In the new world of carbon emission regulation by governments, there’ll be winners and losers. The regulatory frameworks the federal government and provinces adopt will determine how they share the cost burden of tackling climate change.

The main concept behind this pricing scheme is both to put a price on pollution and to recycle that money back into the economy, explained Chris Ragan, associate professor of economics at McGill University and chair of Canada’s Ecofiscal Commission,¹ speaking at a CFA Society Toronto seminar in June. Regardless of the type of pollutant, Ragan says, the idea is the same: to move away from our current system of taxing “goods” like income and profits and, instead, to put more of the tax burden on “bads” like carbon emissions, garbage, or other environmental pollutants.

When considering a particular carbon price, Ragan pointed out that the price being looked at is not a genuine market price; rather, it’s a price created by policy-makers.

The logic behind attaching a policy-created price to carbon emissions, rather than a market price, is simple: to create an incentive to change behaviour (in this case, to produce fewer emissions).

How to effect this change in behaviour? There are two main ways: a tax, or a cap-and-trade system. While prescriptive regulation could have been another option, that approach has often failed in the past, since having the government specifying technology remedies is seldom as efficient as motivating companies and markets to figure out a solution on their own.

CARBON PRICING POLICIES

Within Canada, the provinces have taken the lead in designing their own carbon pricing policies, which have come into being for two reasons. The first is that provincial governments have recognized climate change as a problem that requires a concerted long-term response. The second is that it’s generally accepted that a carbon pricing regime is superior to prescriptive regulations. As a result, today, 80% to 85% of Canadian jurisdictions have some form of carbon pricing in place.

But that means there are still policy gaps that need to be filled in some jurisdictions. That’s where the Pan-Canadian Framework—which mandates that a carbon price will be in place in every jurisdiction by 2018—can help. Under the framework, each province or territory will decide on its policy. The federal government will step in only if the province or territory fails to implement its own policy, at which time a federally designed system (known as the Fed “backstop”) would fill the policy gap.

HOUSEHOLD ISSUES

When regulators put a price on carbon, two major issues arise: the impact on households and the impact on business competitiveness. For households, Ragan said that the purpose of the tax is to raise the price of a product based on that product’s carbon content. However, as prices rise due to the tax, life can become more difficult for low-income families. (In this sense, a carbon tax could be considered regressive, as it has a disproportionate impact on low-income households.)

Even more worrying are the falling incomes in certain jurisdictions. Businesses can’t always pass on higher costs to their customers; this action could result in pressure on wages and profits and, therefore, the incomes of workers and business owners. The potential for income impacts of this sort are relatively high in Alberta, due to its oil sand operations and coal-fired power plants, in contrast to jurisdictions like Ontario or Manitoba, which have comparably “carbon-light” economies by nature of their economic structures.

The solution to these issues can be as simple as cutting a cheque to low-income families. Ragan noted that, in some estimates, it would cost only 4% of carbon tax revenue to fully offset the impact on the bottom 20% of households.

BUSINESS ISSUES

The second issue—and perhaps the one that receives the most attention—is the impact on business competitiveness. Consider the example of an Ontario cement producer that would be subject to a carbon pricing regime and the associated costs of emissions. How much competitiveness will it lose to, say, a cement producer in New York that doesn’t have to pay a price for the carbon it emits? Not only could this lead to shrinking of the Ontario cement industry, but it’s also possible that there would be zero net reduction in global emissions if the cement production simply relocates across the border in response to the lighter regulatory regime.

One solution to avoid this bad outcome is to provide financial assistance to the Ontario producer based on its output of cement. (In this case, the producer pays the carbon price but gets an offsetting form of subsidy.) As the theory goes, such subsidies would be provided temporarily to high-intensity sectors until other regions catch up with their own carbon prices.

If all of this makes for a complex policy choice for provinces and territories, there’s at least help available. The Ecofiscal Commission has published a research paper—“Choose Wisely: Options and Trade-offs in Recycling Carbon Pricing Revenues”—highlighting the pros and cons of various policy options.

INVESTOR IMPLICATIONS

The implications for investors are straightforward, Ragan said. There will be risks for high-carbon products and opportunities for low-carbon products. Carbon pricing, it seems, will be a critical factor that will separate the winners from the losers.

¹ Go to www.ecofiscal.ca to learn more about Canada’s Ecofiscal Commission.