Comment on Proposed Amendments to Canada’s Output-Based Pricing System Regulations

Carbon pricing is widely recognized as the most cost-effective way to reduce emissions. However, the differences between the federal backstop system and provincial carbon pricing systems might ultimately result in increased internal/external carbon leakage risks and competitiveness challenges for provinces with more stringent climate policies. For this reason, it is necessary to improve the economic incentives for provinces and territories, creating incentives for them to do more than the minimum possible to meet the federal standard.

It is also important to take into account different regional realities in the country. Some provinces are intensive producers of GHGs because of specific industrial structure resulting from regional specialization patterns (e.g., the oil and gas industry in Alberta, British Columbia, Saskatchewan, etc.). As carbon pricing affects the costs of economic activity, especially in energy-intensive industries, it might cause companies to at least partially move production to other provinces or countries with more lax carbon emission regulations (called the carbon leakage competition channel). If Canadian goods and services become relatively more expensive as a result of an increase in the carbon price, consumers, both domestically and abroad, can switch to foreign goods and services. Without appropriate countermeasures, internal/external carbon leakage can undermine the effectiveness of provincial mitigation activities and decrease public support for climate policy.

The carbon pricing policy must consider the risks of both production and investment leakage, caused by direct and indirect carbon costs. There are some concerns that even very large investments from the government alone could not ensure that the energy transition will happen in time. Engaging the private sector may be helpful in accumulating sufficient financial resources to shift the Canadian economy away from carbon and towards the net-zero future by 2050. Clear policy signals demonstrating government support in the long term are critical for business decisions to invest in low-carbon technologies and infrastructure.

In addition, policy makers might be motivated by one more concern pertinent to carbon leakage risks – employment migration and leakage of human capital – to protect some sectors from the negative impact of carbon pricing.

The carbon leakage issue is also closely related to the question of who should be responsible for emissions released in one province (country) to produce goods and services that are consumed in other provinces (countries).

From a game-theoretic perspective, climate policies in different provinces can be considered “strategic substitutes”, such that for each province the best response to carbon emission reductions made by other provinces is to allow itself to increase its own emissions (called the carbon leakage free-riding channel). Furthermore, the mere anticipation of an increasing minimum national price on carbon pollution by $15 per tonne each year starting in 2023 could provide an incentive for fossil fuel owners to accelerate their extraction, which would result in intertemporal GHG leakage (so called green paradox).

Strengthening сlimate measures in North America lowers the demand for fossil fuels and hence reduces their world market price. Other world regions can be expected to increase their consumption of fossil fuels as a result (called the carbon leakage energy market channel).

Negative internal carbon leakage, i.e., emissions reductions in one province resulting in lower emissions in the remaining provinces, is also possible. For instance, decreasing demand for natural gas in provinces with more stringent emissions reduction targets might reduce its market price, increase gas consumption in other provinces and push coal, with nearly twice the emission intensity, out of the Canadian energy system.

An assessment of the carbon leakage risks needs to address the following questions. Firstly, how do we determine whether carbon leakage is a threat and what economic sectors/industries are at significant risk of competitiveness impacts and carbon leakage? The second part of the problem is to determine what options are available to prevent carbon leakage and how to evaluate the effectiveness of those options.

It’s highly important to measure carbon leakage accurately. A sector’s leakage risks are usually established based on such quantitative criteria as emissions and trade intensities. The first criterion is used to assess the relative cost increase of a sector; the second to evaluate whether or not these costs can be passed through to buyers. However, there is considerable uncertainty about both. The existing theoretical literature has not reached consensus on a common approach to measurement of carbon leakage. It can be overestimated if innovation incentives in non-energy intensive sectors are not taken into account. Another source of uncertainty is related to the economic liability for leaked emissions. Conducting evaluations using aggregated data (sector or regional) masks cost impacts experienced at firm or facility levels. The leakage rate across provinces depends significantly on the stringency of the climate policies and the scale of energy efficient technologies’ implementation. Finally, estimating carbon leakage could be difficult in Canada, since monitoring techniques have focused on small scale studies so far.

In general, such energy-intensive industries as mining, oil and gas, petroleum refining, iron and steel, cement, aluminium, chemicals, fertilizer, pulp and paper are exposed to significant carbon leakage risks in Canada.  But sectors’ exposure can also vary within country due to the differences between provinces in carbon pricing regulations, production processes, fuel mix, recycling rate, technologies, product mix, etc.

Sector-specific modification to existing carbon pricing regulations may be required, with special requirements and economic incentives for the emissions-intensive industries at significant risk of GHG leakage. A sector-by-sector carbon leakage risk coordination policy could generate specific actions that each industrial activity needs to reduce leakage. This focus will provide more flexible and individualized approach to decision-making where carbon leakage is a valid concern. It takes emissions reduction opportunities for each of those industries individually adapting technologies and processes to each production profile. This risk-oriented approach shouldn’t replace any of the existing regulations for GHG emissions (OBPS, the clean fuel standard, the methane regulations, etc.). It could be just another additional element of the current climate policies.

In the international context it is advisable to continue to explore a carbon border adjustment mechanism (a border tariff for carbon-intensive goods coming from the countries that either do not have carbon pricing or apply a lower carbon price). This is particularly important given European Union treatment of Canadian output-based pricing under its carbon border adjustment mechanism is uncertain. However, variations across countries, both in terms of approach and speed of implementation of carbon taxes, can undermine Canada’s regional competitiveness (external carbon leakage risks). As part of the G7 climate club, the Government of Canada should advance international cooperation for common position on this important issue.