Issue In Brief: Understanding the Carbon Tax

The debate around the carbon tax frequently misses its broader economic and environmental benefits.

Understanding the carbon tax, what it is and how it functions, is crucial if we are to make a smart decision about its future.

Introduction

The leader of the Conservative Party, along with several provincial premiers, has been vocal in urging the federal government to “axe the [carbon] tax” and to postpone planned increases. They contend that the carbon tax is not only ineffective, but also exacerbates inflation and deepens the affordability crisis for Canadians.

Federal Conservative leader, Pierre Poilievre, has made trashing the carbon tax a central theme of his electoral strategy.

This illustration of Poilievre combines a frame from a now notorious engagement where he belittled a journalist while eating an apple, with a photo of a forest fire added as a backdrop, in place of the orchard.

Understanding Externalities

To start, let’s develop an understanding of what the carbon tax does.

An externality occurs when a person or business’s actions have effects on others that are not accounted for in the cost of those actions. These can be positive (benefits not compensated) or negative (costs not accounted for).

For example, pollution from a factory can affect the health and property values of people living nearby, but these costs are not reflected in the price of the factory’s products. This is a negative externality. Conversely, a homeowner planting a garden improves the neighbourhood’s appearance and biodiversity, benefiting others without direct compensation, illustrating a positive externality.

The Carbon Tax: A Tool for Internalizing Externalities

The carbon tax is designed to address the negative externality of carbon emissions, which contribute to climate change and its associated costs on society and the environment. By putting a price on carbon emissions, it “internalizes” these external costs, making businesses and consumers more mindful of their carbon footprint.

The principle is straightforward: the more you pollute, the more you pay. This incentivizes cleaner energy use and investment in greener technologies without dictating specific methods for achieving these reductions.

Perhaps the most important thing to understand about the carbon tax is it is addressing costs that are placed on the public, in the form of air pollution and climate change, which are the result of activity that private companies, like oil and gas producers, profit wildly from. All a carbon tax is doing is correcting a market failure that has been exploited to make a few rich, at the expense of the rest of us (not to mention future generations).

Correcting a Market Failure

Perhaps the most important thing to understand about the carbon tax is it addresses costs placed on the public, in the form of air pollution and climate change. These costs are the result of activity that private companies, like oil and gas producers, profit wildly from.

All a carbon tax is doing is correcting a market failure, which has been exploited to make a few people very rich at the expense of the rest of us (not to mention future generations).

Economic Perspective on Carbon Tax

In response to the claims made by Conservative Party leader, Poilievre, as well as others, more than 300 economists published an open letter voicing support for the carbon tax, highlighting its efficacy in reducing emissions in a cost-effective way and with minimal impact on inflation.

Yes, the carbon tax is helping reduce emissions

A recent study by the Canadian Climate Institute estimates that carbon pricing will reduce GHG emissions by between 19 and 22 megatonnes per year by 2030. This is about 10% of the share of currently legislated reductions achieved overall, and is the equivalent to the total annual GHG emissions of Manitoba.

This is 10% reduction is that achieved under current legislation, which brings us to roughly 549 Mt by 2030. The Paris Agreement goal Canada has committed to, of 40-45% below 2005 levels by 2030, would see us at 440 Mt. In other words, when the high degree of difficulty of the endeavour is considered, that 10% reduction becomes even more significant.

This chart, using data from the Canadian Climate Institute, shows high and low estimates of the impact that different policies are likely to have on the amount of GHG emissions in Canada.

The Carbon Tax, noted here as “Fuel charge”, is an important part of a suite of tools needed to bring emissions down.

Even so, as outlined on the emissions forecast chart, below, more needs to be done.

Addressing Misconceptions

Perhaps the most prominent argument opponents of the carbon tax have made is that it is making life more expensive.

The government has a few things going against it when it comes to countering these claims.

There are obvious and unhelpful connotations that come with anything called a “tax”, and in that respect (as well as in others) the government has done a pretty poor job marketing the policy.

Then there’s the experience of high inflation post-pandemic, which remains a big concern for many, and rightly so.

Fuel, and a degree of legitimacy, was added to this argument last summer with a report from the Parliamentary Budget Officer (PBO) that, on its surface, seems to confirm that the carbon tax is a net cost for Canadians.

While the answers the report provides aren’t strictly wrong, the questions it asks, are.

The PBO looked at two broad factors – whether the carbon tax paid and the rebate received resulted in individuals having more or less money at the end of the day.

For this question it found that yes, the carbon tax, combined with the rebate, known then as the “Climate Action Incentive Payment”, resulted in more money for the majority of Canadians. (Moreover, the rebate program is progressive, meaning that, by giving more to those with lower incomes, it also helps to address economic disparity.)

The second question the PBO looked at was whether, once the carbon tax was factored into economic productivity, and the gains that Canadians could expect under growth scenarios without a carbon tax, whether, in such a scenario, they would have more or less money.

For this, second, question, the PBO found that when the growth + carbon tax scenario was compared to the growth – carbon tax scenario, Canadians would have more money in the one without a carbon tax.

Astonishingly, what the PBO did not do was include modelling of the costs that climate change will have on Canadians and how those costs will impact the growth scenarios used.

The Costs of Inaction

The thing with climate change is that it’s an escalating cost, and the more that it is left unaddressed, the more those costs pile up.

In addition, tipping points, such as thawing permafrost, which has the potential to release vast amounts of methane, a greenhouse gas that is far more portent than carbon, add a high degree of uncertainty to future efforts to successful address climate change. Policies that assume certain scenarios to calculate emission reductions could be rendered meaningless in the event of such tipping points. Another way of understanding risk is as potential costs, which need to be hedged against.

A black swan event is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black swan events are characterized by their extreme rarity, severe impact, and the widespread insistence they were obvious in hindsight/

Tipping points can be understood as potential black swan events.

Black swan events can be difficult to guard against, as costs associated with building resilience, such as with redundancies, are often hard to sell politically.

Furthermore, successfully guarding against a black swan event means that it doesn’t happen, or doesn’t happen to as great an extent as was feared. The justification for the expense, or helping the public understand it was worthwhile, thus, is often hard to make, even though the benefit of the avoided black swan far outweighs the likely cost.

The chart below, which uses data from a study by the Institute for Sustainable Finance, outlines costs that are relatively certain based on four different scenarios, of 2°, 3°, 4°, and 5° warming.

The total costs for Canada associated with the different scenarios are represented at the bottom of the chart, and are more than $5 trillion by the end of the century under a 5° scenario.

The longer we delay addressing climate change, the greater the cost will be. This table uses a heatmap to illustrate that inaction will ultimately end up costing us far more.

In its study, the PBO assumes a business-as-usual annual GDP growth of 1.72%. With Canada’s current GDP of $1.72 trillion, that comes out to $2.52 trillion by 2030.

Running the scenario that the PBO uses to estimate the most aggressive cost, which uses a carbon tax rate of $239 per tonne, provides an estimate of a 0.62% reduction to GDP growth, results in a $2.35 trillion, a difference of $17 billion.

As you can see on the table above, that puts the cost right in the range of the 2°/3° warming scenarios of 2030.

Now factor in additional costs associated with the fossil fuel industry, such as stranded wells (currently well in excess of $33 billion in Alberta alone), and air pollution (estimated by Health Canada to cost Canadians $120 billion per year) and it quickly becomes apparent that actions to reduce fossil fuel emissions are a no-brainer when it comes to value for the Canadian taxpayer.

The Costs of Inaction

In its study, the PBO assumes a business-as-usual annual GDP growth of 1.72%. With Canada’s current GDP of $1.72 trillion, that comes out to $2.52 trillion by 2030.

As you can see on the table above, that puts the cost right in the range of the 2°/3° warming scenarios of 2030.

Different GHG emission forecasts by Environment and Climate Change Canada (ECCC).

According to ECCC, “the “Reference Case” scenario includes federal, provincial, and territorial policies and measures that were in place as of August 2023 and assume no further government action.”

Event with the most optimistic scenario, which is the “Additional Measures Scenario”, which includes all current and fully implemented announced policies, as well as contributions from land -use, forestry, nature-based climate solutions, and credits through the Western Climate Initiative, we still fall short of meeting our global commitments.

Conclusion

The debate around the carbon tax frequently misses its broader economic and environmental benefits.

By effectively addressing the externality of carbon emissions, the carbon tax stands as a critical component of Canada’s strategy to combat climate change and promote sustainable growth.

Clear communication and understanding of the policy’s benefits, including the progressive rebate program, are vital in navigating public concerns and fostering support for this essential environmental initiative.

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