Developing a robust plan is going to take plenty of consultation, persistence, and creativity on the part of Ontario's policy makers.

Last week, Ontario released a detailed consultation document outlining the shape that its upcoming cap and trade program for greenhouse gases will take. The forthcoming system is important, as it will be the main regulation governing greenhouse gases in Ontario, and will continue building the momentum for effective climate policy at the provincial level.

In common with other cap and trade systems, this one will set a cap on total emissions from covered sectors in Ontario, and create a number of permits equal to that cap. Government will distribute those permits, either for free or by auction, to emitters, who need to hold a permit to cover each unit of their emissions, or else face a penalty.

The program is clearly still under development and a number of important details remain to be filled in; indeed the consultation document is purposefully vague in order to solicit input from stakeholders. However, there is beginning to be enough detail that it is possible to understand how the program is likely to unfold in broad strokes, as well as what key questions remain to be answered.

The program will be implemented in 2017, and that year will essentially be a “practice” year, in which the system is intended to be non-binding (the number of allowances issued will be set equal to the forecast of total emissions). The number of allowances will then be reduced in subsequent years, such that by 2020 it will be equal to 85% of 1990 emissions: the province’s emission reduction target. This likely entails a reduction of somewhat less than 10% from today’s levels. It is likely that emission permits will trade at between $10 and $30/t CO 2 in order to reach this target, roughly similar to levels in Quebec and California, which already have similar systems (and to which Ontario’s system will be linked, either right away or with some delay).

The long-term plan is for the number of permits created each year to be continually reduced to reach Ontario’s long-term goals for greenhouse gas reduction, eventually limiting greenhouse gases to just 20% of 1990 levels by the year 2050. This strikes me as perfectly sensible, and indeed most economists would endorse this approach as a cost effective way to reach an emission reduction target. However, sustaining the system as it ramps up in stringency may be difficult, since permit prices will likely reach several hundreds of dollars per tonne as emissions are squeezed out of the economy by 2050. While this is unlikely to have large negative consequences for the average Ontarian (the IPCC’s summary suggests that reducing emissions by 80% will have overall economic costs of only around 1% of total income) it will likely induce significant structural changes in the economy, as certain high-emitting sectors become non-viable. The recent EcoFiscal report suggests that lime, cement, fertilizer, and petrochemical, and petroleum product production are all likely to have difficulty remaining competitive with markedly higher carbon prices.

Dealing with this type of structural change takes up a large portion of the consultation document, and is where much of the feedback on the document will likely be concentrated. The current proposal is that emitters would receive all of their permits for free in the initial period from 2017-2020. The intention seems to be a mix of mitigating leakage of firms and their emissions to other jurisdictions as well as providing “transition assistance.” Mitigating leakage is a sensible goal – if firms simply close up shop and move to another regulation with lower regulatory stringency, Ontario suffers economically without an environmental benefit. It is less clear to me that providing significant “transition assistance” – which I read as a payout to firms to compensate shareholders or owners – is necessary. Firms have known for some time that carbon regulation is coming, both in Ontario and in other regions: the announcement of a cap and trade system can’t have come as a shock. Indeed, many firms have been hedging with strategic low-carbon investments and internal carbon prices for some time.

Aside from the motivation, the details around how the support for industry will be determined remain vague and are an important determinant of the incentives that these payments will provide to firms. The consultation document goes through three potential options that could determine how free permits to existing industries are calculated.

In the first case, credits might be granted based on benchmark greenhouse gas intensity for different sectors. For example, if on average producing a tonne of cement in Ontario generates 10 tonnes of carbon dioxide emissions, then in the first period, facilities would be granted 10 emission permits (each permitting one tonne of emissions) for every tonne of cement produced. This approach helps to mitigate leakage, since it effectively subsidizes production of cement (and other products) in Ontario: firms that produce more cement get more free permits, which have value. There are some challenges, however. First, it can be difficult to know how to categorize some firms. For example, the cement firm might also produce other products, like clinker or lime, and it can be difficult to know how to allocate emissions across multiple products. It can also be difficult to know exactly what a “product” is: is a 2×4 a different product than a 2×6? What about hardwood vs. softwood? What about pulp vs. paper? What about paperboard, cardboard, etc.? Second, in certain sectors where there are few firms, a firm can have significant leverage over the “benchmark” intensity. In the extreme when there is only a single firm, rebating emissions permits in this manner completely eliminates the incentive for reducing emissions. There are a number of sectors with high concentration in Ontario, including some of the emissions-intensive sectors. (Note that using a historic benchmark, rather than updated benchmark, would fix this latter problem.)

In the second case, credits might be granted based on historical emissions. For example, if a cement firm produced 1 million tonnes of cement in a reference period (2015, say), it would receive 1 million free permits every year from 2017 to 2010. There are a number of problems with this approach as well. First, and perhaps most importantly, it doesn’t change the incentives of the firm. If our cement plant finds that it is not able to compete with cement plants in other states due to a carbon tax, giving it a one-time windfall won’t change that calculus. This type of “grandfathering” approach is therefore ineffective at reducing emissions leakage. Second, giving firms all of their permits for free in this type of grandfathering approach is likely to dramatically overcompensate them. In a recent paper, Stanford’s Larry Goulder and colleagues calculate giving firms more than 15% of their historical emissions in the form of free permits risks providing them with windfall profits. Third, this approach seems to violate the “polluter pays” principle, as the largest historical emitters get given the largest number of free permits.

In the third case, free credits would be granted based on how much energy a firm consumes. It is difficult to see the logic behind this proposal, which provides direct incentives for firms to consume more energy, effectively cancelling out the incentive to improve energy efficiency that is created by the cap and trade system in the first place. This is the worst of the options on the table.

I am sympathetic to the notion that it is important to try to design Ontario’s cap and trade system so that it reduces emissions leakage. However, it is critical to think through the design of the industry assistance package to make sure that it will do what it is supposed to do. It is not clear that all of the options on the table provide the right incentives for firms to reduce emissions, while maintaining production in Ontario. In addition, it is worth remembering that money provided to industry as support can’t be used somewhere else, where it might be more productive, such as in reducing taxes, paying down the debt, or building up infrastructure.

Ontario’s cap and trade proposal is off to a good start, but there are lots of details that need careful thought over the next year before it is in place.