rather we tend to see intensity caps, soft pricecaps, and no auctioning (all are in the AB and Ottawa models) and often Offsets that may be hard to verify. This may be appropriate for a phasing-in period, but the real and political “property rights” that are created may make evolution difficult. • C&T systems can be very complex to implement and manage. This is because a veritable bureaucracy has to be put in place: bankers, brokers, lawyers, insurers, auditors, regulators and regulations , as well as an enforcement mechanism for violations of the C&T • In a C&T where government gets no revenues, a concern is to manage price spikes and aid to at-risk citizens. This provides some rationale for auctioning and for price caps, and it moves C&T toward carbon tax regimes with “double dividend” possibilities. Indeed a C&T with a binding price cap is, at the margin, equivalent to a carbon tax. TC-083

14. Carbon Taxes vs. Cap and Trade Systems:Some Speculative Comments • Economists in both Canada and the USA favour carbon taxes over C&T, but elected officials tend otherwise. • This may be because the public tends to believe that the costs of carbon taxes are borne by consumers whereas the costs of C&T are borne by the polluters. There is little recognition that without an increase in carbon prices, a C&T will do little. Indeed, the carbon price under a C&T will ramify through the economy as the same way as the carbon price under a carbon tax. This reality needs to be made public • With admittedly some degree of representation, for carbon taxes the higher price for carbon products can be offset with equivalent tax cuts or tax expenditures, whereas for C&T the higher prices for carbon are offset by the higher value of the non-auctioned permits held by corporate Canada. Auctioning permits would allow C&T to also have the carbon tax “double dividend” • Would industry be more in favour of a carbon tax if they knew that the permits issued under C&T would be auctioned? • Assertion: A tax on the carbon content of fuels is not a tax on GHGs TC-083

15. The Provinces and Carbon Pricing: Carbon Sinks • It seems to us that command/control policies relating to carbonsinks fall rather naturally under provincial jurisdiction, e.g., carbon capture and storage (CCS) for electricity plants, and reforestation policies. (Note that Freeman Dyson believes that genetically engineered carbon-eating trees will appear within two decades.) • These and other carbon sinks will be obvious offsets under C&T. And they will come into play under carbon tax systems if they are cheaper than paying the tax. But might it also make sense to have a these activities qualify for a carbon subsidy or for incentive programs under any revenue-neutral schemes. This provides a further rationale for sharing any carbon pricing revenues with the provinces. • Harvesting forests decreases carbon sinks. Should forestry activities (harvesting/ reforestation) be integrated more fully into carbon pricing schemes (with appropriate intergenerational discounting). • The relevance of this is two fold: i) that carbon pricing schemes need to be cast more widely, and ii) they need to fully engage the provinces since many key aspects of climate change need provincial approval TC-083

16. C&T with Provincial Allowances/Targets:Carbon Assignments and Auctioning • Although the ETS has a single international price, it sets its overall target as the sum of national targets. It will abandon this over time and move to ETS targets. The WCI also has state and provincial targets. • Should our carbon pricing targets also come initially from provincial allocations? If so, two challenges may arise : • 1. Continued growth in developing nations can drive up energy and resource prices, so resource firms will be able to afford to drive up carbon prices and crowd out production elsewhere. Part of the problem here is that the carbon footprint associated with these exports will be assigned to our provinces rather than to the importers. • 2. Under full information, etc, carbon auctioning will not affect the allocative outcome of a C&T. However, it will have income distribution effects, again with crowding-out implications. This could argue for a gradual introduction of auctioning to soften the impact of point 1. • Moreover, Kyoto assignments ignore population growth (see chart 2) • Recommendation: Canada should publish results for all 3 approaches: absolute, per capita and consumption-based targets. TC-083

17. The WCI Cap and Trade System;The Provinces End-Run Ottawa? • In September 2008, seven states and four provinces agreed to an international C&T. • This is as close to a model C&T as currently exists. • There will be state/province targets, permit auctioning, rigorous (and international) offsets, a single international price across participating states and provinces, and platform that may be extended to embrace an integrated Canada-US C&T regime. • This is truly remarkable in its own right, and in the present context: Whereas constitutional, efficiency, equity and fiscal considerations may assign the trump cards to Ottawa in terms of designing and operating national carbon pricing schemes, the exceptional reality where 4 provinces with over 75% of our population have embarked on the creative cross-border C&T means that federal inaction on the climate change file may well have served to abdicate leadership and moral authority to the provinces. Welcome to Environmental Federalism! TC-083

18. Thank You For Your Attention Comments Welcomed tom.courchene@queensu.ca John.Allan@queensu.ca TC-083