Maximizing innovation in a cap and trade system

Maximizing innovation in a cap and trade system

This April Premier Kathleen Wynne announced plans for Ontario to join the cap and trade system with Quebec and California. Joining the ranks of British Columbia, Alberta and Quebec, Ontario’s carbon pricing system would impact all of its 13.6 million residents, having the potential to have a significant impact on Canada’s total emissions.

In a cap and trade system the government limits the total emissions by issuing a set number of permits to carbon producers. These permits can then be traded on the market allowing companies with high carbon output to buy permits from companies who emit below their limit. Over time the total amount of carbon permits shrinks, motivating more firms to reduce emissions. The ability to trade permits rewards early adapters of carbon-reducing technologies as they can avoid rising prices of permits and profit from their sale.

While the cap and trade system is traditionally known as the least invasive of carbon pricing mechanisms (as the prices are all determined by the market, not the government) critics are sceptical of its ability to spur carbon-reducing innovation. Many argue that the cap and trade system just shifts emissions around industries, often does not capture the full scope of carbon-emitters, and that an overestimation of the cap on emissions can sometimes incentivize pollution eroding any potential for innovation.[1] Cap and trade systems may see a fast reduction in the short run but to balance long term growth and environmental sustainability certain policy considerations must be made.

After reviewing current literature and analyzing past examples it is apparent that there are three important factors that Ontario should consider to maximize the innovation inducing effects of the cap and trade system.

Write policy for technological diffusion

The goal of carbon pricing is often not just to reduce emissions but to facilitate a transition to a more energy efficient economy where green technology is mainstreamed. This paradigm shift comes about through the creation and diffusion of new technology.  The major problem that arises under cap and trade is that firms with high replacement technology have little, or no, incentive to share this technology with other firms. In particular, under a carbon tax system, innovators can sell their technology and still make a large profit; however, under a cap and trade regime, the proliferation of green technology lowers the number of permits demanded, lowering the price. This process decreases the profit the firm can raise from the sale of excess permits (from their carbon reduction), reducing the incentive to share technology. Therefore, finding replacement technologies is made more expensive as firms pursue projects individually with little information sharing.

To maximize firms’ propensity to innovate, Ontario should consider putting some of the revenue raised from the sale of permits toward research and development grants for clean energy and manufacturing strategies to offset the initial cost to innovation. An incentive system could also be created rewarding firms who share their low carbon technology. Proper attention needs to be given to technological diffusion to both foster and protect innovation in the green tech industry.

Fully capture the effects of the transportation sector

One of the largest sources of carbon pollution is the transportation sector (34% of 2012 emissions), including personal use of light duty vehicles. The transportation sector also represents one of the largest areas for innovation both in public transit infrastructure and the use of electric cars. Therefore, the cap and trade system must ensure it fully captures the effects of this sector in order to reap the benefits of innovation.

This sector poses a unique policy dilemma as emissions from the transportation sector are one as the hardest areas to fully capture within cap and trade as on aggregate emissions are large but are spread across many small polluters. Thus, Ontario will likely see the highest benefit from using a system targeting the retail value of gas, similar to the one proposed at the MIT Joint Program on the Science and Policy of Global Change. Under this program, credits are auctioned off to gas distributors who pass on additional costs to the pump – this lowers consumption and increases demand for energy efficient vehicles. The proceeds of the auction could be returned to families as a tax break (especially for low income and rural communities), balancing economic wellbeing with a change in consumer preference.[2] While Ontario currently has a gasoline tax it has not proven to be a sufficient incentive and instead should be rolled in with the cap and trade system to respond in price as the market changes. Special attention should also be given to research and development projects focusing on electric cars and green public transportation as they are not only carbon reducing strategies but also high growth areas with potential to benefit the Ontario economy.

Protect against loopholes

The last hurdle cap and trade will have to overcome is balancing flexibility and integrity in the system. Quebec and California’s cap and trade system have incorporated certain pricing policies, such as a minimum price for carbon permits, to achieve this goal. However, even within this well-thought out system there are loopholes that contradict its integrity. One is the ability to “bank” credits for future use. While this tactic can smooth out price volatilities in the long run it also allows firms to manipulate the system. Banking can benefit wealthy firms who stock up on credits when the price is low and then use them up as the price rises, doing little to change pollution habits or encourage innovation. One way to mitigate this would be to implement expiry dates or depreciation rates for the banked credits and putting a cap on the amount one firm can bank.

Green innovation is related to both environmental and economic benefits. The cap and trade system introduced by the Ontario government should not only be designed to reduce carbon emissions, but should also foster private sector innovation. Policies geared toward technological diffusion, innovation in the transportation industry, and balancing the flexibility and integrity of the cap and trade system could transform Ontario’s carbon abatement plan to an economic revitalization project.


[1] David Driesen, "Does Emissions Trading Encourage Innovation, “Environmental Law Institute, 2003.

[2]A. Denny Ellerman, Henry D. Jacoby, and Martin B. Zimmerman, "Bringing Transportation into a Cap-and-Trade Regime," MIT Joint Program on the Science and Policy of Global Change, 2006.

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