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The Cost and GHG Implications of WCI Cap and Trade in Ontario

Ontario is going cap and trade. Now is therefore a good time to put into the public domain some initial results on the cost and GHG implications of the WCI system applied to Ontario.

Outlined below in this post are the assumptions and data sources used to estimate the cost and GHG implications in 2020 of Ontario joining the WCI. The information underlying the analysis in the infographic above will change in time, as design features are revealed, but the analysis provides a first order estimate of what we can expect. While Ontario has a 2050 target, it is set aside for now.

In reviewing these results, there are three key points to keep in mind.

First, climate policy is about the long-term. To the extent future carbon policy is uncertain, businesses and consumers will make choices that result in high emitting capital stock being deployed. Simply, when they think policy is not credible, they will not factor in carbon costs in new capital decisions. When we then decide to get moving, as in Ontario now, it takes time for that high emitting capital to switch out, especially if the carbon price is low. Policy delay is costly.

We can expect, therefore that emission reductions in the short-term under Ontario’s cap and trade program will be small, but in the longer-term capital deployment will be more significantly impacted. Our analysis and modeling below shows this to be the case, where short-term reductions in 2020 are limited in Ontario to about 6.5 Mt under the WCI.

Second, linking cap and trade systems with Québec and California is both environmentally and economically responsible. Linking cap and trade systems allows lower-cost emission reductions to be sourced outside of the province. This then avoids higher domestic costs as cheaper reductions can be found elsewhere. Given that emission reductions under the WCI system are credible, we can also expect actual GHG reductions with the imported allowances.

Our analysis and modeling below find significant gains from trade where Ontario can meet its climate change commitments through linking with Québec and California while keeping costs low and minimizing competitiveness. Our analysis shows that linked allowance trade could be in the order of 11.5 Mt to close Ontario’s forecast gap to its 2020 target of 18 Mt.

Third, cap and trade systems raise significant revenue. The marginal cost of abatement is really a small share of the total cost of a cap and trade program. Indeed, assuming Ontario is trying to close the gap to its 2020 target, emission reductions are in the order of 18 Mt at a total cost of $261 million in 2020.

This then leaves about 140 Mt of emissions unaffected. To the extent that a significant share of these are auctioned following Québec and California, the auction revenue is in the order of $2 billion in 2020.

How governments choose to deal with this auction revenue, whether to reduce income taxes to reduce the overall economic impact of the policy, or to invest in transit and other low carbon technologies to obtain reductions further down the road, is the single most important economic question in cap and trade.

Our results find that the auction revenue is in the order of eight times greater than the actual cost of emission reductions. It is therefore incumbent on governments to use this money wisely to both reduce the overall cost of the policy through income tax cuts but also to invest in innovation to make longer-term emission reductions cheaper.

Modelling Discussion for the Wonks…

Ontario’s target is 150 Mt in 2020, on a forecast of 168 Mt. The first set of data needed is a forecast of GHG emissions in 2020. As part of the Deep Decarbonization Pathways Project, Navius Research and Carbon Management Canada have developed a new national GHG forecast that reflects the current low oil price environment (based on the National Energy Board’s low oil price forecast, 2013). The new 2020 emissions forecast, absent Ontario’s coal phase-out, transport regulations and the FIT program, is 183 Mt. Emission reductions from these programs brings the forecast down to 168 Mt, which leaves a gap of 18 Mt in 2020 relative to Ontario’s target of -15% below 1990 in 2020.

Covered emissions would likely be about 85% of 2020 emissions. The first WCI design question for Ontario is which emitters are covered by the cap and trade policy?

Ontario has two choices here:

  • Consistent with Québec and California, it can start with a narrow coverage of just heavy industry and electricity facilities that emit more than 25,000 kt annually. According to 2012 Ministry of Ontario data this would equate to less than 150 large emitters in 25 economic sectors with about 53 Mt of emissions.

  • The alternative would be to start with broad coverage which would add liquid fuels and natural gas used in transportation and buildings. This is currently where Québec and California are sitting. For Ontario, aligned coverage would equate to about 85% of total 2020 GHGs of 168 Mt.

The modelling assumes a broad coverage of 85% of Ontario’s emissions in 2020.

We apply to our 2020 GHG forecast marginal abatement cost curves developed from the CIMS techno-economic model. We then developed a simple emissions trading model that uses the WCI allowance price in 2020 to determine the distribution of emission reductions within economic sectors in Ontario. To the extent that Ontario abatement at the WCI allowance price does not close the 18 Mt, we then know that Ontario would be a net importer of WCI allowances. In our analysis, we estimate both Ontario abatement and permit imports from WCI to close the 18 Mt gap.

Our analysis shows that Ontario could reduce 6.5 Mt at the WCI allowance price in 2020 of CDN $17.16 per tonne, which is just above the 2020 floor price in the WCI system. To close the 18 Mt gap in our scenario, 11.5 Mt would need to be purchased by emitters from WCI partners.

Ontario abatement cost for the 6.5 Mt reductions could be about $55 million, while the 11.5 Mt of WCI permit imports would cost $205 million. This large quantity of permit imports significantly reduces compliance costs in Ontario relative to a case where Ontario is not linked with WCI.

We also estimate the revenue potential. Because we know the quantity of the remaining emissions, and we know how allowances are distributed by Québec, we can make some assumptions about which industrial sectors will receive free allocations to address competitiveness impacts and which sectors would likely have to obtain permits at auction.

Freely allocated allowances to industry to address competitiveness impacts would total about $500 million in 2020. Total auction revenue would likely be in the order of $2 billion with about 60% of this coming from transportation and 27% from buildings.

Given this large tranfer from the consumer sector, serious consideration should likely be given to reducing personal income taxes to mitigate the cost impact of the policy. Using some of the funding for innovation and transit investments also makes economic sense to drive down the long-term costs of mitigation.

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