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With a newly found exuberance for carbon pricing in the United States, Canada faces a conundrum. Either it harmonizes its policies with those of the U.S., which reflect the politics there, or adopts a made-in-Canada plan to reduce carbon emissions with a better approach. It won't be easy to follow either course, but we should not take it for granted that harmonization is better.

This week, President Barack Obama announced a new fuel-efficiency standard of 35 miles per gallon by 2016, sharply higher than the present average of 25.3 mpg. Energy efficiency is almost a no-brainer in policy terms. As Europe has shown, it is practical to reach the new limit over time. Americans, whose purchases of small cars are currently only 16 per cent of demand, need to shift away from gas guzzlers to vehicles such as the little Fiats that Chrysler will soon be selling. Both carbon emissions and U.S. imports of oil will be curtailed, accomplishing twin environmental and security objectives.

Of course, an arguably better solution would be to sharply increase gasoline taxes to encourage the purchase of smaller cars. Mr. Obama has rejected increasing U.S. gas taxes - even to the Canadian level - which would have provided significant revenues for his deficit-plagued budget plan.

ANOTHER NAIL IN THE COFFIN

Canada might as well follow the same regulatory course of action, given our integrated auto market. It is too troublesome for companies to comply with Canadian-specific regulations, since our market is too small for many brands. Auto production may be faced with some additional costs but another nail in its coffin won't make much difference, so long as similar policies are adopted elsewhere.

A much more difficult policy for Canada to imitate is the proposed U.S. cap-and-trade policy that has begun to wind its way through Congress under a House bill sponsored by Representatives Henry Waxman and Ed Markey. It would impose a hard cap to reduce aggregate U.S. greenhouse gas emissions by 3 per cent from 2005 levels by 2012, 20 per cent by 2020, 42 per cent by 2030 and 83 per cent by 2050. With permit trading, regulatory costs are alleviated since companies facing high compliance costs purchase credits at less cost from those who emit less than their allowance.

With a growing economy, these requirements will be a challenge unless economic technologies are adopted in sufficient time. The system will apply to large emitters (with more than 25,000 equivalent carbon tons of emissions) in the utility, petroleum, industrial and other sectors. As part of the package, companies may buy domestic and international offsets, borrow allowances from other years and bank current allowances to be used in other years.

While Mr. Obama's initial proposal would require the full auctioning of credits, thereby raising $1.2-trillion over 10 years, the proposed scheme has bought political support from the coal-based regions and power companies by giving away 85 per cent of permits. This will blow another hole in the U.S. budget, adding to its already immense, Italian-style debt burden. (“What's a trillion?” to paraphrase C. D. Howe.)

Moreover, the allowances soften substantially the impact of energy plans on the electrical coal industry, which accounts for the largest share of emissions in that sector. Surprisingly, allowances are far less generous to natural gas, which is a much cleaner source of power. Of course, the oil industry is a substantial loser; refining costs are expected to skyrocket.

Cap-and-trade schemes are quite complex and intrusive, not much different from imposing a new value-added tax with multiple tax rates on goods and services. The U.S. Congress is well aware that energy-intensive goods will be most affected by a cap-and-trade system; the new bill includes unspecified subsidies as an offset for internationally competitive, energy-intensive sectors.

Much to its discredit, the U.S. bill's free distribution of permits and subsidies mitigates the impact of carbon pricing on consumer behaviour, because consumer price impacts are softened. To some extent, this will shield consumers from price hikes, which would encourage better conservation practices and energy efficiency. It is not a good way to go.

It also gives the President the power to impose border adjustments on a case-by-case basis. Call it a tariff on foreign manufacturers and importers who would pay for special allowances to cover carbon contained in U.S.-bound products. Supposedly, countries with similar carbon pricing schemes would be exempt.

Canada faces an immense challenge with the development of this complex cap-and-trade plan now being considered in the United States. Federal and provincial governments will feel pressured to harmonize their policies with the U.S. to minimize distortions in trade, at the cost of adopting what could be a highly inefficient and unfair carbon pricing model.

The inefficiency of such systems is well known from European experience. While cap-and-trade has the virtue of achieving the specific objective of emission reduction with precision, the carbon price will fluctuate according to the state of the economy. Price variability makes it hard for businesses to adopt the expensive technologies that will clearly be needed to realize climate change objectives.

Further, many complex issues arise with cap-and-trade systems, such as determining allowances for new facilities and the phasing out of old ones. Offsets are notoriously difficult to monitor at an international level. And, as the Europeans have learned, utility companies engaged in different technologies, such as hydro, nuclear and coal-fire electricity, can profitably expand all forms of production, since they are in a net credit position.

On the other hand, as many experts now agree, a carbon tax or levy such as that adopted in British Columbia and in a different form, in Alberta, is in principle more efficient and fair. It gives more price certainty to businesses and is less subject to the complexities involved with the implementation of trading systems.

A carbon tax can be applied on all emitters, as well as yielding substantial revenues to governments so as to reduce other taxes or fund technologies needed to reduce greenhouse gas emissions. Nancy Olewiler of Simon Fraser University and I have estimated that Canada could collect almost $20-billion in revenues by imposing a $40 carbon tax on all energy sources, similar in value to the existing federal fuel excise tax of 10 cents a litre on gasoline. This proposal was adopted as part of the Liberal Green Shift, and soundly rejected in the last election.

Politically, a cap-and-trade system with auctioned credits looks like a tax on “dirty” industries, not on consumers or employees working for the businesses. Yet the effect of any carbon pricing scheme is to force up prices. A tax makes the cost much more obvious. That in itself is a virtue.

If Canada wants to pursue a completely different approach to carbon pricing rather than harmonizing its system with an ill-thought-out U.S. system, is it possible to do so? In principle, countries operate with quite different public polices, so we should not immediately accept the proposition that we must have a cap-and-trade system identical to one used by the Americans. After all, Canada relies much more on sales taxes and less on payroll taxes, compared to the United States, and our corporate tax system is very different in its application. We need not duplicate the U.S. approach.

REGIONAL POLITICS

In particular, Canadian politics is very sensitive to regional issues. Alberta and other energy-producing provinces (B.C., Saskatchewan, Newfoundland and Nova Scotia) would resent a scheme that would lead to a large transfer of wealth to the rest of the country or, for that matter, the United States. The latest thinking in Ottawa on avoiding a federal-provincial conflict is that public revenues received from carbon-pricing systems should be used to fund new clean-energy technologies that would significantly benefit energy-producing provinces and accomplish environmental objectives. This could be easily achieved with a carbon tax or auctioned credits, two approaches that the U.S. has largely rejected. Again, this argues for a made-in-Canada solution.

The most critical issue, however, has to do with the potential border-adjustment charges the United States might impose on goods sold into its market. If Canada adopts a different scheme, will the U.S. recognize it as equivalent to their regime, so that no such border adjustment is required?

While countries are free to apply environmental policies, if they equally affect domestic production and imports, the proposed border adjustments in the House bill will likely result in a large number of legal challenges under the World Trade Organization and NAFTA. Too much discretion will be needed to measure the value of carbon in a product to determine the tariff. And when products are produced by global chains, it will be nearly impossible to discern which country's carbon regime is embodied to the product. Even if Canada adopts a cap-and-trade system instead of a carbon tax, equivalence will become a never-ending game of conflict unless the systems are identical.

We are at a beginning of a long road, with Ottawa and Washington engaged in talks under a process called the Clean Energy Dialogue. We could adopt the U.S. scheme as a whole, but it would be far better to pursue a smarter, made-in-Canada approach.

Jack Mintz is Palmer Professor of Public Policy, School of Public Policy, University of Calgary.