Demystifying Cap and Trade in Canada

What is cap and trade? For starters, it's a way to help business if we get the details right. As part of B.C.’s efforts to reduce greenhouse gas emissions, the province has committed to implement a “cap-and-trade” system by 2012. If you’re like many people I talk to, you’re still trying to understand what cap-and-trade means, whether it’s good or bad for business and whether or not it will actually reduce pollution.?

B.C. is embracing the cap-and-trade system to minimize pollution and let businesses figure out for themselves the most cost-effective way to do it.

What is cap and trade? For starters, it’s a way to help business if we get the details right.

As part of B.C.’s efforts to reduce greenhouse gas emissions, the province has committed to implement a “cap-and-trade” system by 2012. If you’re like many people I talk to, you’re still trying to understand what cap-and-trade means, whether it’s good or bad for business and whether or not it will actually reduce pollution.


In the simplest terms, cap-and-trade is a market-based solution to an environmental problem. The government puts a cap on pollution (greenhouse gas emissions in this case) and allows businesses to figure out the most cost-effective way of keeping their combined pollution under the cap. 


But within this broad framework a lot of details need to be worked out, and the costs and benefits to businesses will depend on how the government tackles these finer points.


At the core of a cap-and-trade system is the pollution permit (often called an allowance), which is essentially a commodity created by governments in recognition that the atmosphere can’t be treated as a free dumping ground. Businesses regulated by cap-and-trade are required to own one tonne’s worth of pollution permits for every tonne of pollution they produce. 


If pollution permits are costly, businesses will choose to reduce their pollution so they need fewer permits. Like a carbon tax, this approach strengthens the economic case for investing in clean energy. 


The amount a business needs to spend on pollution permits depends on how much pollution it produces and three other factors. The first is the amount of pollution allowed under the cap. If the cap is relatively lax and there are plenty of permits to go around, they won’t be worth much. If the cap is tight, there will be fewer permits available, and those permits will end up being worth a lot because they’ll be in greater demand. The downside of a lax cap is that it minimizes the environmental benefits.


The second factor is the number of offsets allowed. Offsets are projects that reduce pollution in sectors of the economy not covered by a cap. An offset project costs money, so it has a value, just like pollution permits. The potential advantage of offsets is that they can be cheaper for businesses than reducing pollution or buying permits. The downside is that even the best efforts to verify their legitimacy will accredit some offsets that won’t effectively reduce pollution.


The third factor in determining the cost of pollution permits is how governments decide to allocate them: they can give them away for free or auction them. If permits are given away, the businesses given permits will have lower costs. If permits are auctioned, governments collect the full value from businesses. In addition to providing governments with revenue, auctioning simplifies the rules by eliminating any need to decide which businesses get permits and which do not. 


Many businesses question what cap-and-trade will do to their competitive advantage, or to B.C.’s, for that matter. For businesses providing products and services that help reduce pollution, like a wind farm for example, cap and trade will create market opportunities.


For businesses that have to buy permits, at least two other aspects of cap and trade can help maintain or improve competitiveness. First, cap-and-trade systems typically include multiple jurisdictions, so they provide a level playing field for all businesses in the system. Second, governments have flexibility to decide how best to use any auction revenue they collect, and there are plenty of ways money can be invested to improve the economy. B.C.’s approach of using carbon tax revenue to reduce other taxes is an example that could also be used for cap-and-trade revenue.


The bottom line is that a well-designed cap-and-trade system can be part of a climate change solution that is good for the environment and good for the economy.