As the federal government prepares to unveil its 2023 budget, and especially its response to the hundreds of billions of dollars the U.S. government has committed to addressing climate change, it should remember that Canada’s best chance of economic and emission-reduction success rests with the private sector.

The government has without doubt an important enabling role to play in driving low-carbon investment, but that role is to address market failures. It is not to supplant the role of businesses in choosing which sectors and technologies to invest in.

“Industrial strategy” is once again a term heard in corridors of power, although it is now preceded with the adjective “green.” Governments do need to think strategically about ensuring that Canada maintains economic growth and competitiveness through the global energy transition. In doing so, governments may be tempted to develop detailed plans for economic activity where they see opportunities, such as the production of green hydrogen or sustainable aviation fuels or batteries for electric vehicles.

But businesses, when risking their own money and jobs, are much better placed to make these risky bets.

At the same time, we need to recognize that markets do not always produce optimal outcomes from a societal perspective, and government policy needs to address those market failures. Doing so will reduce obstacles for the massive investments we need to achieve a prosperous low-carbon future. We see three main sources of market failure for the energy transition: insufficient pricing of the societal costs associated with energy production and use; global and domestic policy and market uncertainty; and risks associated with the development of beneficial new technologies.

Left to their own devices, markets do not account for the climate or environmental damages that result from economic activities. Government policy, through carbon pricing and regulations, can correct this. The U.S. is relying on tax credits and expensive subsidies to drive low-emissions investment. In contrast, Canada has adopted carbon pricing across the country, and the federal benchmark carbon price is scheduled to rise significantly over the next decade. This will increase economic incentives to reduce emissions and develop low-emissions technologies. Canada should focus on improving its pricing and regulatory foundation, and only turn to subsidies and tax credits to address those areas where carbon pricing is ineffective.

The second type of market failure comes from the enormous amount of policy and market uncertainty facing companies and investors. Policy reversals can be very costly for business, and few governments are able to provide credible long-term trajectories for their policies.

Of course, markets can also be fickle: shifts in technologies and consumer demand or the entrance of new competitors can wipe out returns. These uncertainties act as a barrier to investment. Governments can reduce this uncertainty through policies such as “contracts for difference” that compensate companies if policies or carbon price trajectories change. If the federal government’s proposed $15 billion Canada Growth Fund focuses on addressing these kinds of investment risks, it will be a worthy policy experiment.

The third kind of market failure stems from the technology risk associated with the commercial-scale deployment of many early-stage emissions-reducing technologies, which require huge up-front capital investments and then many years to realize an investment return. However, many of these projects will generate societal benefits by reducing technology risk for similar future projects. Governments can play a role in overcoming barriers to investment in early-stage projects by sharing some of the risk with investors, and potentially some of the financial benefits too. The U.S. has taken the approach of generous production tax credits for emerging products such as green hydrogen and sustainable aviation fuels, which could pull investment away from Canadian projects. Maintaining a competitive edge without breaking the bank will be one of the defining challenges of Canada’s upcoming budget.

In implementing these policies, governments should see their role as an enabler of private-sector success. If they take an overly top-down or government-knows-best approach, public spending could crowd out private investment and Canada could be left with costly white elephants or an endless demand for subsidies to prop up unsuccessful ventures. There has been insufficient research on enabling policy tools to date, and governments could benefit from a more rigorous external analysis of various approaches.

The coming energy transition will be complicated and full of uncertainty. Governments should resist the siren song for direct involvement in the direction of specific sectors or technologies, and focus instead on addressing the market failures that are obstacles for low-emissions investment. Once those broad direction-setting policies are in place, the private sector will have all the market signals it needs to get us to the cleaner future we all want.

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Christopher Ragan is an economist and Director of the Max Bell School of Public Policy at McGill University. Rachel Samson is Vice President of Research at the Institute for Research on Public Policy

This op-ed was first published by The Hill Times on March 22, 2023