THE ONTARIO CAP AND TRADE SYSTEM – A CRITIQUE

Contributed by Robert Lyman © 2017 

Robert Lyman is an Ottawa energy policy consultant with 27 years experience as a public servant and 10 years experience as a diplomat.

Heat or eat poverty hits the poor and elderly hardest; they have the least means and resources to respond. (Photo: Image licensed from Shutterstock)

The province of Ontario has implemented Cap and Trade, a regulatory program that limits the ability of firms to emit greenhouse gas emissions (GHGs) by requiring them to buy from the government allowances to emit, while permitting them to trade these allowances with others. The Cap and Trade program is intended to increase the cost of fossil fuel energy sources like oil, natural gas and coal, and thereby discourage their use. This article takes issue with the Ontario system.

The idea that increasing consumers’ costs of lighting and heating their homes and transportation is a good thing rests upon two hypotheses. The first is that human-related GHG emissions are causing catastrophic global warming, the effects of which, according to United Nations models, will grow worse with time. The second is that reducing emissions in Canada, even at great cost, will prevent that warming from occurring. The first hypothesis is unproven and the second is patently false.

Cap and Trade and carbon taxes, the evil twins of “carbon pricing”, are sometimes favoured by economists who believe that, if governments are to force GHG emissions reductions, they can do so more efficiently by harnessing market forces (i.e. increasing prices through adding taxes and other charges). This theory only applies, however, under certain conditions. Notably, the carbon pricing must replace, not supplement, the many other programs and regulations now in place, the revenues received by the government must be channeled back into the economy by reducing other broadly based taxes, and there must be credible evidence that the economic cost incurred will be offset by environmental improvements. These conditions will not apply in Ontario.

Aside from these fundamental problems, there are flaws in the design of the Cap and Trade program:

• The prices of allowances will undoubtedly rise over time and could reach $100 per tonne or higher within a decade and much higher after that. The movement of the prices, however, will be based on the supply and demand for permits and the way permits are issued (free allocation, auction, or sale) by the government, which is difficult to predict.
• During the period to 2021, the main burden of the program will fall on individuals and families, not on industry and commercial energy users, because until then businesses will be issued free allowances.
• The system is rife with opportunities for commercial fraud, as happened in Europe, and for political manipulation. Billions of dollars will go into a new fund that can be used to create yet more GHG programs and subsidies.
• The complexity of the program will make it a bureaucrat’s dream and an auditor’s nightmare.

Introduction

In a previous article published on the Friends of Science blog, I provided a primer on or introductory summary of, the main features of the province of Ontario’s Cap and Trade program. The Cap and Trade program is, in essence, a way of using carbon pricing to reduce greenhouse gas (GHG) emissions. The program proceeds in two phases. It imposes limits on the volume of emissions permitted by participating organizations in the provincial economy and steadily reduces these volumes over time.  Then, it allows the organizations to trade allowances with others who might be able to achieve emissions reductions more cheaply. The system’s intent is to reduce emissions while allowing the interaction of competitive market forces to discover the lowest cost options for doing so.

The purpose of this article is to take issue with the Ontario system. I hope to explain why there is no convincing rationale for such costly emission reduction measures, why the Ontario approach to carbon pricing is not justified in public policy terms, and why the present system contains significant design flaws.

The Science is Not Settled

It is sometimes difficult to have an honest and fact-based discussion of climate change in Canada because of the pervasive claim that “the science is settled” and therefore no further discussion will be tolerated. In fact, the claim that human emissions are causing catastrophic global warming, with all its implied effects, remains a scientific hypothesis. Science, in fact, is not driven by consensus or majority opinion. It relies on the empirical testing of theses and the subsequent replicating of these results by others in competition with alternative theses.

The central global warming thesis is that GHG emissions produced by humans are the central cause of the warming in global temperatures observed over the period since the beginning of the industrial revolution, and that these emissions, unless drastically reduced within 33 years, will cause catastrophic damage to the earth’s ecosystems. It would be beyond the scope of this article to review the controversies that now rage about this thesis. An excellent summary of these controversies was produced following a January 2014 workshop of the American Physical Society (APS) and can be found here:

A Summary of the APS Workshop on Climate Change

One of the most articulate and respected scientists who represent the “skeptical” side in the global warming debate is Dr. Judith Curry. She is an American climatologist and former chair of the School of Earth and Atmospheric Sciences at the Georgia Institute of Technology. On March 29 2017 Dr. Curry made a statement to the U.S. House of Representative Committee on Science, Space and Technology. Because of its prescience and relevance, I will quote it at some length here:

‘Scientifically proven’ is a contradiction in terms – science does not prove anything. Scientists have a vision of reality that is the best they have found so far, and there may be substantial disagreement among individual scientists. Science works just fine when there is more than one hypothesis to explain something – in fact, disagreement spurs scientific progress through creative tension and efforts to resolve the disagreement. Science is driven by uncertainty, disagreement and ignorance – the best scientists actively cultivate doubt. Scientists do not concentrate on what they know, but rather on what they don’t know.

The meta-theory of greenhouse warming of the climate system incorporates many hypotheses and theories about how components of the climate system work. It is an empirical fact that the Earth’s climate has warmed overall for at least the past century. However, we do not know how much humans have contributed to this warming and there is disagreement among scientists as to whether human-caused emissions of greenhouse gases is the dominant cause of recent warming, relative to natural causes.

• Dr. Judith Curry

Dr. Curry explained how much of climate science and modelling came to serve what is fundamentally a political agenda.

In the 1990’s, the world’s nations embarked on a path to prevent anthropogenic climate change by stabilization of the concentrations of atmospheric greenhouse gases, which was codified by the 1992 UN Framework Convention on Climate Change (UNFCCC) treaty. This objective has led to a focus on identifying human influences on climate, dangerous environmental and socio-economic impacts of climate change, and stabilization of CO₂ concentrations in the atmosphere. The IPCC has become conflicted by its makeup and its mandate from the UN – to focus on a change of climate that is attributed to human activity. If the UN had found that climate change was not being affected by human alteration of the atmosphere or that it is not ‘dangerous’, the UNFCCC would not need to exist. Findings of ‘dangerous human-caused climate change’ seem inevitable with this framing of the climate change problem and the mandate from policy makers.

In the early 1990’s there was a belief in the feasibility of reducing uncertainties in climate science and climate models, and a consensus seeking approach was formalized by the IPCC. Global climate models were elevated to a central role through investigations of climate change impacts and applications. Very substantial investments have been made in further developing climate models, with the expectation that these models will provide actionable information for policy makers.

The hope, and the potential, of climate models for providing actionable information for policy makers have not been realized. With the failure of climate models to reduce uncertainty about the sensitivity of the climate system to CO₂ and the failure to accurately simulate decadal and regional climate variability, we have arguably reached the point of diminishing returns from this particular path of climate modelling – not just for decision support but for scientific understanding of the climate system.

The climate community has worked for more than two decades to establish a scientific consensus on human-caused climate change, prematurely elevating a hypothesis to a ruling theory. The IPCC’s consensus-seeking process and its links to the UNFCCC emissions reduction policies have had the unintended consequences of hyper-politicizing the science and introducing bias into both the science and the related decision-making process. The result of this simplified framing of a wicked problem is that we lack the kinds of information to more broadly understand climate variability and societal vulnerabilities.

• Dr. Judith Curry

The full text of Dr. Curry’s statement can be read here:

Statement to the Committee on Science, Space and Technology of the United States House of Representatives

In short, the hypothesis that humans are causing catastrophic global warming is unproven, and the U.N.’s haste to reduce GHG emissions at great cost is driven by unreliable models and a political agenda.

There is No Policy Rationale for Canada to Make Massive Emissions Reductions

Even if the there were complete agreement on the scientific hypothesis that humans are the main causes of global warming and that the effects of that warming could be severe, the policy rationale for a country like Canada to make massive and disruptive GHG emissions reductions would be lacking.

Since the U.N. Framework Convention was signed in 1992, the countries of the world have held 22 conferences of the Parties in efforts to reach agreements on their collective actions and responsibilities. Even where agreements have been reached, the major emitters have either failed to ratify the agreements or to achieve the commitments they made to emissions reduction.  At the COP21 Conference in December 2015, the Parties reached a new agreement. The international environmental movement and the media greeted this as a historic breakthrough. If one reads the actual provisions of the agreement, however, it is far from this. The agreement contains very few binding legal requirements, there are no formulas for determining what each country’s obligations are, and there are no penalties for non-compliance. Rather, it represents a best-efforts political commitment to keep the level of global GHG emissions below that which, in theory, might produce a two degree Celsius increase in average global temperatures. So, no one knows how much emissions would have to be reduced, and the countries did not agree on individual targets.

What has happened to global emissions since countries began setting emission reduction targets? In 1990, according to the U.S. Carbon Dioxide Information Analysis Center, global emissions were 22.3 gigatonnes of carbon dioxide equivalent. In 2014, emissions were 36.1 gigatonnes. In other words, emissions grew by 62% over the 24-year period. Almost all of this growth occurred in the less developed countries, and especially in Asia.

This has not stopped governments in Canada from committing politically to ever more restrictive targets. The former Harper government committed in principle that Canada would reduce its GHG emissions by 50 to 70 % below 2005 levels by 2050. A number of provincial governments, including Ontario and Quebec, have committed to reducing emissions by 80% or more below 1990 levels by 2050. The New Democratic Party, in its Leap Manifesto, has vowed to eliminate the use of fossil fuels in Canada by 2050.

To understand what this would mean, let us examine the sources of GHG emissions in the recent past and today in Canada. In 2005, Canada emitted 738 million tonnes (Mt) of carbon dioxide equivalent. In 2015, after a prolonged recession, emissions were down to 722 Mt. These were divided by economic sectors as follows: oil and gas 189 Mt (26%); transportation 173 Mt (24%); buildings 86 Mt (12%); electricity generation 79 Mt (11%); heavy industry 75 Mt (10%); agriculture 73 Mt (10%); and waste and others 48 Mt (7%). The future will witness a race between efforts to improve the emissions intensity (or energy efficiency) of the economy on the one hand and the effects of increasing population and economic activity on the other.

Using today’s shares by sector as a guide, reducing emissions to meet the 2020 target of 17% below 2005 levels (i.e. 613 Mt) looks possible, but unlikely to be met. The 2030 target of 30% below 2005 levels (i.e. 517 Mt.) would mean a reduction of 221 Mt., or the equivalent of eliminating all emissions from coal and natural gas for electricity generation plus eliminating 75% of all emissions from oil and gas production. Eliminating 80% of Canada’s GHG emissions by 2050 would mean a reduction of 574 Mt from 2015 levels to 148 Mt in 2050. Doing this the face of a (one hopes) growing economy and population would be very close to impossible in economic, technological and political terms. It would mean the equivalent of eliminating all oil and gas production, all emissions from electricity generation, all emissions from transportation and all from emissions-intensive heavy industry.

The consequences of such a sacrifice can best be understood in a global context. The most authoritative source of future projections of world energy supply, demand and emissions is probably the United States Energy Information Administration (EIA). In its 2016 International Energy Outlook, the EIA examined the likely trends in the world economy, including technological change, over the period to 2040. It concluded that, in fact, worldwide energy use will grow continuously over the next three decades, led by strong increases in Asia. Energy-related carbon dioxide emissions will grow from 32.3 gigatonnes (Gt) in 2012 to 43.2 Gt in 2040, a 34% increase. Ninety-one per cent of the emissions growth will take place outside of the countries of the Organization for Economic Cooperation and Development (OECD), again mainly in Asia. If Canada eliminated 80% of its emissions, the global total would grow to 43.14 Gt in 2040.

The United Nations insists that, to avoid a serious risk of warming, global emissions will have to decline by at least 50% by 2050, to about 16 Gt. Global emissions, driven by the desire of many countries to enjoy the benefits of higher economic activity, are headed in precisely the opposite direction to that favoured by the U.N. Further, there is absolutely nothing that Canada, or even the entire OECD, can do about this, as almost all the emissions growth is occurring elsewhere.

The stark reality is that Canada’s emissions represent only 1.6% of global emissions and over 90% of the global emissions growth is taking place in the developing countries. Even eliminating Canada’s emissions entirely would not meet the U.N. emissions reduction goal. It would simply be self-destructive symbolism, with no environmental benefit.

The Unfortunate Reality of Carbon Pricing

Even if Canada’s emissions reduction had some likelihood of reducing global emissions, it would make no sense to choose the emission reduction options that are the most expensive and the least cost-effective in terms of emissions reductions per dollar of expenditure. This is why, in principle, economists and businesses tend to support carbon pricing and other market-placed approaches. In theory, these approaches leave less room for governments to intervene in the economy in costly and highly intrusive ways through regulation and subsidy programs.

The theory that allegedly justifies carbon pricing, however, fails in practice. Professor Ross McKitrick of the University of Guelph has explained why.

• First, a carbon tax is only desirable in theory if it acts as the replacement for the long list of regulations, programs and subsidies that are now in place; the federal, provincial and municipal governments, however, have no intention of removing those measures.
• Second, to avoid damaging the economy, a carbon tax or allowance price paid to governments must be genuinely revenue neutral, in the sense that the funds must be channelled back into the economy by lowering the rates of other broadly based taxes, not by being used to fund a host of new programs and subsidies that benefit the “green” lobbyists and industries; while British Columbia claims to have done this, there is zero chance any other provincial government will.
• Third, the size of the carbon tax or allowance price has to be set at a rate that properly reflects the alternative cost of reducing emissions and the best estimate of what damage is being avoided by reducing emissions; the current federal tax and the allowance prices that will emerge from Ontario’s system have no connection to either of these standards.
• Fourth, there has to be credible evidence that the economic cost incurred will be offset by incremental improvement in the world’s environmental condition; Canada is too small an emitter to matter and, as explained previously, Asian countries are rapidly increasing their emissions in any case.
• Finally, we should not impose a new carbon tax or allowance cost burden on Canadian companies seeking to compete in international markets; proceeding here where we know the Americans will not impose a comparable system of carbon pricing is simply irresponsible.

There is a complex relationship between the actions that the Ontario government already has underway to reduce emissions and the additional ones that would be “incented” by the Cap and Trade system. The government’s current regulatory and program actions run the gamut of potential interventions, notably: the massive subsidization of wind and solar electricity generation through feed-in-tariffs and the requirement that these sources be given first-to-the-grid rights; grants and tax exemptions for renewable energy, ethanol producers, electric vehicle purchasers and others; and regulatory restrictions on land use, housing, appliances and a wide range of products. By taking and continuing these actions, it may be argued that the government reduces the scope for Cap and Trade to be effective, or alternatively, that it is implementing several duplicative and redundant emission reduction measures.

In the parlance of those who support Cap and Trade, the regulatory and program actions are “complementary measures”, implying that they exist to support the Cap and Trade program, notwithstanding the fact that virtually all of the complementary measures now in place long preceded the Cap and Trade Program. In practice, the terminology is backwards. Past actions by Ontario, and those future measures included in the province’s Climate Change Action Plan (CCAP) published in June 2016, will deliver the lion’s share of the emissions reductions. The CCAP outlines up to $8.3 billion (to come out of the proceeds from the sale of emissions allowances) for emission reduction measures between 2017 and 2020. The Province estimates these will deliver 9.8 megatonnes of CO₂e emissions reductions by 2020.

A study performed by ICF Consulting Canada Ltd. in May 2017 noted that successfully implementing these complementary measures would reduce the province’s forecasted emissions and thereby place downward pressure for demand of emissions allowances; allowance prices would decrease accordingly. The cost per tonne of GHGs avoided by the complementary measures is often significantly higher than the carbon prices now charged in the market, yet governments cannot resist the political appeal of intervening, especially to aid favoured industries.

An Important and Unresolved Legal Issue

Under the Constitution Act, Ontario only has the jurisdictional authority to impose a price on carbon if it is a regulatory charge or direct tax, not an indirect tax, and if the proceeds are kept separate from general government revenues and used specifically for the purposes of the specific regulatory scheme that creates the regulatory charge. The Climate Mitigation and Low-carbon Economy Act, 2016 is intended to reduce GHG emissions. The government of Ontario argues that it can therefore only use the proceeds to reduce emissions and cover the costs of administering the regime.

If the government of Ontario uses the money for other purposes, or as part of its general revenues, the Cap and Trade program will be more vulnerable to legal challenge.

Despite this, Ontario has chosen to place the proceeds from its emissions allowances into a Greenhouse Gas Reduction Account (GGRA), a notional (not separate) account within the provincial Consolidated Revenue Fund. When the revenues from allowance sales grow to many billions of dollars per year, the pressure on the government (as well as the natural inclination of politicians) will be to spend the funds on a wide variety of programs with few or only tenuous connections to reducing GHG emissions.

One can only assume that the reason there has been no legal challenge already is that the likely alternative to a Cap and Trade program is a carbon tax that would have the same or perhaps even a worse effect on the provincial economy.  It appears, however, that the grounds for a successful legal challenge are already present and will only increase with time as the use of GGRA funds proliferates.

Flaws in the Design of the Ontario Cap and Trade Program

The Potential Escalation of Allowance Prices

In the report of the Environmental Commissioner of Ontario document entitled Introduction to Cap and Trade in Ontario, it is acknowledged that there is “uncertainty about the cost for participants (market-based fluctuation)”. The report can be read here:

Introduction to Cap and Trade in Ontario

The report states that, “Market controls aim to keep prices stable and predictably increasing over time”. This is true in one sense. The Ontario regulations provide that, before each auction, the government may establish minimum auction sale prices and that these prices will rise annually by 5% plus indexation based on the consumer price index. Assuming an inflation rate of 2%, this means allowance prices will double in the first ten years regardless of emissions market conditions.

While the regulations thus establish a rising floor for allowances sold at auction, they do not establish a ceiling. The Ontario Energy Board, which is responsible for regulating the rates charged by electricity and natural gas utilities in the province, contracted with ICF Consulting Ltd. to prepare a forecast of the carbon price under cap and trade over the first ten years of the program. The ICF study can be read here:

Long-Term Carbon Price Forecast Report

The ICF developed scenarios that would produce minimum, mid-range and maximum allowance prices. The key assumptions underlying the minimum scenario are that Ontario links with the Western Climate Initiative (WCI) market with California and Quebec in 2018 and the joint market allowance supply and demand stays in surplus though 2028. The market is now in surplus because California deliberately issued too many allowances in the early years of its program to increase political acceptance. Under the mid-range scenario, ICF assumed that Ontario links with WCI in 2018, Ontario will enter WCI with a shortage of allowances, the joint market will see surplus until 2020 and then enter a period of cumulative allowances shortages in the mid-2020’s. Under the maximum scenario, ICF assumed that Ontario does not link with the WCI market. The resulting allowance prices are shown in the following table.

The allowance prices could go much higher still, especially if, as now appears likely, governments decide to continue carbon pricing indefinitely. The former National Roundtable on the Environment and the Economy projected in 2012 that carbon prices would have to rise as high as $300 per tonne to reach the federal government’s 2050 emissions reduction target, and even that seems unlikely to force an end to all hydrocarbons use. The inherent characteristic of markets is that they respond to changing supply and demand conditions. If governments truly wanted stable, predictable prices, they would use carbon taxes, not cap and trade.

The Favouritism Granted to Certain Emitters during the Initial Compliance Period

During the initial compliance period from 2017 to 2020, the only entities that will be covered by the Ontario Cap and Trade program are the importers of electricity, generators of gas-fired electricity, natural gas distributors and wholesale vendors of liquids fuels (mainly oil and propane products). In other words, the program will fall heaviest on the companies that directly serve the energy needs of most individual and family end users. The large industrial and commercial users and institutions like hospitals and universities will be exempt. Further, 18% of the province’s emitters will be completely excluded from the program, not just for the initial compliance period but perhaps indefinitely; these include the 31 megatonnes of annual emissions from agriculture, waste management and forestry. In terms of equity, it is not clear why these businesses should not bear the same burden as all others. The special treatment seems intended to seek the acquiescence of large industry while the Cap and Trade program initially is being implemented and thus make it more difficult for industry politically to oppose it when the system is extended to include them. De facto, the entire initial burden of Ontario’s Cap and Trade program will fall the average person.

Further, the Minister of the Environment and Climate Change has the authority under the Climate Change Mitigation and Low-Carbon Economy Act 2016 to decide which groups will be exempted from coverage by the Cap and Trade system in future.

The System Allows for Excessive Exercise of Ministerial Discretion

John Adams famously wrote that the political system ideally requires “a rule of laws and not of men”. While this statement has been variously interpreted, its application to the design of regulations and regulatory systems can properly be said to mean that the rules should be clear and applied fairly to everyone affected, and that the opportunity for Ministerial discretion (or “tinkering”) to decide individual cases on political grounds should be minimized.

The Ontario Cap and Trade system includes far too much scope for Ministerial discretion. I noted previously the Minister’s authority to determine which industries and firms would be exempted from coverage under the system. The Minister also will have the authority:

• To create an unspecified number of “early reduction credits” that can be claimed by covered organizations for actions to reduce emissions before the Cap and Trade system began.
• To decide the categories of emissions reduction or avoidance that will qualify for emissions “offsets”.
• To decide how to spend the billions of dollars that will accumulate in the Greenhouse Gas Reduction Account (GGRA) from the sale of emissions allowances.
• To decide how much transparency (i.e. public records and accountability) will apply to the government’s use of funds from the GGRA.

As the size of the GGRA grows to tens of billions of dollars per year, this potential for discretion (and political bias) will become increasingly problematic, with the public, and perhaps even the legislature, unaware of the reasons for Ministerial decisions.

Cap and Trade is Subject to Abuse and Fraud

The vulnerability of Cap and Trade systems to abuse and fraud has been well demonstrated by the European Union Emissions Trading System (ETS). The ETS has consistently seen businesses pass on carbon “costs” to consumers that in reality were never incurred in the first place. A handful of large companies have received billions of euros in unearned funds this way, as shown by various academic studies and program evaluations. The power sector has benefitted the most, although there is some evidence that other industrial sectors have engaged in similar pricing tricks.

In his commentary on the Cap and Trade system, the Environmental Commissioner for Ontario noted specifically that one of the key design issues was the potential abuse of market power arising from the small number of natural gas and petroleum products distributors. In effect, he was cautioning that market concentration could affect market liquidity and the cost of allowances in the Ontario-only market. The system has some features to discourage this, such as a price “collar” (intended to keep official allowance prices within a certain range), holding limits for individual entities, and a market monitor, who will be looking for evidence of non-competitive behaviour.

All commodity markets contain some risk of illegal activity, but carbon markets have been particularly susceptible to fraud. One key reason is the commodity being traded. Carbon, unlike corn or iron, is not a tangible product. Carbon permits are a “permission to emit in the future”, which tends to be estimated by proxy rather than directly measured. In Europe, the most famous case was a five billion euro Value Added Tax fraud, but there have been other scandals involving stolen and re-used allowances. According to the EU Court of Auditors, the ETS remains under-regulated. The legal definition of emission allowance is not sufficiently clear, the Registry of allowances lacks adequate fiduciary controls, and there is poor cooperation between the European Commission and national financial regulators. If such problems emerged in Europe, it seems highly likely that similar problems will arise with respect to the Cap and Trade system in North America.

Conclusion

The Ontario Cap and Trade program is a very complex regulatory regime that is likely to become even more complex over time as problems emerge and regulatory patches are placed on the trouble spots. Complexity itself is a problem because the public and the affected industries will find the system difficult to understand. The program unintentionally creates many opportunities to “game” it, and an equally large number of opportunities for Ministers to intervene politically to either exempt certain favoured groups or firms from the requirements of the system or adjust the system to serve the political interests of the government of the day.

The administration of this program will be a bureaucrat’s dream and an auditor’s nightmare. New organizations will be required to conduct the auctions and the sales, to monitor trading and compliance, to design and administer the early reduction credit and offset systems, to monitor the secondary markets, to police the banking provisions, and to audit and evaluate the results to ensure that the program is actually serving its purpose.

The effect of Cap and Trade, even though potentially blunted by the various complementary measures, will be to sharply increase energy prices for consumers and industry over time, but to do so indirectly rather than through visible taxes. The merits of this effect are such that they are better achieved by stealth.

Ultimately, the Cap and Trade program, like all the other major climate change programs imposed on Canadians, will be an extremely expensive and disruptive intervention that will harm Canada’s economy and competitiveness with no offsetting gain in terms of global emissions or temperatures.

The next article in this series will examine how the operation and effects of the Ontario Cap and Trade system may be altered as a result of its planned integration with those of California and Quebec.

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