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Canada's Carbon Tax: The ‘Sticks’ and ‘Carrots’ of Motivating Decarbonization

Although often cast as an environmental matter, climate change is ultimately an economic concern. Rising temperatures across the globe will take a toll on countries and on industries of all kinds, from agriculture to manufacturing to real estate. A 2019 study released by the International Monetary Fund found that unabated temperature increase would reduce world real GDP per capita by more than 7% by 2100. However, today, few governments or corporations are taking an active approach to manage climate risk by linking financial outcomes to greenhouse gas (GHG) emissions.

When action is most often motivated by financial incentives, carbon pricing can be a key lever to combat the worst effects of climate change. It can also drive the achievement of the many emerging carbon neutrality targets being announced around the world.

Carbon tax and cap-and-trade programs are market-based strategies that aim to put a price on carbon. Put simply, when emitting carbon becomes more expensive, companies will seek alternatives.

The number of pricing schemes around the world has almost doubled since 2012 with 61 jurisdictions now putting a price on carbon emissions. Most of these policies are being deployed in the European Union, and studies show that among these, few prices are high enough to accurately reflect climate change-related costs or to produce meaningful reductions in emissions.

Pressure is building for more effective carbon-reduction mechanisms to be adopted, as is the need for access to cost-effective decarbonization technologies. While public-private cooperation is needed from global economies to meet this challenge, one country has recently taken steps that could lay a foundation for the future of decarbonization policies.

The “stick”: Canada’s carbon tax

In March 2021, Canada’s supreme court deemed GHG emission reduction a matter of national concern when it found the federal carbon tax to be constitutional. The landmark decision allows provinces to design their own GHG pricing systems so long as they align with the federal government’s outcome-based targets. Existing pricing regimes, such as in Quebec and British Columbia, may stay in place, but the federal tax will apply for provinces that do not meet the standard or do not have a mechanism in place.

Aside from incentivizing critical carbon reductions, carbon taxes on businesses and industries have the potential to generate significant revenues that can further aid in a just, low-carbon transition. For example, the revenue from a carbon tax could be used to invest in renewable energy, clean fuels, and climate-resilient infrastructure for a country. From an environmental justice perspective, it could be used to offset the impacts of higher energy prices for low-income households or by providing funds to invest in communities that face disproportionate effects from fossil fuel pollution.

In Canada, the carbon tax established in 2018 and now reinforced by the supreme court decision, was written as ‘revenue-neutral’. This means that all taxed money would go back to the provinces, where it can be used to rebate individual taxpayers and support disproportionately impacted sectors. For 70% of Canadian households, the rebates are predicted to exceed the marginal increase in energy costs due to the tax.

The “carrot”: Sustainability-linked lending

In parallel with Canada’s carbon tax legislation, regulators and banks in the country are seeking to increase the attractiveness of ESG-linked loans. These loans are a type of financing that provides funding specifically aimed at facilitating environmentally and socially responsible investments.

While the carbon tax forces companies to act, this emerging ESG funding mechanism offers a viable approach to deploy energy efficiency and sustainability projects, and a pathway to achieving more aggressive carbon neutrality commitments. While sustainability-linked lending accounts for a low volume in Canadian investments today, with the carbon tax going into effect, it is expected to grow rapidly. Even in our own research, we find evidence that green funding mechanisms are on the rise—between 2020 and 2021 respondents to our survey indicated a 20% increase in their likelihood to fund energy and sustainability initiatives using green bonds.

As more governments around the world enact legislation that puts a price on carbon, companies must recognize that climate risk equals financial risk. Whether due to the physical risks, such as sea level rise and extreme weather events, or the transition risk of climate change or carbon legislation, businesses must recognize that there is a true economic risk of inaction. The longer a company delays its own decarbonization efforts, the more likely they become to encounter the “stick” of a mandated tax on their emissions.  For some industries that are behind the curve on sustainability, these developments may be seen as a threat. But, in reality, both the carrot and the stick are a huge opportunity to seize the moment and make a profitable low-carbon transition.

Ready to decarbonize your organization? Read our paper, The Decarbonization Challenge: Closing the Ambition to Action Gap, to learn about how to translate your company’s climate aspirations into meaningful, pragmatic action.