The Key to Carbon Pricing

With a proper carbon-pricing policy, Canada can fight climate change, put its fiscal house in order, and solve its productivity gap.

Canada is emerging from a global economic crisis of rare severity; by most measures in better shape than many of our trading partners and competitors. Our national economy has started to grow again, and some of our provincial economies are returning to the kind of growth rates that were the norm before the crisis hit. The fundamentals of our economy, from the banking sector to our natural-resource export base, remain strong.

But whatever “good news” story can be told about our economy at this specific point in time, a pervasive insecurity about the future lingers. People and governments are beginning to acknowledge that a return to “business as usual,” such as it was before the crisis hit, is not enough to ensure our ongoing future prosperity. Yes, we’ve successfully weathered the most severe economic storm of the past half-century, but we now understand that the crisis did not clear away some of the long-standing perennial challenges we face, both economic and environmental. In fact – with the deficit created by the necessary fiscal response to the crisis – we are, in a very significant way (i.e. in the government’s ability to address these larger challenges), in a much more difficult position than before.

This situation presents us with a unique opportunity to think creatively about what long-term sustainable prosperity means for Canada. The fiscal box that we find ourselves in is real, and it’s serious. But there is a way to think about unlocking this box using a key that can also help us with at least two other serious long-term policy “boxes” that we face: climate change and Canada’s innovation and productivity challenge. That key is a national carbon pricing policy.

How does a carbon-pricing policy help us achieve long-term sustainable prosperity? The answer is in some ways most obvious when applied to addressing climate change. A carbon-pricing policy (either through a carbon tax or through the auction of allowances under a cap-and-trade system) changes the economics of our energy system in a way that promotes the more effective and efficient use of carbon-based energy and also the dissemination of energy sources that generate less (or no) carbon emissions in their use or production.

Such a policy would also help us get out of the fiscal box. Either a carbon tax or an auction of the allowances created under a cap-and-trade system would generate new revenue streams for governments across the country. These revenues could be directed toward addressing the short-term fiscal deficits we currently face as well as long-term fiscal challenges caused by aging populations demanding greater public services. And if the threat of deficits, either short-term or structural, subsides, they could allow for the reduction of other forms of taxation that are considered distortionary or contrary to other economic policy objectives (taxes on labour or savings being the classic cases). New fiscal resources could also be applied to existing challenges – climate change mitigation and adaption being the most obvious – or new ones.

Of direct interest to us should be the fact that every one of the proposals tabled in the U.S. Congress for a carbon pricing-based climate change policy has included provisions for channelling revenues back into deficit reduction. To the degree that our prudent fiscal management over the years has created a comparative advantage for the Canadian economy, that development alone should prompt serious consideration of what carbon pricing can bring to long-term fiscal policy options.

In some ways, though, the most interesting and positive case for carbon pricing is to be found in how such a policy might help Canada address its perennial innovation and productivity challenges. The ongoing significance of those issues was given at least rhetorical attention in the recent federal budget.

Both innovation and productivity are extremely complex issues, involving the interplay of many interdependent factors. But at their core, they involve some fairly basic dynamics. Innovation involves the creation of new ways of doing something, through the application of new knowledge or technology. Increased productivity, fundamentally, translates into getting more from the same input or getting the same amount from less of that input. Carbon pricing, by changing the basic economics of energy, goes to the heart of both of those dynamics.

Creating a market condition where energy – as an input into economic activity – becomes more expensive means that entrepreneurs and innovators will come up with more efficient ways to use that energy or find ways to avoid using it at all. The application of that innovation, and the efficiency it introduces into our use of energy, will drive us to become more productive in the use of an input that is critical to most of our economic activity. That will make us, as an economy, more productive, reduce the impact of energy prices on economic activity (resulting, in theory, in lower energy prices overall), and reduce our exposure to an economic sector which – as evidenced by the recent oil spill in the Gulf of Mexico – involves some significant environmental challenges outside of climate change.

Carbon pricing is far from a silver bullet to address the myriad economic and environmental problems we face. But it has the potential to help us address at least some of the most important ones, and to put us on the path to sustainable prosperity.