Cap and trade explained: What Ontario’s shift on emissions will mean

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On Monday, Premier Kathleen Wynne formally announced what The Globe revealed two weeks ago: that Ontario will launch a cap-and-trade system for carbon emissions.

The plan is to link Ontario's system to those already in place in Quebec and California, creating a carbon market of 61 million people and covering more than half of Canada's economy.

The details still have to be worked out over the coming months, but the broad outlines are clear. Here's how it works.

What is cap and trade?

It's a system where the government caps the total amount of carbon emissions allowed. The government then issues permits to companies, specifying exactly how much carbon that company can burn. If a company wants to burn more than its share of carbon, it must buy extra permits from other companies that have burned less.

The laws of supply and demand govern exactly what the price of a carbon permit ends up being. Over time, the government gradually lowers the cap, cutting the number of permits it issues and driving up their price.

The idea is that some companies will cut their carbon emissions in order to make money by selling their extra permits, while other companies will cut emissions to avoid having to pay the price to buy more permits.

What does it mean to link your cap-and-trade system to another jurisdiction's?

Quebec and California have linked their cap-and-trade systems, which means the governments issue permits jointly. Companies in Quebec can also buy permits from companies in California and vice versa.

The benefit of this is that it should create a more stable carbon price over time, because so many more companies are participating.

How does the government allocate permits?

The government gives out some permits for free, usually to companies in sectors that are vulnerable to competitors in other jurisdictions without cap-and-trade systems. (One example is the aluminium industry in Quebec, which faces stiff competition around the world.) The rationale is that these companies should not face a disadvantage – and therefore be tempted to relocate – by doing business in a jurisdiction with cap and trade.

The government can also auction off some of the carbon permits, which helps set a price for them and raises money for government.

In Ontario's case, the province is estimated to be able to raise between $1-billion and $2-billion per year from carbon-credit auctions. The government is promising to direct this money into other environmental projects – new public transit lines, for instance. Whether they keep this pledge remains to be seen.

How is cap and trade different from a carbon tax?

Under a carbon tax, the government simply sets a price on carbon and everyone who buys a product that creates emissions must pay it. For example, British Columbia's carbon tax is $30 per tonne, which translates into about seven cents for a litre of gas.

In theory, people will cut their carbon use over time to avoid paying the tax.

The advantage of a carbon tax, compared with cap and trade, is that it is relatively easy to administer and straightforward to understand. Everyone pays the same price to burn carbon. The downside to a carbon tax is that it does not set an exact cap on emissions. The government just sets the price and hopes that consumer behaviour will do the rest.

Cap and trade, on the other hand, allows government to mandate the exact reductions it wants to see.

But there is a downside. Cap and trade is a lot more complicated than a carbon tax, and can be gamed by industry. For example, if companies over-report the amount of carbon they are burning to begin with, government could set the caps too high and not actually achieve significant reductions.

The allocation of permits also allows government to pick winners and losers: if one company's industry has a really good lobbyist, it could convince the government to allocate more free permits to it, and fewer to other sectors – with potentially unfair results.

There is also a transparency issue. Under a carbon tax, everyone knows more or less what they are paying. Under cap and trade, companies will likely pass the cost to consumers, but it may not be clear exactly what those costs could be.