Selected Issues

Abstract

Selected Issues

Climate Mitigation Policy in Canada: A Prototype for Other Countries 1

A. Introduction

1. Canada has set an ambitious target to achieve net zero greenhouse gas (GHG) emissions by 2050 (pending legislation would make this legally binding), has an intermediate target for 2030 aligned with this long-term commitment, and there are federal-level targets for the sales shares of zero-emission vehicles (ZEVs), phaseout of coal generation, and forest carbon sequestration. Requirements for carbon pricing at the provincial/territorial level are progressively scaling up. Carbon pricing is the most (cost)-effective instrument for promoting reductions in energy use, shifting to clean fuels, and establishing the critical price signal for redirecting new investment towards clean technologies. The pricing requirement of CAN $40 per ton (CO2) for 2021 will make Canada, along with the EU, the frontrunner on carbon pricing, while planned price increases over the next decade put it on track to meet its 2030 emissions targets. Canada’s mitigation strategy therefore provides a valuable model for others to follow at the national level and its approach shows how a price floor arrangement among large-emitting countries could work to effectively deliver emissions reductions at the global level that are urgently needed over the next decade.

2. Canada’s mitigation strategy has several key elements:

  • Most importantly, a proposed requirement that provinces and territories phase in an explicit carbon price floor, or an equivalently scaled emissions trading system (ETS), with a proposed price progressively rising to CAN $170 by 2030;

  • A federally imposed carbon pricing backstop, where sub-national carbon pricing falls short, consisting of (i) a fuel charge and (ii) an output-based performance standard (OBPS) for energy-intensive, trade exposed (EITE) industries;

  • Reinforcing federal incentives at the sectoral level, including tax credits for ZEVs, emission rate standards for vehicles and power generators, and building retrofit programs;

  • Public funding to support low-carbon investments and transitional assistance; as well as

  • Equitable and transparent recycling of carbon pricing revenues to households and (where revenues substitute for distortionary taxes) incentives for work effort and investment.

3. Although modelling suggests the carbon price floor trajectory is aligned with the 2030 emissions target, there is some uncertainty over the emissions impacts, and political acceptability, of high carbon prices. Additionally, some sectors (e.g., transportation, forestry, agriculture) are difficult to decarbonize through pricing alone or are not currently covered by pricing. Federal policies at the sectoral level, combined with the planned carbon pricing, could help enhance the overall effectiveness and acceptability of Canada’s mitigation strategy.

4. This chapter recommends policymakers consider the use of federal-level feebates to reinforce private mitigation incentives at the sectoral level. Feebates apply a revenue-neutral, sliding scale of fees on products or activities with above-average emission rates and a sliding scale of rebates on products or activities with below-average emission rates. They do not impose a fiscal cost to the government (which is important given current budgetary pressures induced by the pandemic) and they can help with acceptability because (unlike carbon pricing) they avoid the burden of higher energy prices on the average household and firm. Feebates are more flexible and cost-effective than regulations and can provide powerful mitigation incentives. While feebates have most appeal for the transportation sector, they could also be used alongside existing policies in the power, industry, building, and forestry sectors. Variants of pricing schemes might also be applied to fugitive emissions, logging on public forestland, and agriculture (in the latter case supported by consumer-level incentives to encourage plant-based diets).

5. The chapter also discusses strategies for enhancing the acceptability of carbon pricing. The pricing scheme by itself would impose an average burden on households of 2 percent of consumption in 2030 with burdens evenly distributed across household income groups. Returning carbon pricing revenues to households (as already common at the provincial level) offsets about 80 percent of this burden, however. For the most part, burdens at the provincial level are broadly representative of those at the national level.

6. Policymakers might also consider, over the medium term, a transition away from the OBPS to a border carbon adjustment (BCA), which is slated for introduction in the EU and is under consideration elsewhere (e.g., UK, US). With deeper decarbonization of industry, the BCA could address competitiveness and emissions leakage concerns more effectively than the OBPS, by applying carbon charges to imports with high embodied carbon (exempting trading partners with adequate carbon pricing). A BCA applied to EITE industries would limit administrative burdens and perhaps legal risks while raising revenues of 0.7 percent of GDP in 2030 with 35 percent from charges on imports from China and 28 percent from the US. An international carbon price floor (ICPF) arrangement, based on the Canadian model is, however, a potentially far more effective mechanism (than unilateral BCAs) for achieving the mitigation among large-emitting countries that is needed over the next decade to stay on track with climate stabilization goals.

Table 1 (below) summarizes the main policy recommendations of the chapter.

Table 1.

Summary of Recommended Federal Policy Actions Table 1. Canada: Summary of Recommend Federa Poli y Actions

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B. Background on Emissions, Targets, and Policies

The window of opportunity for containing global climate change to manageable levels is closing rapidly. Global carbon dioxide (CO2) and other greenhouse gas (GHG) emissions must be cut 25–50 percent below 2018 levels by 2030 to be on track with containing projected warming to 1.5o–2oC above preindustrial levels (on a linear reduction pathway) with rapid reductions to emissions neutrality thereafter. Due to the pandemic-induced crisis, global emissions projections for 2020 are about 8 percent below 2019 levels. However, without strong mitigation policies, global emissions are likely to start rising again in 2021 as economies recover (Figure 1). With governments bringing forward investment plans to boost their economies, the pandemic has added to the urgency of ensuring this new investment is efficiently allocated to low-carbon technologies. This, in turn, requires strengthening carbon pricing or equivalent measures to level the playing field for clean technologies.

Figure 1.
Figure 1.

Global Fossil Fuel CO2 Emissions Trends

Citation: IMF Staff Country Reports 2021, 055; 10.5089/9781513574295.002.A003

Source: IEA (2020), Fund staff estimates, IPCC (2018).

7. Canada has set aggressive targets to reduce carbon dioxide (CO2) and other GHGs. Key targets include:

  • A goal (made legally binding by the tabled Canadian Net-Zero Emissions Accountability Act, if passed by Parliament) of zero net GHG emissions by 2050.2 Other large emitters including the EU, Japan, Korea, UK and the US have also set carbon or GHG neutrality targets for 2050, while China has announced a carbon neutrality target for 2060.3 On a linear emissions reduction pathway, emissions neutrality in 2050 would require cutting 2030 emissions by one-third below current levels and 2040 emissions by two-thirds.

  • An intermediate goal—from Canada’s Nationally Determined Contribution (NDC) submitted for the 2015 Paris Agreement—to reduce GHG emissions to 511 million tons of CO2 equivalent in 2030 or 30 percent below the 2005 level and 15 percent below the 1990 level.4 Since Canada’s 2020 emissions are approximately the same as in 2005 (see below), the NDC target is aligned with a linear pathway to emissions neutrality.

  • Increasing the sales shares of ZEVs (for passenger vehicles) to 10 percent by 2025, 30 percent by 2030, and 100 percent by 2040.

  • Phasing out coal-based power generation by 2030.

  • Sequestering a net 7–46 million tons of CO2 in forests (depending on harvest rates) in 2030.5

8. GHG emissions in Canada were 729 million tons in 2018, with 74 percent of emissions from fossil fuel energy (see Figure 2). Another 8 percent of GHGs were from industrial processes like metal and cement production and fluorinated (F-) gases, 8 percent were fugitive emissions (leaks from extraction, storage, processing, and distribution of oil and gas), 8 percent from agricultural sources, and 2 percent from waste (e.g., methane leaks at landfills). By sector, energy (i.e., power and district heating) accounted for 36 percent of fossil fuel CO2 emissions in 2018, industry and construction 12 percent, transport 34 percent, and other sources (principally buildings) 18 percent. By fuel type, coal accounted for 26 percent of fossil fuel CO2 emissions in 2018, oil 42 percent, and natural gas 32 percent. Land use, land use change, and forestry (LULUCF) emissions were negative 13 million tons in 2018.6

Figure 2.
Figure 2.

Breakdown of GHG Emissions, 2018

Citation: IMF Staff Country Reports 2021, 055; 10.5089/9781513574295.002.A003

9. GHG emissions peaked at 744 million tons in 2007, or 24 percent above the 1990 level . Emissions were 2 percent below this peak in 2018. In a business-as-usual (BAU) scenario (i.e., with no new, or tightening of existing, mitigation policies) IMF staff7 project fossil fuel CO2 emissions to be 7 percent lower in 2030 than in 2018—although projected GDP is 15 percent higher this is more than offset by a decline in the energy intensity of GDP.8 In contrast, in large emerging market economies, BAU emissions expand rapidly. Nonetheless, without its planned mitigation policies, Canada would be the third largest per-capita emitter among G20 countries in 2030, and the tenth largest emitter in absolute terms. See Figure 3.

Figure 3.
Figure 3.

Fossil Fuel CO2 Emission Trends

Citation: IMF Staff Country Reports 2021, 055; 10.5089/9781513574295.002.A003

Source: Fund staff estimates.

10. The Pan-Canadian Framework on Clean Growth and Climate, adopted in 2016, ensures that carbon pricing applies throughout Canada with increasing stringency up to 2022, and the 2020 Climate Plan proposes to extend the horizon of escalating carbon prices to 2030.9 The framework covers all emissions sources except those from forestry, agriculture, and waste. Canadian provinces and territories have the flexibility to either implement an explicit price-based system—a carbon tax as in British Colombia or levy (i.e., where revenues are earmarked) as (initially) in Alberta—or an ETS. Jurisdictions with an explicit price-based system need a minimum price rising by CAN$1010 per ton of CO2 equivalent per year to reach $50 per ton by 2022. The Climate Plan proposes raising the annual increase in the carbon price to $15 per ton from 2023, implying a 2030 carbon price of $170 per ton. Jurisdictions with ETSs should have: (i) a 2030 emissions reduction target equal to or greater than Canada’s 30 percent reduction target; and (ii) declining annual caps corresponding, at a minimum, to the projected emissions reductions that would otherwise result in that year from a price-based system. The federal approach evolved from earlier provincial carbon pricing schemes which led federal policy to provide flexibility for provinces to maintain control over their carbon pricing systems.

11. Under Canada’s Greenhouse Gas Pollution Pricing Act, a federal ‘carbon pricing backstop system’ imposes pricing of fossil fuel GHGs in any province or territory that requests it or that does not have carbon pricing systems aligned with federal criteria (or, if needed, will supplement sub-national schemes with a ‘top-up’).11 The backstop has two components:

  • a tax-like component that is a regulatory charge on fuels; and

  • a tradable performance standard for EITE facilities called the Output-Based Pricing System (OBPS). Facilities with annual emission rates per unit of output above industry standards (which, to varying degrees, are set below the industry average) can meet their compliance through purchasing credits from facilities with emission rates below the standard. They can also use banked credits, pay a fee (equal to the carbon price), or buy offsets from provincial offset schemes (generated from projects in sectors not covered by pricing).12 Emitters registered for the OBPS are exempt from regulatory fuel charges. Most provincial carbon pricing systems meeting federal requirements have a version of the OBPS. See Annex 1 for further details.

12. Carbon pricing systems that fully meet or exceed federal requirements are in place across the country though there is a risk this could change due to pending legal actions in jurisdictions where it was more difficult to gain public acceptance of pricing. Carbon pricing systems in British Columbia, the Northwest Territories, Nova Scotia, and Quebec are fully meeting federal requirements. Systems in place in Alberta, New Brunswick, Prince Edward Island, and Saskatchewan also meet them for the emission sources they cover while the federal backstop supplements these systems for other sources. The federal backstop is in place in Manitoba, Nunavut, Ontario, and Yukon. See Annex 1 for more detail on provincial schemes. Alberta, Ontario, and Saskatchewan have taken the pricing requirement to the supreme court claiming it is not constitutional as it steps on provincial jurisdiction while Manitoba, New Brunswick, and Quebec also argued the law should be struck down.13

13. Proceeds from the federal carbon pricing backstop remain, by law, in the jurisdiction of origin. Provincial and territorial governments with systems meeting the federal benchmark, or who have voluntarily adopted the federal system, retain revenues. For provinces that have not committed to carbon pricing, the federal government returns approximately 90 percent of revenues from the backstop directly to households in the form of tax-free Climate Action Incentive payments.14

14. The price floor establishes Canada as one of the most aggressive emission pricing countries. Current prices in most carbon tax and ETS schemes are around US$5–25 per ton, though the EU’s ETS price has risen to $35 per ton, and some countries (e.g., in Scandinavia) have much higher prices (Figure 4). By 2022 and 2030, Canada’s price floor would reach the equivalent of US$36 and $133 per ton respectively.

Figure 4.
Figure 4.

Selected Carbon Pricing Schemes, 2020

Citation: IMF Staff Country Reports 2021, 055; 10.5089/9781513574295.002.A003

Source: World Bank, Climate Watch, Fund Staff Estimates.Note. Updated as of Nov. 2020. GHGs from 2017. EU includes Norway, Iceland, Liechtenstein. Revenues less than 0.005 percent of GDP are of equal size for illustrative purposes.

15. The federal government is pursuing complementary actions to reduce emissions and meet sectoral targets. These include:

  • emission rate standards on coal and natural gas-fired power stations (adopted in 2018);

  • federal rebates of $5,000 ZEVs and long-range plug-in hybrid vehicles and rebates of $2,500 for short-range plug-in hybrid electric vehicles;15

  • standards for the average emission rate of vehicle manufacturers sales fleets that are progressively declining from 210–275 grams CO2 per mile in 2016 to 130–175 grams CO2 per mile in 2025, depending on the vehicle footprint;16

  • building retrofit programs to improve energy efficiency;

  • incentives for reducing hydrofluorocarbons (HFCs) (the major F-gas) and methane leaks from the upstream oil and gas sector and a Clean Fuel Standard (CFS) to lower the carbon intensity of all fossil fuels.17

16. Public funding for green projects. This includes:18

  • Buildings: $2.6 billion over seven years starting in 2020–21 for residential energy efficiency improvements through grants for upgrades and energy audits; $1.5 million over three years for refurbishment of community and municipal buildings; $2 billion for retrofitting commercial and large-scale buildings.

  • Power: $964 million over four years for renewable energy and grid modernization projects (e.g., power storage); $300 million in clean power projects for remote and Indigenous communities.

  • Transport: $150 million over three years for charging/refueling stations for ZEVs; $1.5 billion for adoption of zero emission buses.

  • Industry: $3 billion over five years for a Strategic Innovation Fund that expedites decarbonization projects with large emitters.

  • Agriculture: $165.7 million over seven years for clean technology development and deployment.

  • Forestry: Up to $3.16 billion to partner with local actors to plant two billion trees by 2030.

  • Clean fuels: $1.5 billion for production and use of low-carbon fuels (e.g., hydrogen, biocrude, renewable natural gas and diesel, cellulosic ethanol).

  • Just Transition: $35 million fund supporting skills development and economic diversification in Canada’s coal regions; $150 million infrastructure fund for projects in impacted communities.

  • Net-Zero Advisory Body: $15.4 million over three years, starting in 2020–21 providing guidance on net zero emission pathways.

17. Although road fuels are subject to tax, fuel prices in Canada prior to carbon pricing (as in other countries) undercharge for supply costs and non-carbon environmental costs (Figure 5). That is, the existence of fuel taxes does not undermine the case for carbon pricing. In fact, accounting for unpriced, non-carbon environmental costs (e.g., local air pollution and, for road fuels, congestion, accident, and road damage externalities) enhances the economic case for carbon pricing—at least for coal and road fuels.19

Figure 5.
Figure 5.

Comparison of Efficient and Actual Fuel Prices, G20 Countries, 2015

Citation: IMF Staff Country Reports 2021, 055; 10.5089/9781513574295.002.A003

Source: Coady and others (2018).

18. Canada is in the vanguard of climate mitigation policy, though a variety of reinforcing fiscal measures at the federal level could help enhance the effectiveness and acceptability of the mitigation strategy. This paper first assesses Canada’s mitigation strategy. It then discusses reinforcing federal fiscal policy options for the transport, power, industry, building, extractive, forestry, and agricultural sectors. The paper also addresses the incidence of carbon pricing and strategies for addressing burdens on households and EITE industries. It also discusses an ICPF to scale up near-term action among large emitters using Canada’s approach as a prototype.

C. Assessing Canada’s Mitigation Strategy

19. For most countries, carbon pricing should be the centerpiece of climate mitigation strategy. Pricing: (i) provides across-the-board incentives to reduce energy use and shift towards cleaner fuels; (ii) automatically minimizes emissions mitigation costs (regardless of future energy prices or availability of carbon-saving technologies) by equalizing the cost of the last ton reduced across fuels and sectors; (iii) provides a robust price signal for redirecting private investment to clean technologies; (iv) mobilizes government revenue; and (v) generates domestic environmental benefits, like reductions in local air pollution mortality. It can also be straightforward administratively if, for example, it builds off existing fuel tax collection.

20. The pan-Canadian carbon pricing scheme is well designed. The scheme:

  • Comprehensively applies to all provinces and territories and all fossil fuel and industrial process emissions within those jurisdictions.

  • Has a clearly specified trajectory of robust and rising prices—recently proposed to be extended to 2030—which provides the critical price signal for redirecting investment towards low-emission technologies.

  • Allows flexibility in the use of revenues. Using revenues to increase economic efficiency is important for containing the overall costs of carbon pricing for the economy—efficient uses include, for example, lowering distortionary taxes on work effort and investment, or increasing socially efficient investments, whereas lump-sum transfers to households do not increase economic efficiency. In fact, combinations of policies like feebates can have significantly lower costs than (equivalently scaled) carbon pricing schemes where revenues are not used efficiently. See Annex 2 for further discussion.

  • Is compatible with overlapping instruments at the federal or sub-national level. In other words, other instruments reduce emissions without affecting price floors at the provincial and territorial levels. In contrast, if nationwide emissions were subject to a pure ETS, overlapping instruments at the federal or sub-national level would have no effect on emissions and instead would lower the ETS allowance price.

21. According to government and IMF projections, the carbon price is approximately in line with the 2030 emissions target (Figure 6), though estimates are subject to uncertainty. IMF staff estimates suggest the price would cut nationwide CO2 emissions about 33 percent below BAU levels which result in emissions slightly above the 2030 target. This projection however is sensitive to BAU emissions growth, which depends, for example, on GDP projections, and on the responsiveness of emissions to pricing, the latter of which relies on the future cost and availability of clean technologies, among other elements. Significant uncertainties surround all these factors, and uncertainties on the price responsiveness of emissions rise with the level of pricing. Political resistance to pricing, at the jurisdictional, industry, or household level may also intensify with the level of pricing.20

Figure 6.
Figure 6.

2030 CO2 Projections

Citation: IMF Staff Country Reports 2021, 055; 10.5089/9781513574295.002.A003

Source: Fund staff estimates, GOC (2019).Note. Target assumes CO2 is reduced in proportion to GHGs. GOC targets are BR2 for BAU and BR5 for $170 CO2 price.

22. The acceptability of pricing in Canada will partially depend on progress with pricing elsewhere – and implicit prices in some G20 countries’ 2030 targets are much lower than Canada’s. This reflects both less stringent targets, and greater responsiveness of emissions to pricing, in these countries. For example, carbon prices implicit in 2030 current mitigation pledges in China, India, Russia, and South Africa are all well below US$25 per ton (Figure 7).

Figure 7.
Figure 7.

CO2 Reductions for Pledges/from Pricing

Citation: IMF Staff Country Reports 2021, 055; 10.5089/9781513574295.002.A003

Source: Updated from IMF (2019a).Note. Pledge is from Paris Agreement or subsequent pledge. Price is additional to any existing pricing.

23. Complementary federal instruments to promote mitigation at the sectoral level that avoid (i) a fiscal cost and (ii) the burden of higher energy prices on households and firms can enhance the effectiveness and acceptability of the mitigation strategy. Sectoral measures promote a somewhat narrower range of behavioral responses to reduce emissions than carbon pricing. However, these measures have an important reinforcing role if carbon pricing becomes constrained from opposition to higher energy prices.

24. Existing Federal measures play a valuable role but have limitations. For example, meeting the coal generation phaseout and sales share requirement for ZEVs would reduce nationwide emissions by 3 and 1.5 percent respectively in 2030.21 Emission rate standards for power generators designed to phase out coal may not strike the cost-effective balance of emissions reductions across shifting from coal to gas, from these fuels to natural gas combined cycle (NGCC) with carbon capture and storage, and from all these fuels to zero-carbon fuels.22 Tax incentives for ZEVs do not promote shifting among conventional vehicles to reduce emissions and impose a fiscal cost on the government.

D. Fiscal Policy Options for Enhancing the Effectiveness and Acceptability of Canada’s Mitigation Strategy Without a Revenue Loss

Road Transportation

25. Generalizing ZEV tax credits with a more comprehensive feebate would strengthen incentives for progressively and cost-effectively decarbonizing the vehicle fleet, while avoiding a fiscal cost to the government. A feebate would provide a sliding scale of fees on vehicles with above-average emission rates and a sliding scale of rebates for vehicles with below-average emission rates. That is, each new vehicle would be subject to a fee given by:

CO2 price × {CO2/mile-CO2/mile of the new vehicle fleet} × {average lifetime vehicle mileage}

Certified CO2 per mile by model type (currently used to administer the vehicle emissions program) provides the data needed to assess the fees and rebates for each vehicle. The feebate cost-effectively promotes the full range of behavioral responses for reducing emission rates, as there is always a continuous reward (lower taxes or higher subsidies) from switching from any vehicle with a higher emission rate to one with a lower emission rate.23 In addition, the feebate maintains (approximate) revenue neutrality: by definition, fees offset rebates as the average emission rate in the formula is updated over time.

26. For illustration, a feebate with a price of US$300 per ton CO2 would apply a subsidy of US$7,500 for ZEVs and a tax of US$1,800 for a vehicle with a CO2 emission rate of 300 grams per mile (Figure 8).24 Other countries in Europe with elements of feebates generally impose much higher taxes on high emission vehicles than this illustrative feebate though the sales shares for these vehicles is smaller than in Canada. Subsidies for ZEVs would decline over time as the average fleet emission rate declines, which is appropriate as the cost differential between clean vehicles and their gasoline counterparts falls over time (e.g., with improvements in battery technologies). The feebate price can be scaled up if needed to keep on track with ZEV targets.

Figure 8.
Figure 8.

CFig2 -Based Components of Vehicle Taxes

Citation: IMF Staff Country Reports 2021, 055; 10.5089/9781513574295.002.A003

Source: ACEA (2018) and Fund staff estimates.Note. Assumes discounted lifetime driving of 62,000 miles.

Power Generation

27. Incentives for de-carbonizing the power sector could be strengthened with a federal level feebate. Under this scheme, power generators would be subject to a fee given by:

CO2 price × {CO2/kWh ─ industry-wide average CO2/kWh} × electricity generation

The feebate cost-effectively, and in a revenue-neutral way, promotes the full range of responses for reducing emission rates per kWh—improving generation efficiency and shifting the mix of fuels from coal to gas and from these fuels to nuclear, fossil plants with carbon capture, and renewables. The feebate avoids the increase in electricity prices under carbon pricing which might be politically challenging, though it does not generate the same reduction in electricity demand. For illustration, a feebate with a price of CAN$50 per ton would currently apply a subsidy of 0.5 cents per kWh for zero-carbon generation plants and fees of 1.2 and 4.5 cents per kWh for natural gas and coal plants respectively (Figure 9).

Figure 9.
Figure 9.

Illustrative Feebate for Power Sector

Citation: IMF Staff Country Reports 2021, 055; 10.5089/9781513574295.002.A003

Source: Fund staff estimates.

Industry

28. Carbon pricing for industry (for both emissions from fuel combustion and process emissions) may be constrained in practice by concerns about competitive and leakage impacts. The burden of carbon pricing on industry would consist of the costs of cutting emissions (e.g., from switching to cleaner but more expensive technologies) and the, typically much larger, tax or allowance purchase payments for remaining emissions (Annex 3). The leakage rate for carbon pricing—the offsetting increase in emissions in other countries in response to comprehensive domestic carbon pricing—has been estimated at 19 percent for Canada.25 To date, competitiveness concerns have been, in part, addressed in Canada through OBPSs that, for the average firm, do not charge for most infra-marginal emissions.

29. Feebate schemes for industries could reinforce incentives for reducing emissions intensity but with a smaller burden on the industries than from higher carbon pricing (Annex 3). Under a feebate firms would pay a fee given by:

CO2 price × {CO2/production ─ industry-wide average CO2/production} × production

Feebates are essentially the fiscal analog of OBPSs, but they avoid the need for trading markets and provide more certainty over emissions prices—prices would be easily harmonized with carbon prices applied to fossil fuels to promote cost effectiveness across the EITE sector and the rest of the economy. Annex 3 provides illustrative comparisons of the impacts of carbon pricing and feebates on production costs in the steel and cement industries.

Buildings

30. Improvements in the energy efficiency of new and existing buildings, and appliances used in buildings, reduce both direct emissions and (through lowering electricity demand) indirect emissions. These improvements may, however, be hindered by possible market failures (e.g., liquidity constraints, cost-benefit mismatches between owners and renters, unawareness or uncertainty of energy savings from renovation). These would warrant some policy intervention, even if nationwide emissions were adequately priced.26 Codes for the design, construction, alteration, and maintenance of buildings are implemented at the state level.

31. Various feebate schemes could strengthen incentives for energy-efficient and low-carbon appliances and equipment. For example, sales of refrigerators, air conditioners, and other energy-consuming products could incur a fee given by:

CO2 price × CO2 per unit of energy × {energy consumption per unit ─ industry-wide energy consumption per unit} × number of units

For refrigerators, for example, the energy consumption rate would be kWh per cubic foot cooled (and the number of units would be cubic feet). A similar scheme applying taxes to gas- and oil-based heating systems, and a subsidy for electric heat pumps, could accelerate the transition to zero-carbon heating systems. Again, feebate schemes avoid a fiscal cost to the government and the carbon prices in feebate programs across different product categories are easily harmonized to promote cost effectiveness.

Fugitive Emissions from Extractive Industries

32. Venting accounted for 55 percent of fugitive emissions in Canada in 2018 (two-thirds from oil, one-third from gas), flaring 13 percent (mostly from oil) and other leaks 30 percent (the majority from gas). 70 percent of the CO2 equivalent emissions were from methane releases and 30 percent from CO2.27 Possibilities for mitigating fugitive emissions include: (i) reinjecting gas for enhanced oil recovery or storage; (ii) using methane for on-site or regional power generation; (iii) compressing the gas, or liquifying it, for sale; and (iv) improved maintenance of infrastructure for gas processing and distribution. Canada has adopted a target of reducing fugitive methane emissions by 40–45 percent below 2012 levels by 2025 and 60–75 percent below by 2030 in line with international best practices. Current regulations take the form of targeted interventions (e.g., routing emissions to vents, replacing or controlling individual high-emitting components, inspecting equipment for methane leaks).28

33. Pricing schemes for fugitive emissions would promote the full range of responses for reducing emission rates and are administratively feasible using default emission rates with rebating for firms demonstrating lower emission rates.29 Emissions monitoring technologies30 generally provide only discrete measurements at a limited number of sites, though technologies are improving, and CO2 emissions from flaring are measurable. Fuel suppliers might be taxed based on a default leakage rate with rebates to firms demonstrating lower leakage/venting rates than the default rate through mitigation and installing their own continuous emission monitoring systems. Fugitive emissions are released within Canadian borders, and therefore should be priced regardless of whether the fuel is for domestic or overseas markets. Pricing approaches can be more flexible and cost-effective than regulatory approaches—under the latter approach, there is no automatic mechanism for equating the cost of the last ton reduced across different mitigation opportunities.

34. For illustration, an emissions tax of $25 per ton of CO2 equivalent on fugitive emissions would apply charges equivalent (prior to mitigation) of approximately $0.5 per barrel of oil and $0.1 per thousand cubic feet of natural gas. These charges are equivalent to about 0.6 and 2 percent of current supply prices.31 Studies suggest however, that this modest level of pricing could lower emission rates by around 20 percent.32

Forestry

35. Ideally, federal forestry policies should cost-effectively promote, nationwide, the three channels for increasing forest carbon storage. These include: (i) afforestation; (ii) reducing deforestation; and (iii) enhanced management of tree farms (e.g., planting larger trees, longer rotations, fertilizing, tree thinning). Most forestland is publicly owned, and measured changes in forest area have been very modest.33 Nonetheless, marginal land use change at the forestry/agriculture border, and reduced logging (which is not classified as deforestation) on public lands, could usefully complement public tree planting programs.34 Forest carbon inventories can be measured, albeit in a rudimentary way, through a combination of satellite monitoring, aerial photography, and on-the-ground tree sampling.

36. A national feebate program could cost-effectively promote responses for increasing carbon storage on private land without a fiscal cost to the government. The policy would apply fees to landowners at the agricultural/forestry boundary that reduce stored carbon relative to a baseline level and rebates to landowners that increase stored carbon. That is, the fee is given by:

{CO2 rental price} × {carbon storage in a baseline year ─ stored carbon in the current year}

The scheme would reward all three channels for enhancing carbon storage, either through reduced fees or increased subsidies. Feebates can be designed—through appropriate scaling of the baseline over time35—to be revenue-neutral in expected terms. Feebates should involve rental payments—on an annualized basis, a CO2 price times the interest rate36—rather than large one-off payments for tree planting, given carbon storage may not be permanent (e.g., due to subsequent harvesting or loss through fires, pests, windstorms). For illustration, fully stocking a hectare that previously had no trees would increase the land value by about $2,000 under a $50 feebate (or 25 percent of average agricultural land values in Canada in 2019).37 Fees and rebates could be administered based on the registry of landowners used for business tax collection.38

37. Logging taxes are common around the world, but generally in the form of sales or income taxes.39 Technically, however, it would be straightforward to modify logging taxes to link them to carbon. Partial exemptions from fees may be warranted for timber harvested for wood products (e.g., furniture, houses) because the carbon emissions (released at the end of the product life) will be delayed, perhaps by several decades or more.

Agriculture

38. Agricultural GHGs can be reduced through several channels. Reducing livestock herds (particularly beef and dairy cattle) reduces methane releases from enteric fermentation (41 percent of Canadian agricultural GHGs) and nitrous oxide emissions from manure (14 percent), while reducing crops for human and animal consumption (42 percent) reduces nitrous oxide emissions from soils, especially where there is intensive chemical fertilizer use.40

39. Pricing could be based on proxy estimates of emissions but a compensation scheme for the farm sector may be needed to enhance acceptability and limit emissions leakage. Direct monitoring of farm-level emissions is not currently practical, but emissions can be estimated indirectly using farm-level data (on livestock herds, feed, crop production, fertilizer use, and acreage), as well as default emissions factors.41 Emissions taxes might face strong political opposition and could cause significant emissions leakage as the tax burden reduces the international competitiveness of Canadian farmers. A feebate approach is worth studying, perhaps based on GHG-equivalent emission rates per hectare, nutritional value, or per $ of output.42 Alternatively, an emissions fee could be combined with the revenues recycled to the agricultural sector in the form a rebate proportional to the value of farm output (this would be operationally equivalent to a feebate based on emissions per $ of output). These approaches promote behavioral responses for reducing the emissions intensity of farming and, from an administrative perspective, the fees and rebates could be integrated into collection procedures for farmer business tax regimes. Demand responses at the household level might be promoted through taxes on meat and dairy products (from both domestic and overseas suppliers).43

E. Addressing the Burden of Carbon Pricing on Households and Firms

Household Incidence

40. A $170 carbon price in 2030 would, on average, increase retail electricity prices in Canada 20 percent above BAU levels, road fuel prices 30 percent, and natural gas prices 200 percent. Absolute and proportionate price increases for natural gas and road fuels would be similar across provinces and territories but absolute and proportionate price increases for electricity differ to the extent power grids are not integrated.44 In proportionate terms, carbon pricing has larger impacts on natural gas prices in Canada than in most other G20 countries, but smaller (nationwide) impacts on electricity prices—see Table 2 comparing impacts of a US$75 carbon price. In most other G20 countries, the proportionate increase in natural gas prices is lower due to higher BAU prices, while the proportionate increase in electricity prices is larger due to more emission-intensive generation.

Table 2.

Energy Price Impacts of US$75/ton CO2 Price, Selected Countries, 2030

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Source: Updated from IMF (2019a).Note. BAU prices are retail prices from Coady and others (2019), including preexisting energy taxes, and adjusted for projected changes in international reference prices. Coal and natural gas prices are based on regional reference prices while electricity and gasoline prices are from cross-country databases. Price increases are proportional to carbon emissions factors which are exogenous for coal, gas, and road fuels and endogenous for electricity. GJ = gigajoule; kWh = kilowatt-hour.

41. On average, the burden on Canadian households from increasing the carbon price to $170 carbon price in 2030 (relative to the 2020 price of $30) is 2 percent of consumption prior to revenue use. See Figure 10. Burdens are evenly distributed across (population-weighted) household per-capita consumption deciles at the national level. About 35 percent of the burden comes from higher road fuel prices, 33 percent from higher natural gas prices, 6 percent from higher electricity prices, and 25 percent comes indirectly from the impact of higher energy costs on the general consumer price level. Burdens for most provinces are broadly representative of the national average, though burdens are noticeably lower in Quebec where natural gas consumption is limited. About 80 percent of the average household burden in 2030 is offset (at least for the near-to-medium term) when revenues are recycled back into the economy (e.g., in the form of broad income tax reductions or general investments).

Figure 10.
Figure 10.

Burden from Increasing the Cth2 Price to $170 per ton by Household Income Decile and Region Prgior to Revenue Reecycling, 2, 2030

Citation: IMF Staff Country Reports 2021, 055; 10.5089/9781513574295.002.A003

Source. Fund staff estimates updating from IMF (2019b). Note. Deciles are ordered poorest to weathiest.

Firm Incidence

42. Iron and steel mills and other ferrous alloys stand out as the most vulnerable industries to carbon pricing. Other vulnerable industries include chemicals; petroleum and coal production; steel production (from purchased steel); pesticide, fertilizer and other agricultural chemicals; as well as resin, synthetic rubber, and artificial fibers and filaments manufacturing. See Figure 11.

Figure 11.
Figure 11.

Cost Increases from $50 Carbon Price, 2030

Citation: IMF Staff Country Reports 2021, 055; 10.5089/9781513574295.002.A003

Source: IMF (2019).Note. Estimates account for behavioral responses by firms.

43. Competitiveness impacts of a given level of carbon pricing would be less severe at the national level in Canada than in some other large emitters (due, in part, to Canada’s high share of renewables in electricity). Averaged across the 20 percent of most vulnerable industries, cost increases from the same level of carbon pricing (US$50) in 2030 (prior to any pass-through into consumer prices) would be 1.7 times as large in the United States as in Canada, 2.7 times in India, and a striking 4.1 times in China. See Figure 12.

Figure 12.
Figure 12.

Burden of a US$50/Ton Carbon Price on Industries in 2030 Before Pass Through, Selected Countries

Citation: IMF Staff Country Reports 2021, 055; 10.5089/9781513574295.002.A003

Source: IMF (2019a).

44. There is debate about the possibility of a border carbon adjustment (BCA) for Canada imposing charges for the embodied carbon in imports. The EU intends to announce a proposal for a BCA in June 2021 that would come into force in 202345 and the Biden Administration’s climate plan46 contains a BCA proposal.

45. BCAs have three main rationales.47 First, they help address the competitiveness impacts of carbon-price-induced increases in energy prices, which can be critical for enhancing the political viability of high carbon prices. Second, they reduce the risk of ‘emissions leakage’, that is, partially offsetting increases in emissions in overseas countries induced by domestic mitigation policy. Third, at an international level, they might encourage (through BCA exemptions for those with adequate pricing) stronger carbon pricing in other countries. The last rationale has little relevance for Canada, unless it were acting in coordination with other large emitters.

46. BCAs would be at least as effective as other approaches for addressing competitiveness and leakage, encouraging pricing elsewhere, maintaining mitigation incentives for industry, as well as mobilizing revenue (see Table 3). For example, a BCA can be more effective at assisting EITE industries on competitiveness than OBPSs. More precisely, the latter do not compensate for the costs of reducing emission rates, which increase rapidly with the level of abatement (see Annex 3).

Table 3.

BCAs Versus Other Instruments

article image
Source: Fund staff.

47. Concerns about BCAs revolve around administrative complexities and legal risks and both might be lessened by limiting the BCA to EITE industries. A BCA would be administratively burdensome if it applied to imports of every manufacturing product from all Canada’s trading partners. In contrast, administration is much simpler if it is limited to EITE industries—reliable data on embodied carbon in trade flows for these industries is publicly available at an aggregated level.48 Moreover, EITE industries account for nearly 90 percent of the emission from manufacturing in Canada.49 Another concern is the possibility of legal challenges at the World Trade Organization (WTO), or retaliation by trading partners. Limiting the BCA to EITE industries, however, may enhance the prospects for legality under trade law—reducing carbon leakage is a potential legal justification for trade measures like BCAs under GATT Article 2050 which has credibility for industries with substantial embodied carbon.

48. There are various other design issues, but they should be administratively practical and EU experience should provide useful guidance. Other design issues include, for example, whether to allow rebates for individual overseas exporters that are less carbon intensive than the industry average, how to adjust charges for carbon pricing or mitigation measures in trading partners, whether to rebate charges for embodied carbon in exports, and whether to set lower BCA rates for developing country trading partners. See Annex 4 for further discussion. The authorities should consider whether a BCA might be an appropriate instrument for Canada and, at least to some degree, design features that might be harmonized with those adopted by the EU.

Table 4.

G20 CO2 Outcomes Under Alternative ICPF Scenarios

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Source: Fund staff estimates.Note. aAssumes CO2 reduced in proportion to total GHGs. bHigher/lower price for advanced/emerging market economies or higher/middle/lower price for advanced/high income emerging market/low income emerging market economies.

49. A Canadian BCA with a carbon charge of $170 applied to EITE industry imports would have raised revenues of 0.5 percent of GDP in 2015. 41 percent of the revenue would have come from imports from China, 23 percent from the United States, and 6 percent each from India and the EU (Figure 13). Using revenues for assisting the domestic clean energy transition (e.g., clean technology infrastructure investments, assistance for vulnerable workers and regions), international climate finance, or rebates to governments of developing country trading partners may enhance the likelihood the BCA is viewed as an environmental measure (and compatible with the WTO) rather than a protectionist measure.

Figure 13.
Figure 13.

Revenue from $170 BCA, 2015

Citation: IMF Staff Country Reports 2021, 055; 10.5089/9781513574295.002.A003

Source: OECD (2021).

F. Global Mitigation: Canada’s Price Floor as a Prototype for an ICPF

50. Even if countries achieved their current mitigation commitments for the Paris Agreement, worldwide GHG emissions in 2030 would be reduced less than one-third of the amount consistent with containing projected global warming to 2oC or below.51 The main issue is that the bulk of low-cost mitigation opportunities is in large emerging market economies, but these countries have relatively lax commitments at present, at least in part because they have differentiated responsibilities or a lower valuation of the insurance properties of mitigation policy52 than advanced countries. Acting unilaterally, countries lack incentives to scale up carbon mitigation due, for example, to concerns about competitiveness impacts. IMF staff53 recommend an ICPF arrangement to complement and reinforce the Paris Agreement with the principal aim of increasing near-term mitigation effort in large emerging market economies.

51. Canada’s carbon pricing scheme provides a valuable prototype for how an ICPF arrangement among large emitting countries might work to scale up global mitigation action . An ICPF arrangement would be the most efficient approach for addressing countries’ concerns about the competitiveness impacts of carbon mitigation. The arrangement need only include a small number of large emitting countries facilitating negotiation. It could be designed equitably with lower requirements for non-advanced economies, and/or transparent transfers, to reflect their lower per-capita income and small contribution to the historical stock of atmospheric GHGs. The floor could also be designed flexibly to accommodate different approaches at the national level including carbon taxes, ETSs, and combinations of pricing, feebates and regulations that achieve the equivalent emissions outcome as implementing the price floor.

52. A carbon price floor could be highly effective in scaling up global mitigation. For illustration, if the United States, China, and India were subject to price floors of $75, $50, and $25 per ton respectively in 2030, this would cut G20 emissions about 28 percent below baseline levels, which is just consistent with the 2oC target. Including all G20 countries would increase G20 emissions reductions, but only moderately, to about 30 percent. Emissions reductions under the $75/$50/$25 price floor would, broadly speaking, be evenly distributed—about 20 percent below baseline levels in the EU and India, about 28 percent in the US, and somewhat over 30 percent in China.54

53. Implementation issues would need to be fleshed out. For example, the focus could initially be on emissions from the power and industry sectors as: (i) these emissions are generally the most responsive to pricing and, therefore, play a key role in the early stages of clean energy transitions; (ii) most ETSs currently in place are limited to these sectors; and (iii) historically, fuels in these sectors were largely untaxed (or subject to minimal taxation, in terms of CO2 equivalent taxes) making for a clean comparison to a baseline without carbon pricing. Over time, as the arrangement transitions to broader coverage of fossil fuel emissions, and measuring conventions are developed, the focus might move to countries’ ‘effective’ carbon prices which take into account potentially incomplete coverage of formal carbon pricing schemes and changes in pre-existing energy taxes (which are typically large for transport fuels). In relation to this, participants could agree to increase their effective carbon prices by a given absolute amount over time, relative to effective prices in a baseline year.55

G. Summary of Policy Recommendations

  • Introduce a system of revenue-neutral federal feebates to provide strong, reinforcing incentives for reducing emission rates in the transport sector.

  • Apply feebates to reinforce decarbonization in power generation and industry.

  • Use feebates to promote adoption of energy-efficient appliances and clean heating systems for buildings.

  • Apply a fee to fugitive emissions from extractive industries with rebates for firms demonstrating their emission rates are below default rates.

  • Consider feebates and a logging tax to promote forest carbon sequestration.

  • Consider feebates or emissions pricing schemes (with within-sector revenue recycling) to promote shifting to less emissions-intensive farming practices, reinforced with fiscal incentives at the consumer level to encourage plant and poultry-based diets.

  • Consider a medium-term transition from the OBPS to a border carbon adjustment applied to EITE industries.

  • Promote dialogue on an ICPF arrangement among large emitters to complement the Paris Agreement using Canada’s model as a prototype.

References

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Appendix I. Further Details on the OBPS and Provincial/Territorial Carbon Pricing Schemes

1. Facilities covered by the federal OBPS include those that emitted 50,000 tons of CO2 equivalent in 2014 or any subsequent year in the following industries: oil/gas production, minerals, chemicals, pharmaceuticals, iron/steel/metal tubes, mining/ore processing, nitrogen fertilizers, food processing, pulp/paper, automotive and electricity. Facilities emitting 10,000 tons or more in certain sectors can also apply to participate voluntarily in the OBPS. Most provincial carbon pricing systems have a version of the OBPS including Alberta, Newfoundland and Labrador, Nova Scotia, Quebec, and Saskatchewan. Standards for sectors assessed to be at low or medium risk of competitiveness impacts are set at 80 percent of the sector’s average emissions intensity; those assessed to be at high risk are set at 90 or 95 percent of the average. Effectively, carbon pricing applies to 100 percent of emissions but there is an offsetting output subsidy valued at 80–95 percent of the industry average.1

Table A1 provides detail on sub-national pricing schemes.

Table A1.

Canada: State of Provincial Emissions Pricing Initiatives, 2021

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Sources: WBG (2021). WBG (2020). Canadian Energy Research Institute (2020). International Carbon Action Partnership (2021). New Brunswick Gov (2018). NWT Gov (2019). PEI Gov (2018). Ontario Gov (2021).Notes. LNG is liquefied natural gas operations. WCI is the Western Climate Initiative including the California ETS. *Increases delayed due to COVID-19. Territories in reduce GHG emissions

Appendix II. The Economic Importance of Using Carbon Pricing Revenues Productively

1. Carbon pricing imposes two sources of costs on the economy. First is the cost of the mitigation responses themselves. For example, firms producing with cleaner (but more expensive) technologies or households using less fuel than they would otherwise prefer. Second are broader macroeconomic costs. Higher energy prices tend to slightly contract overall economic activity as they increase the general price level, which in turn reduces the real returns to work effort and investment and causes compounding of distortions in factor markets created by taxes on labor and capital income. These costs can be largely offset (or perhaps more than offset, in some cases) from using carbon pricing revenues to increase economic efficiency, for example for lowering taxes on work effort or funding investments warranted on cost-benefit grounds.1

2. An assessment for the United States (Figure A2) suggests that an ETS with free allowance allocation and emissions price of $50 per ton (or the equivalent carbon tax with revenues returned in lump-sum dividends to households2) is about twice as costly—for a given nationwide emissions reduction—as a combination of feebates exploiting the major opportunities across the economy for reducing emission rates. This is because feebates have smaller impacts on energy prices and, therefore, smaller macroeconomic costs. The most cost-effective policy, however, is an ETS with allowance auctions, or a carbon tax, with the bulk of revenues used to cut distortionary taxes on labor and business income, or otherwise increase economic efficiency.

Figure A2.
Figure A2.

United States: Economic Efficiency Costs of Alternative Mitigation Instruments ($50/Ton Carbon Tax), 2030

Citation: IMF Staff Country Reports 2021, 055; 10.5089/9781513574295.002.A003

Source: IMF (2019a).Note. Policies reduce economywide CO2 emissions 22 percent below BAU.

Appendix III. Burden of Carbon Pricing on Industries

Conceptual Analysis

1. The increase in unit production costs for an industry subject to carbon pricing has two components (Figure A3). First is the efficiency (or resource) cost of the induced changes in production methods (e.g., the cost of switching to cleaner technologies and fuels), indicated by the area under the marginal abatement cost schedule. Second is the transfer payment, equal to the carbon price times the remaining emissions per unit of output, which is a private rather than social cost (it reflects a tax payment to the government or a payment to allowance sellers). Schemes that avoid (for an average firm) the transfer payment, are effective at offsetting most of the increase in unit production costs for modest levels of abatement, but they become progressively less effective at higher levels of abatement. For example, they offset about 95 percent of costs when emissions reductions are 10 percent but only 45 percent of costs when emissions reductions are 70 percent.1 This in part explains the growing interest in a BCA as the EU moves to deeper de-carbonization of industry.

Figure A3.
Figure A3.

Unit Cost Increases for Industry from Carbon Pricing

Citation: IMF Staff Country Reports 2021, 055; 10.5089/9781513574295.002.A003

Illustrative Impacts of Carbon Pricing and Feebates on Production Costs for Steel and Cement

Steel

2. Traditionally, steel is produced using an integrated process involving heating coal to form coke, feeding coke and iron ore into a blast furnace, and using an oxygen furnace to purify the molten metal. This process produces about two tons of CO2 per ton of steel.2 Alternatives include an electrified process using scrap metal, and emerging technologies—for example, applying CCS, or feeding an electric furnace with iron made by direct reduction (e.g., using natural gas). These alternatives produce CO2 emissions of about 0.3–0.4 tons per ton of steel.

3. A carbon price of CAN$50/ton of CO2 would increase the cost of integrated production by about CAN$100/ton of steel through the first-order transfer payment, about one seventh of recent steel prices.3 t would also increase the cost under alternative technologies by about CAN$20/ton of steel.4 In contrast, under a feebate, the cost increase for integrated production (given an assumed industry average emission rate of 1 ton of CO2 per ton of steel) would increase costs by CAN$50 per ton of output, while alternative technologies would receive a subsidy of about CAN$30 per ton of output.

Cement

4. Most cement is produced using traditional kilns to decompose calcium carbonate into clinker and CO2 and then using mills to mix clinker with other minerals (e.g., limestone) and grind it. This process produces about 1 ton of CO2 per one ton of cement, with process emissions contributing about 70 percent of these emissions. Alternatives include state-of-the-art plants in terms of energy efficiency, currently about 10 percent of production, and CCS—either post-combustion (where CO2 is extracted from exhaust gases) or oxy-combustion (where fuel is burned with a mixture of pure oxygen and exhaust gases). State-of-the-art plants largely eliminate non-process emissions. Post- and oxy-combustion reduce emissions about 55 and 85 percent respectively, while increasing capital costs by about 25 and 100 percent respectively.

5. A carbon price of CAN$50/ton of CO2 would increase the cost of traditional production by about CAN$50 per ton of cement, or about 30 percent,5 while also increasing the price of more efficient and CCS-fitted plants by CAN$30, and CAN$8–25 per ton of output respectively through the first-order transfer payment. In contrast, a feebate with price CAN$50/ton of CO2 would only increase the cost of traditional production by CAN$5 per ton of cement, while providing a subsidy to more efficient and CCS-fitted plants of CAN$10 and CAN$18–35 per ton of output.

Appendix IV. Design Issues for BCAs

Design issues include the following.

Sectoral coverage

1. Limiting the BCA to EITE industries may make sense on competitiveness, targeted leakage, administrative, and legal grounds. Competitiveness and leakage concerns are less severe for industries with relatively low energy intensity and trade exposure. The narrow focus also limits administrative burdens, as only a few key products from trading partners need to be tracked and there is publicly available data on carbon content for these products. It may also limit legal risks because: (i) the BCA would be replacing the OBPS which has not been subject to legal challenge; and (ii) the motivation based on leakage is more transparent for EITE products than for other manufactured products with low embodied carbon (relative to output) value.

2. Applying a broader BCA to all manufactured products more comprehensively addresses leakage and provides a larger incentive for carbon pricing overseas but these effects are modest, and administration is more complex. As noted above, the difference between emissions from EITE and all manufacturing industries is generally not that large. Administrative burdens rise rapidly with broader coverage due to the need to track more products. In addition, calculating embodied carbon for non-EITE products is more difficult. Indeed, charges on these products may need to be at a high level (e.g., taxing the value of all electronic products at the same rate). Moreover, a broader BCA might involve higher legal risks. If WTO compatibility is met through the leakage rationale, this might be more open to question, as leakage risks for an individual non-EITE product (with low carbon relative to value product) are generally small.

Measuring embodied carbon

3. The first issue here is whether to assess BCAs on imports using country-specific or domestic measures of embodied carbon. Using country-specific data has appeal on economic efficiency grounds, as domestic consumers will face the right set of relative prices across imported products with different carbon intensities. Administration is more complex however, as a different BCA rate needs to be calculated for each overseas exporter and there are uncertainties over whether objective criteria for applying differentiated rates across countries would breach WTO rules. A pragmatic approach may be to use domestic embodied carbon (initially to limit legal risks while the BCA is being established, with a view to progressively transitioning to country-specific BCAs at a later stage).

4. The second issue is whether to use industry-wide, or firm-level, measures of embodied carbon. Where BCAs are based on country data, it may seem appropriate to use firm-level data because of the heterogeneity of production methods used in many EITE industries. This would add further administrative complexity, however, and, at present, measures of embodied carbon in trade flows are publicly available by country and product only for broad product classifications. Using industry average benchmarks may, therefore, be the more practical approach. However, a ‘rebuttability’ provision allowing individual firms in trading partners to claim rebates, subject to third-party verification that their production is lower than this average, may help with WTO compatibility. There could be a risk of gaming, however, if the BCA induces firms to switch production from their cleaner plants for export to Canada while redirecting products from dirtier plants to other countries. To avoid this issue, the BCA rebate could be based on embodied carbon for an exporter averaged over all their production.

Rebates for domestic exporters

5. From a competitiveness perspective, including a symmetric rebate on exports reflecting the difference between domestic and foreign carbon prices levels the playing field in international markets. However, the subsidy element of a BCA reduces domestic mitigation incentives, making it harder to meet national mitigation targets, and forgoes government revenues.

Adjusting import charges for carbon pricing or other mitigation policy overseas

6. Lowering the BCA rate for an overseas exporting country with carbon pricing is consistent with the motivation to reduce carbon leakage and avoids double taxation of overseas emissions. If the primary motivation for a BCA is maintaining competitiveness for EITE industries or reducing carbon leakage, the BCA might be linked to pricing just for the power generation and industrial sectors (as emission pricing for residential and transport fuels has little impact on production costs for EITE industries). In principle, adjusting the BCA for formal carbon pricing elsewhere would be straightforward from a measurement perspective, as up-to-date details on the scope and price levels in carbon pricing schemes around the world is available.1 One complication is that formal carbon pricing may be partially offset by reductions in pre-existing fuel taxes. Furthermore, if the BCA is linked to economy-wide pricing, schemes with partial coverage would need converting to economy-wide equivalents. In principle, these complications could be addressed through linking the BCA to changes in ‘effective’ carbon pricing in overseas countries, but this would complicate administration. Some practical compromise should be feasible, however. One example would be to simply weigh formal pricing schemes by the fraction of emissions covered, at least until widely accepted measures of effective carbon prices are developed.

Differentiating charges by country income

7. Applying a lower BCA rate for exporters in low-income countries (LICs) would partially undermine the ability of the BCA to address competitiveness and leakage (but only moderately so given their modest shares in trade with Canada). Excluding LICs would, in a blunt way, be consistent with the principle of common but differentiated responsibilities and it may be consistent with the WTO’s Enabling Clause, if the exemption criteria are based on objective development indicators. Country-based exemptions would need to be designed to prevent the trans-shipment of goods from covered countries through exempted countries, but this challenge should be manageable.

1

Prepared by Ian Parry, Simon Black, Danielle Minnett, and Victor Mylonas.

2

See https://mcmillan.ca/Canada-Legally-Commits-to-Net-Zero-Emissions-by-2050. Emissions in some sectors (e.g., transportation) may be positive so long as they are offset elsewhere by negative emissions (e.g., from reforestation, using biomass with carbon capture and storage technologies in power generation, deploying air filter technologies to directly remove CO2 from the atmosphere).

4

See Government of Canada (2015) and CAT (2020a). All 190 parties to the 2015 Paris Agreem ent are submitting revised climate strategies for the November 2020 UN climate meeting in Glasgow.

5

ECCC (2018).

7

Staff analysis is based on an IMF model parameterized to individual countries. Use of fossil and other fuels in the power generation, road transport, industry, and household/commercial sectors are first projected forward in a BAU scenario using assumptions about: (i) GDP growth; (ii) income elasticities (i.e., the responsiveness of energy demand to higher GDP); (iii) autonomous rates of technological change (e.g., that improve energy efficiency and the productivity of renewables); (iv) future international energy prices; and (v) the price responsiveness of fossil fuels in different sectors. The responsiveness of fuel use to carbon pricing and other policies depends on: (i) the proportionate change in energy prices in different sectors and (ii) various price elasticities for electricity and fuels. Parameter values are based on mid-range assumptions from the modelling and econometric literature. The analysis of nationwide policies below is based on the IMF staff model.

8

Reflecting gradually improving energy efficiency and an assumption that the demand for energy increases by less than in proportion to GDP.

10

Unless otherwise indicated, monetary figures below are in current CAN $.

12

A federal offset program is currently under development.

13

The hearing concluded on September 23, 2020 but a decision could take several months.

16

See https://laws-lois.justice.gc.ca/eng/regulations/SOR-2010–201/index.html. 130 and 275 grams of CO2 per mile are equivalent to about 70 and 33 miles per gallon respectively. Canadian standards have traditionally been aligned with fuel economy standards in the US and, therefore, may be tightened if the Biden Administration adopts stricter standards than the Obama Administration.

17

The CFS sets standards, starting in 2022 and increasing annually until 2030, to reduce the lifecycle carbon intensity of gasoline, diesel, kerosene and other liquid fuels (e.g., through blending biofuels, improving the energy efficiency of refineries, adopting carbon capture and storage technologies, investing in hydrogen and renewables). Suppliers failing to meet the standards will be required to purchase credits in the CFS market.

19

Some level of fuel taxation is efficient to reflect local external costs of driving, including traffic congesti on, accidents, and air pollution—at least until more efficient instruments like mileage-based charging systems are widely applied. Parry and others (2014) provide an extensive discussion of second-best efficient fuel taxes, methods for quantifying them in different countries, and more efficient policies.

20

For example, France’s attempt to rapidly increase a carbon tax for non-ETS emissions was suspended in 2018, due to public opposition, when the price reached US$49 per ton.

21

IMF staff calculations.

22

NGCC generators with fast ramp up speeds can be used as a complement to intermittent renewable generators (e.g., Verdolini and others 2018).

23

Vehicle manufactures are, therefore, rewarded for going beyond prevailing emission rate standards (and penalized for not meeting them). In this way, the feebate reinforces existing regulations.

24

For comparison, a 2015 Honda Fit, Toyota Camry XV70, and Ford ranger T6 currently have mpgs of 49, 41, and 31 respectively or CO2 emission rates of 181, 217, and 287 g CO2 per mile respectively.

26

See, for example, Arregui and others (2020).

27

From https://di.unfccc.int/detailed_data_by_party. One ton of methane is equivalent to about 25 tons of CO2 in terms of warming equivalents over a 100-year horizon (IPCC 2007).

28

See https://laws-lois.justice.gc.ca/PDF/SOR-2018–66.pdf. The federal government has also announced a $675 million Emissions Reduction Fund for reducing onshore methane emissions and establishing a leak detection and repair program to reduce fugitive emissions (see www.nrcan.gc.ca/science-data/funding-partnerships/funding-opportunities/current-funding-opportunities/new-oil-gas-sector-emissions-red/emissions-reduction-fund-onshore-program/23050).

29

Norway, for example, imposes a tax on methane emissions. See www.norskpetroleum.no/en/environment-and-technology/emissions-to-air.

30

Including satellites, aircraft, drones, and remote sensing from vehicles.

33

90 percent of forestland is owned by provinces and territories, 4 percent by the federal government, and 6 percent by private landholders. Over the last 30 years, less than 0.5 percent of Canada’s forestlands have been converted to a non-forest land use. See www.nrcan.gc.ca/our-natural-resources/forests-forestry/sustainable-forest-management/forest-land-ownership/17495 and www.nrcan.gc.ca/our-natural-resources/forests-forestry/state-canadas-forests-report/how-much-forest-does-canada-have/indicator-forest-area/16397.

34

Temperate forests can sequester up to about 3 tons of CO2 per hectare a year during the growth cycle (Domke and others 2020). In 2018, logging in Canada’s managed forests accounted for removals of about 8 million tons of CO2 (see www.nrcan.gc.ca/our-natural-resources/forests-forestry/state-canadas-forests-report/how-does-disturbance-shape-canad/indicator-carbon-emissions-removals/16552).

35

See Parry (2020) for details.

36

Periods might be defined as averages over multiple years given that carbon storage might be lumpy during years when harvesting occurs.

37

Calculation assumes the planting sequesters an additional 3 tons of CO2 each year over a 20-year growth cycle with payments discounted at 5 percent. Land values are from www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=3210004701.

38

See Mendelsohn and others (2012), Parry (2020) for further discussion of design issues for forestry feebates.

39

See WBG (2021) for further discussion of logging taxes.

40

Figure from UNFCCC (2020).

42

Basing the feebate on emission rates per hectare could be problematic because livestock is land intensive but the emissions per hectare could be smaller than for crops. The feebate could be disaggregated with higher pivot points for beef producers and lower pivot points for crop producers—this might enhance acceptability (by lowering fees for the former) though it would lower incentives to switch from livestock to crop operations.

44

The Canadian grid consists of the Western, Eastern, and Quebec grids.

45

Worldwide, only one BCA has been implemented to date, applying to the embodied carbon in imported electricity under California’s ETS (e.g., Pauer 2018).

47

For example, Morris (2018).

50

See Flannery and others (2020).

55

See Parry (2020) for further discussion.

1

A substantial analytical literature has explored these interactions. See, for example, Goulder and others (1999), Parry and Williams (2012).

2

Dividends have no efficiency benefits as they do not increase the real return to work effort or investment.

1

From a simple comparison of the triangle and rectangle in Figure A3, assuming a linear marginal cost curve.

2

Unless otherwise noted, all data in this Annex is taken from van Reijven and others (2016).

4

Technology switching is more likely to take the reform of retrofitting existing plants, rather than scrapping plants and building new ones, given that existing steel factories can potentially produce for several decades. Incentives will vary across plants, for example with local fuel and electricity prices.

5

Cement prices are currently around US$125 per ton of cement (www.ibisworld.com/us/bed/price-of-cement/190).

Canada: Selected Issues
Author: International Monetary Fund. Western Hemisphere Dept.