2008

Johnson- Shoyama
Graduate School of
Public Policy

Sean McConnachie

CANADA’S
INTERNATIONAL
CLIMATE CHANGE
INITIATIVE: TARIFFS
VS. MARKETS
An analysis of the accumulated carbon tariff and transferable discharge permit
markets in combating global climate change, and what direction Canada should
go based on these two models.
Executive Summary:
With the debate on what steps should be taken to reduce Canada’s climate

change footprint heating up, as the provinces and the federal government begin

implementing alternative measures, one variable of this debate is noticeably

absent. Though it is of the utmost importance that Canada begins to lay a stable

and proactive framework to achieve major GHG reductions in the medium- to long-,

we need to be reminded of the essence of the Kyoto protocol; its international focus.

Though domestic cuts are important, the victories of the global fight against climate

change will be won through the reduction of emissions in the world’s largest and

fastest developing economies.

Though time has shown that the Kyoto Protocol and the Bali Climate Change

Conference have not lived up to their almost unreasonable expectations, it is not

outside of the capacity of the developed states that are currently implementing
climate change policies to contribute to strong international actions through their

own domestic policies. In so far as they can, participating states, with their just

concerns for the involvement of developing states in global climate action, can start

taking drastic steps towards environmental improvements at the international level

by enacting domestic policies that provide incentives for foreign producers to take

steps in reducing GHGs.

Discourse around such actions over the past few years, based on the failure

of the Kyoto Protocol in developing an internationally based emissions trading

market, have been focused on domestic actions to bring international producers

into the regulatory fold of the states that are taking concrete action against the

global phenomena of climate change. Presently there are two major policy options

that are being given the lion’s head of attention; carbon tariffs and the development

of an international emissions trading market. However, in light of the difficulties

with developing an international emissions market from the top down, it has

become evident that the imposition of emission tariffs on imported goods and

services is the best alternative in this debate.

Nevertheless it would be premature to right off emissions trading at the

international level as an inadequate policy option, as most states that are taking

climate change action have, or are in the process of, developing domestic emissions

trading markets; as they see this as the best alternative for providing greater

incentives for long-term action. Based on this, a third policy option has risen like a

phoenix from the ashes of the Kyoto Protocol; importer integration into domestic

emission trading markets.

In light of the impassioned debate that is currently underway in Canada, as to

what domestic policy to implement to reduce GHGs, it is of the utmost importance

that the international ramifications of such policy options be incorporated in at all

stages of analysis. Thus in the Canadian context, the policy that should be chosen

should not only provide the highest level of incentives for domestic producers to

reduce their marginal abatement costs, but it should also provide the highest

possible incentive for international firms, that import into Canada, to do the same.

The purpose of such policy is not only to provide the largest environmental benefit,

but to also provide the most equitable economic circumstances for domestic and

international firms.

Thus based on the analysis provided within the confines of this paper, it will

be shown that Canada is currently on the right course at the domestic level, but

needs to integrate an international component into its policy design. Based on a

microeconomic analysis, it will be shown that domestic importer integration into the

domestic emissions trading market will provide larger incentives for Carbon Dioxide

(CO2) reductions at the international level in contrast to the creation of carbon

tariffs.

The Current Climate Policy Context in Canada:

Canada, unlike many other states that have acted on the initial momentum of

the Kyoto Protocol, has yet to implement a centralized, nation-wide, policy that will

limit the emission of GHGs within its own borders. However, in the wake of the slow

movement at the federal level, many provinces have designed or have begun to

implement policies that will mitigate the carbon footprint of their respective

jurisdictions. Though the recent movement by the Federal Government to outline its

climate change objectives and mechanisms in March 2008 was a step in the right

direction, it has become very apparent that a complex patch work of environmental
policy is slowly beginning to developing in Canada which is resulting in added

complexity in the compliance process at all levels.

At the federal level the current Conservative Government outlined its climate

change intentions through the Regulatory Framework on Air Emissions (the

Regulatory Framework form this point forward). This document was published on

April 26th, 2007, as a guideline for the establishment of air emission targets and

outlining mechanisms that would be used to achieve these targets. This is the first

document of its kind in Canada that proposes an action plan that will reduce

emissions within a given timeframe. The main goal of the Federal Government, as

outlined in the abovementioned document, is to reduce the emissions-intensity of

the Canadian economy by 18 percent from 2006 emission levels by 2010. Every

year thereafter, a 2 percent reduction per year will be required, resulting in a total

emissions intensity reduction of 26 percent by 2015.

These reductions are to be achieved by directly regulating specific sectors of

the Canadian economy in which heavy emitters reside – electricity production by

consumption, oil and gas, forest products, smelting and refining, iron and steel,

some mining, and cement, lime, and chemicals production. The emissions intensity

reduction within these sectors should be enough to reduce Canada’s total emission

of Greenhouse Gases (GHGs) by 20 percent by 2020.

Achieving the targets outlined in the Regulatory Framework will not cause the

economy significant harm. It is estimated by Environment Canada, that Gross

Domestic Product (GDP) should not fall by more than 0.5 percent for any given year

up to 2020. To ensure that the actions taken to reduce GHGs do not drastically

impede economic growth, the Federal Government will use compliance mechanisms
designed to provide flexibility for firms to meet their individual legal obligations as

set out within future GHG regulations.

Under the Federal Government’s current plan, an emissions trading market

will be established and operational as of 2009; this will be a baseline-and-credit

trading system whereby the emission targets for each firm would be based on their

2006 emission levels. Credits, or allowances, would be allocated to firms based on a

comparison of their current emissions intensity versus their baseline intensity.

Credits can also be accumulated through financial contributions to a technology

development fund and through the Clean Development Mechanism (CDM). Under

the CDM, which is administered through the Kyoto Protocol, domestic firms will be

permitted to achieve 10 percent of their compliance obligations through the

investment in projects that will result in GHG reduction in developing economies.

The Federal Government under its framework will recognize the credits obtain

through this program after they have been reviewed by the Clean Development

Mechanism Executive Board (Canada, 2008).

Though the Federal Government has decided that the use of an emissions

trading market will provide the proper incentives for long-term reductions in CO 2

emission, it has become apparent that many provincial governments perceive the

imposition of a carbon tax as the best policy option. Following Quebec’s June 2007

announce, the government of British Columbia declared in February 2008 that it

would become the second provinces to impose a tax on carbon emissions.

In a similar fashion as that of the Quebec tax policy, British Columbia’s tax

will apply to virtually all fossil fuel sources and will be imposed at the point of

purchase. In order to insure that this tax does not harm the BC economy, it will be

implemented at a gradual pace in attempts to provide consumers ample time to

adapt and for producers to implement newer technologies that will reduce their

carbon impact. This tax will begin at $10/tonne C02 as of July 2008 and will then

escalate to $30/tonne in 2012, after which further analysis and impact review will

be conducted determine the level of the tax past 2012 (British Columbia, 2008).

With provinces like Quebec and BC using a tax based approach to achieve

their carbon objectives and the Federal Government using a market based solution,

the debate in Canada over what policy should be the flagship of Canadian

environmental policy still wages on. Currently the focus of such debates is on the

effects of each program at the domestic level and neglects their effects on

reductions in GHGs outside the borders of Canada. Under the imposition of either

system a free-riding problem is created in the long-term as many firms that

currently produce in Canada have an incentive to reallocate to evade these costs. It

is evident that the current policies proposed in the Canadian context do not address

the problems associated with the level of integration of the Canadian economy with

the global market and the escalating emissions being released in developing states.

Thus “success on the climate change front will be beyond our grasp unless the

emerging economic superpowers like China, India, Brazil, Indonesia and others are

effectively co-opted into the process” (Allan and Courchene, 2008).

Outline of the Policy Alternatives:

Based on the current and projected contributions of transitional economies

such as India and China to global warming it is of paramount importance these

countries, and those that follow them, begin to reduce their emissions intensities in

the foreseeable future. In China, based on current projections, it is predicted that in

the coming decade they will have more coal-fired power facilities then both the
European Union and the US combined. With the current technology being utilized in

China, these power plants will remain operational until 2070 to 2080 resulting in

China becoming the world’s largest polluter during this timeframe (Cooper, 2006).

Thus it is important that as we move forward with our own climate agenda that we

provide incentives for firms operating in these counties to increase their efficiencies

and the use of cleaner fuel sources through the creation of green competition.

Carbon Tariffs:

The forbearer of the aforementioned carbon tariff is the domestic carbon tax.

A carbon tariff is the same as a carbon tax in so far as it puts a price on carbon, or

carbon equivalent emissions, with a focus on producers that are outside the

geographical confines of the domestic market. This is an approach that has received

much attention by academics and governments alike, as a policy alternative after

the Kyoto Protocol expires in 2012. Academics, such as Courchene and Allan

(2008), Stiglitz (2006), and Cooper (2006), believe that the implementation of

carbon tariffs is the only sensible means to insure the participation of the world’s

largest emitters in global climate action.

The implementation of a Carbon tariff would be conducted in a similar

manner as the imposition of all tariffs; it would be levied on the product or service

upon its arrival into the domestic market. The tariff that would be issued on imports

would be based on its accumulated carbon content, similar to a Value Added Tax,

equal to the rate of taxation imposed on domestic producers; that is the tariff would

be harmonized at the same rate as the domestic carbon tax structure (Allan and

Courchene, 2008). This will create a price for carbon on goods and services that are

entering Canada and would thus increase the cost of the imports in question.
 The reasoning behind the carbon tariff is twofold: (1) to increase the price of

imports in a fair and unified manner, thus maintaining domestic firm

competitiveness in domestic markets; (2) to provide an incentive for those firms

that are exporting their products to Canada to reduce their overall emissions

intensity. The implementation of this tariff, as Courchene and Allan point out, will

reduce the incentive for multinational firms to outsource production to “pollution

havens” as they will face the same tax constraints, so long as they continue to sell

in Canada.

The implementing of a carbon tariff, however, does raise the question of its

legitimacy in light of Canada’s membership in the World Trade Organization (WTO).

Stiglitz, Courchene, and Allan point out that the creation of such a tariff structure

does not run contradictive to the agreements outlined in the WTO and that any

issues regarding this style of tariff would be won handily by Canada. Stiglitz notes

that by not having proper mechanism in place to reveal the price of carbon,

countries that do not have climate change policies in place are in a sense are

subsidising carbon intensive industries; thus, providing these firms with an unfair

advantage on international markets. Furthermore, it is noted that the WTO, in many

occurrences, has allowed for the implementation of certain import measures based

on a products environmental repercussions; an example of this would be O-zone

tariffs enacted in the 1990s. Courchene further solidifies this argument by pointing

out that if domestic and international producers face the same restraints, in the

form of harmonized tariffs and taxes, then no advantage is being provided to

domestic producers.

The implementation and legitimacy of this tariff would be contingent on the

establishment of an internationally recognized carbon accounting system. This

auditing process would be used to derive the final carbon footprint on a per unit

basis of the import that is entering the Canadian market. The success of such a

program would be largely based on the standing of such an auditing system at the

international level as to derive a legitimate tariff structure. This would most likely

have to be conducted by an international reputable organization; such as the United

Nations Environmental Progrmme or through a mechanism developed by the WTO.

The goal of implementing such a program is not only to reduce Canada’s

emission intensity and the intensity of its trading partners, but is to establish a

framework for the implementation of a Harmonized Carbon Tax (HCT) (Cooper,

2006). As more states engage in this practice there will be a need to establish

corresponding tariff structures, and de facto domestic carbon tax structures, in

order to maintain such a system and shelter it from detrimental trade disputes.

Cooper states that the IMF could easily fulfill the role of mediator and monitor, as it

currently assesses the financial structures of member governments; however the

WTO could also undertake this role to an adequate standard.

Importer emissions trading Integration:

Though the establish of a carbon tariff is widely referred to as being the most

optimal mechanism for establishing the first major steps in international carbon

mitigation and has become a pillar for the establishment of domestic carbon tax

regimes; most states that have either initiated or have committed themselves to

action have selected permit or credit trading as their preferred choice. However,

since the universal realisation of the failure of the Kyoto Accord and the lack of an

established international market for globally recognizable emission credits, this

decision has been called into question and the tariff/taxation policy has risen as the
new policy option for achieving the objectives of both individual states and the

international community.

Nevertheless, there has arisen a policy alternative that allows these states to

maintain their current trading structures while reducing emissions in other countries

through the provision of market incentives through integration. Just recently the 27

members of the EU agreed that measures need to be taken in order to penalize

firms in other jurisdictions that do not have comparable targets and policies. Though

the creation of universal tariffs amongst all members has been touted as being the

best direction, the European Commission is also examine the possible expansion of

the Emissions Trading Scheme (ETS) to involve either those firms that export heavily

to Europe or those firms that import heavily from other countries.

Though the notion of expanding existing or proposed emission trading

regimes is relatively new and undeveloped; it is presenting itself as the most viable

and effective alternative thus far as the EU begins to design the third stage of the

ETS. Both the above mentioned policies hold the possibility of achieving the same

objective, but expanding to firms operating outside the EU holds larger logistical

and transaction costs then integrating importing firms into the ETS. The largest

amount of incentives would be drawn from integrating importing firms into the

market structure, as these firms would be able to transfer the additional costs of

purchasing and trading credits to the firms that they import from. This option would

also reduce the transitional costs for expanding the markets, as importers would be

readily able to adapt their practices to the new constraints that the market

presents.

For Canada, the involvement of importing firms into the current market that is

proposed by the Federal Government would achieve the same objectives as a

carbon tariff, as the cost associated with such a system would be extended to

external produces, thus providing them with incentives to reduce their carbon

footprints in order to remain competitive in the Canadian market. Additional

incentives for mitigation will also be provided through the Clean Development

Mechanism (CDM) as outlined in Turning the Corner. Under this program, Canadian

importing firms can focus investment towards the firms that they import from to

reduce their GHG intensities in order to first increase the amount of credits that are

endowed to them from the Federal Government and secondly reduce the amount of

credits that are necessary to achieve their holding objectives as outlined in the

regulations of the Federal Government. Incentives are also increased for

internationally producing firms to lower their emissions intensity as a new

component will be added to their cost competiveness criterion; that is, these firms

will now also be competing against other firms on the global market based on their

CO2 mitigation capabilities.

It should also be noted that the implementation of carbon market integration

poses no threats to Canada’s current standing under the WTO, the North American

Free Trade Agreement, and the Free Trade Agreement as all firms, whether domestic

or foreign, will face the same market price for carbon. Furthermore, the calculation

of the carbon content of the goods entering Canada could be achieved through the

same mechanisms that would be used for the establishment of a carbon tariff, as

outlined above.

Theoretical Analysis of Models:

Although it is imperative to analysis the ability of foreign firms to transfer

their supply to other markets that do not have climate change restraints, it is not
within the capacity of this paper to examine this to a sufficient degree.

Nevertheless, this paper will concentrate on the incentives that are presented to

domestic importers and how they will react under certain hypothetical conditions.

For the purpose of this analysis we will have to provide assumptions about various

variables incorporated with both alternatives in order to establish a controlled

environment. First, the marginal abatement cost (MAC) curve and the marginal

damage (MD) cost curve faced by the foreign producer are the same, in both

examples. Second, the importer, under both systems, pays for the tariff but not for

the technology initially used in the production process. Third, that the foreign

producer of the good in question only sells to the Canadian market and holds no

ability to shift its supply to other markets.

Carbon Tariff:

The imposition of a carbon tariff on imports coming into the Canadian market

works in the same manner as a tax on domestic firms, as a tariff is a tax on those

firms that choose to import a good or a service from a foreign producer. A carbon

tariff on imports from foreign markets is in essence a tax on the carbon intensity of

each unit being imported. The carbon content of each unit is derived by the total

emissions released from the production and the transportation of the good to the

Canadian market divided by the total units of production. It should be noted at this

point that if you only divided the total emissions of production by the number of

units sold to the Canadian market, the carbon content of each unit would be

artificially high in comparison to that held by domestic producers.

The basic notion behind an emissions tariff is that it provides a price on

carbon without directly setting limits on the total amount of carbon that can be

emitted, thus providing importers with the decision of how much of the product is in
their best financial interest to import. Under this logic, polluters will reduce

emissions to the point where their MD of carbon emissions (the emissions intensity

per unit) are equal tothe per unit tariff rate imposed on them.

Assume that Canada introduces a per unit carbon intensity tariff equal to PT.

Graph 1 shows the current scenario under the initial implementation of the carbon

tariff. Under this situation the importer is paying area C+D+E based on the MD 1 as

derived by the current technology in place (MAC1). The tariff provides an incentive

for the firm to reduce its MD by implementing new technologies that reduce the

production process’s emissions intensity to MD2 based on MAC2. With the new

technology the importing firm now has a tariff bill equal to E and has a new

abatement cost of B+D. This means that the importing firm receives a benefit of

D+C in the reduce tariff bill while the foreign producer receives a benefit of A in the

form of reduced per unit mitigation costs.

Graph 1: Emission Intensity

MD2 MD1
MAC1 per Unit under Tariff System
Price per
tonne of CO2 MAC2

PT Tariff
C
E A

E2 E1 CO2 Tonne
per unit
Importer Market Integration:

The integration of importing firms into the proposed emissions trading market

by the Federal Government will achieve results that are initially similar to that

experienced in example provided for the carbon tax, but will result in additional

incentives for further reductions in the emission intensity of the

production/transportation process. Under this system the price on carbon that would

be experienced by both the importing and foreign producing firms will be set by the

market as per the demand and supply of credits. For all intensive prepossess we will

assume that the market price per credit for one tonne of CO 2 is of the same value as

the tariff used in the previous example, as this will assist us in examining the

benefits presented by this system.

With the incorporation of importing firms into the Canadian carbon market

strong incentives are created for the reduction of GHG emissions by the foreign firm,

which is outlined in Graph 2. As in the first example, the foreign firm faces an

incentive for the initial investment of technology to reduce its emissions intensity

from E1 to E2 by reducing its MAC from MAC1 to MAC2. Based on this investment the

importing firm receives credit revenues in the sum of G+H+I while the foreign

producer receives a decrease in abatement costs of A+D. This results in a net

benefit of G+D+A, though this is the same as before there is a stark difference

between the benefits received in the emissions market. G, under market conditions,

represents profit gained by the importing firm from the reduction in emissions

achieved by the foreign producer; under the tariff system this area only represented

a reduction in money paid to the government upon entry of the good, which is a

“sunk cost”.
 Thus with the added incentive of profits, both firms have motivation to

achieve further technological improvements to reduce their MAC. This is then

compounded with the introduction of the CDM which allows domestic participants to

invest in foreign projects that reduce GHGs in specific states. If the importer applies

this form of investment to a firm that it imports from, dual benefits will be achieve.

As seen in Graph 2, if the importer directly invests in the firm to reduce its MAC and

overall emissions intensity it will receive credits from the lower carbon foot print of

the products it imports and from the issuing of credits from the government based

on the investment through the CDM. The firm in this case will receive J+K in the

carbon intensity reduction of the product and also receives G+H+I through the

CDM. This provides the importing firm with a net benefit of G+H+J as K+I are part of

the mitigation costs.

Graph 2: Emission Intensity

per Unit under Emissions
Price per Trading System
tonne of CO2 MD2 MD1

PT
 CO2 Tonne
MD3 CDM per unit
MAC1

MAC2

MAC3

J G
H D
E A
B
K F
I
C

E3 E2 CDM E1

Conclusion and Recommendation

The direction that the Federal Government of Canada is currently moving in is

the correct one. This path, as guided by market mechanisms to solve market

problems, will result in the deepest cuts into Canada’s long-term carbon footprint

while sustaining viable economic growth. The use of emissions trading, as dictated

by the model used above, will provide the greatest incentives for the production and

diffusion of technology into Canada’s industries and the international market.

Though this is the correct mechanism for domestic reductions and later transitioning

into a foreseeable global market, Canada needs to incorporate an international

focus into its current policy that goes beyond negotiations with its trading partners.

It is advisable that Environment Canada take into strong consideration the

expansion of its international component in the designing of the carbon emissions

market before it releases its final intentions later this year. This would incorporate
the expansion of the Regulatory Framework to include importers of all strips under

the emission intensity targets and not just domestic industries. As these domestic

industries start to incorporate these new costs into their production processes, all

production in Canada will begin to become more expensive as marginal costs begin

to rise. In order to create a level playing field within the domestic market, foreign

producers must face the same constraints.

If the Federal Government begins to move in this direction, the expansion of

the CDM for importers past the 10 percent threshold would provide greater

incentives for deeper reductions in those countries that have larger emission

intensities per unit. The real cuts that will provide the greatest benefits for

Canadians and the international community are those that can be achieve in

countries such as China and India. It is also foreseeable that the expansion of the

CDM will result in larger trade diversification to those areas that present the

greatest incentives for the deepest cuts through the larger provision of credits to

domestic producers.

Canada should continue on its current path, but should incorporate a more

expansive focus on the international ramifications of its policy and devise a strategy

that would not only reduce emissions in other countries, such as China and the US,

but would create an equitable market climate for Canadian firms.