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Economic Instruments for Long-term Reductions in Energy-based Carbon Emissions – Appendix A

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Appendix A: Executive Summary: Case Study on Energy Efficiency

INTRODUCTION Ecological fiscal reform (EFR) is the systematic alignment of fiscal policy with other policy tools for the achievement of simultaneous economic and environmental objectives. This case study explores how fiscal policy can promote the energy efficiency of Canada's industrial sector in a way that leads to long-term reductions in energy-based carbon emissions. For the purposes of this case study, industry is defined as establishments engaged in manufacturing and mining activities. It does not include establishments involved in electrical generation, agriculture or providing services. Energy efficiency refers to the relationship between the output (service) of a device or a system and the energy put into it. Improved energy efficiency is doing more with equal or less energy input. Energy efficiency analysis can be applied to different aspects of the energy system, including energy-using equipment, major industrial processes, supply technologies, delivery networks, and even urban form and infrastructure. Energy intensity is a common indicator in energy analysis, given that energy efficiency cannot be measured directly at an aggregate level. Energy intensity is defined as unit energy per unit output, where output is measured in physical units (gross output) or monetary units (gross domestic product or GDP). There are various ways of reducing the carbon intensity of energy. Improving energy efficiency will result in lower carbon emissions if, as is often the case, the carbon intensity of energy (tonnes of carbon per gigajoule energy) does not increase significantly. In designing policies and assessing their impact and costs, it is useful to clearly distinguish between action and policy. An action is a change in equipment acquisition, equipment use rate, lifestyle or resource management practice that changes net greenhouse gas (GHG) emissions from what they otherwise would be. This study focuses on energy efficiency actions based on changes in technology acquisition, but it also considers these actions in relation to other actions to decarbonate. In describing carbon-based emissions for the industry sector, it is useful to use the concepts of direct and indirect emissions. Direct emissions are emissions that are produced by a source controlled by the sector, while indirect emissions are those resulting from that sector's activity but are produced by an external source. When considering the impact of actions, we consider the combined impact on both indirect and direct emissions, since considering only direct emissions would actually show an increase in emissions for an action such as cogeneration. 2 INDUSTRY SECTOR CHARACTERISTICS The industrial sector, which includes all mining and manufacturing activities, is the largest GHG-producing sector in Canada. In 2000, it produced direct GHG emissions of 237 Mt carbon dioxide equivalent (CO2e), the majority of which were energy consumption-based. Energy consumption reflects activity levels, industry structure and the energy efficiency of energy use, while GHG emissions also reflect the GHG intensity of energy use and process-related emissions. Energy is particularly critical in the production of basic industrial products, which are used to produce goods for final consumption, either within or outside Canada. These primary product industries account for more than 80% of total industrial energy consumption. They include industries such as iron and steel, pulp and paper, metal smelting, petroleum refining, chemical manufacturing and industrial minerals. The remaining industries, which are many and diverse (food processing, transportation equipment manufacturing, etc.), account for only 15% of industrial energy consumption but are responsible for 60% of industrial economic output. Energy intensity (based on GDP) in Canadian industry generally decreased after 1990 to a level 27% below 1990 levels in 2002. The decline in energy intensity is due both to improved efficiency among energy users as well as to structural change in industry. The term structural change in this context refers to a change in product or industry mix that determines total industrial production volume. Between 1995 and 2001, the activity share of less energy-intensive industries has increased while the share represented by more energy-intensive industries has decreased, leading to a decline in total energy use of 11.5% relative to 1995. Trends based on economic output cannot provide an accurate picture of energy intensity because monetary units are affected by many factors not associated with energy, such as costs of labour or selling price of the final product. Indicators computed for aggregate physical energy intensity suggest a smaller decline in energy intensity relative to the measure based on GDP. Managers in industry are considered more directly motivated to minimize costs than are residential and commercial consumers. Thus firms may have already pursued many cost-effective options to reduce energy consumption, particularly when energy costs make up a high percentage of total production costs. Some sectors are more physically limited in their ability to reduce energy use, particularly fossil fuel use. Nevertheless, the potential for energy efficiency improvements can still be significant, depending on the industry sector. 3 CURRENT POLICY Current policies relating to industrial energy efficiency have their roots in the 1970s. The oil price shock of 1973 made energy security a high-priority concern and led to, among other responses, the development of numerous energy efficiency programs internationally and within Canada (e.g., the Canadian Industry Program for Energy Conservation, or CIPEC, and the Industrial Energy Innovators Initiative). Since then, industrial energy efficiency has become closely associated with climate change policy initiatives. It has figured strongly in voluntary efforts by industry to curtail its GHG emissions as part of the Voluntary Challenge and Registry, which was initially launched by government to encourage private and public sector organizations to voluntarily limit their net GHG emissions. Just prior to ratifying the Kyoto Protocol in December 2002, the Government of Canada released the Climate Change Plan for Canada, which established an approach for addressing emissions from large industrial emitters. The federal budget of 2003 followed up on the Climate Change Plan with allocations to provide long-term support for research and development in emerging energy-efficient technologies ($250 million) and to subsidize industrial energy efficiency actions and carbon offsets ($303 million). Research and development in advanced end-use efficiency technologies is one of the five federal priority areas in science and technology. Outside federal policy and initiatives, provincial governments and Crown utility corporations have also been active in promoting energy efficiency in industry and in climate change policy in general. The fiscal system may provide a non-level playing field for competing energy investments due to different tax treatments of investments. A special capital cost allowance (CCA) class for "Energy Conservation and Renewable Energy" equipment (Class 43.1) qualifies certain investments for an annual 30% depreciation rate. This class specifically targets combined heat and power systems, high-efficiency gas generation and heat recovery equipment as energy efficiency investments relevant to the industrial sector. Canada does not employ any other tax incentives as part of the personal or corporate income tax system. Outside the tax system, a few programs operated by government and utilities provide incentives to promote energy efficiency by industry. Most programs are part of broader policies that include information provision. The Climate Change Plan for Canada seeks to develop a tradable permit system that will provide an incentive for decarbonization by large industrial emitters. The government is currently considering how its permit system could be designed to best develop this market. However, it is already operating a pilot "voluntary" emissions trading system, the Pilot Emission Removals, Reductions and Learnings Initiative. As noted above, the Climate Change Plan provides for direct funding for R&D in energy efficiency technologies. The Office of Energy Research and Development coordinates federal energy research and development activities and directs the Program of Energy Research and Development (which includes a strategy for energy efficiency in industry). The Canmet Energy Technology Centre and the Innovative Research Initiative for Greenhouse Gas Mitigation also fund research programs that include energy efficiency projects. Overall, Canada has favoured fiscal incentives over direct funding to support research and development, and it provides one of the most generous systems among all Organisation for Economic Co-operation and Development countries. 4 ENERGY EFFICIENCY OPPORTUNITIES Energy use in industry can be understood in terms of generic or auxiliary services and unique processes. Generic or auxiliary energy services are those that are not specific to a particular industry. They fall into four general categories: steam generation systems (boilers and cogenerators), lighting, HVAC (heating, ventilation and air conditioning) systems, and electric motor systems (pumps, fans, compressors or conveyors). Significant reductions can occur through energy efficiency improvements to steam generation systems and to electric motors and their attached auxiliary devices. The efficiency of steam generation varies greatly depending on boiler design, age and fuel used. Substantial energy efficiency improvements can also be achieved by using cogenerators rather than simple steam boilers. Although some potential exists to improve the efficiency of electric motors, there is greater potential to improve the efficiencies of equipment driven by them (pumping, air displacement, compression, conveyance and other types of machine drive). The remaining energy efficiency opportunities are quite specific to the unique processes of each particular industry. Some industries use large amounts of heat to accomplish their activities. For instance, materials production industries (such as iron, steel, other primary metals and building materials) are characterized by heavy use of direct process heat. Other industries are very dependent on electricity to drive large motors or to generate or purify chemicals or metals in electrolytic cells. Such energy-intensive industries typically have fewer options for energy (or CO2) reduction than industries that make use of many tens or hundreds of processes, each requiring only a small amount of energy, to transform semi-finished products into their final form. Many energy-efficient technologies are on the market today. Some have been available for some time but could still see greater uptake. Others are poised to emerge and are currently at demonstration stages or have been applied in a relatively narrow niche (e.g., direct reduction in iron and steel). Still others have not been technically realized and are the subject of active R&D programs (e.g., inert anodes/wetted cathodes in aluminum electrolysis). Technological innovation may be either radical (disruptive) or incremental. Radical technological innovation represents a transition to a new technology or a new paradigm, which often changes the way people think about the product or process. Incremental innovation occurs as small and gradual innovation in existing technologies. 5 CHALLENGES TO ADOPTION Research during the past 30 years has shown that consumers and firms forgo apparently cost-effective investments in energy efficiency. They appear to discount future savings of energy efficiency investments at rates well in excess of market rates for borrowing or saving. This phenomenon has often been referred to as the energy efficiency "gap" and is a critical issue for this case study in evaluating the economic cost and potential for fiscal policy to influence the uptake of energy-efficient technologies. While there is clearly potential for firms to make energy efficiency improvements, determining the extent of that potential is not easy. New technologies carry a greater potential for failure, and this uncertainty can create a significant investment hurdle for firms considering irreversible investments that can be delayed. Also, different consumers in different locations will face varying acquisition, installation and operating costs, and energy efficiency equipment will be more appropriate in some situations than others. Understanding the impact of energy efficiency improvements on aggregate energy consumption and on decarbonization is complicated by several factors. First, pursuing energy efficiency can result in decarbonization, but one must keep in mind that primary fuels differ substantially in their carbon emissions. There are also significant "second order" feedbacks that occur between the energy demand and supply sectors in the economy. For instance, the widespread adoption of high-efficiency electric motor and auxiliary systems would affect the demand for electricity, with potential price impacts that would affect energy-related decisions throughout the economy. In cases where energy-efficient technologies achieve substantial market penetration, the resulting lower cost of energy services elicits a rebound effect of increased energy service demand and thus greater energy consumption. 6 MODELLING METHODOLOGY A variety of energy economy models can be used to develop a baseline of GHG emissions in the industry sector and to estimate how changes in the energy efficiency, fuel type or emission controls of technologies would lead to different levels of GHG emissions. The CIMS model, developed by the Energy and Materials Research Group at Simon Fraser University, is used in this analysis. Unique technologies, processes and technological interactions in the Canadian industry sector are represented in detail. It is therefore possible to explicitly explore the relationship between the underlying process and technology structure of the sector and its aggregate energy use and GHG emissions. CIMS also portrays technology acquisition decisions based on financial cost and behavioural parameters estimated from empirical studies of consumer and business decision making. The model thus differs from those that use a single, ex ante (expected) estimate of financial cost as the basis for technology selection and thus do not address the complexities of decision making evidenced by the energy efficiency gap. The CIMS model is also able to incorporate energy price feedbacks between energy demand and supply sectors, as well as energy service demand feedbacks. 6.1 Model Overview A CIMS simulation involves six basic steps. 1 Assessment of demand: Technologies are represented in the model in terms of the quantity of service and/or product they provide (e.g., tonnes of paper produced). A forecast of service growth drives the model simulation in five-year increments. 2 Retirement: In each future period, a portion of the initial year's technology stock is retired based on age. The residual technology stocks in each period are subtracted from the forecast energy service demand. 3 New technology competition/retrofit competition: Prospective technologies compete for the new investment required to meet service demand based on the minimization of annualized life-cycle costs, which include identified differences in non-financial technology preferences and failure risks. The model allocates market shares among technologies probabilistically to reflect varying acquisition, installation and operating costs and equipment. In each time period, a similar competition occurs prior to new stock purchases to simulate retrofitting of residual stock. 4 Equilibrium of energy supply and demand: In each future time period, a cycle occurs between technology choice in the energy demand models and technology choice and energy prices in the supply models, until prices and demand have stabilized at an equilibrium. 5 Equilibrium of energy service demand: Once the energy supply and demand cycle has stablized, this step adjusts demand for energy services based on price elasticities. If this adjustment is significant, the whole system is rerun from step 1 with the new demands. 6 Output: Total energy, emission and cost information can be derived from the final model results since each technology has net energy use, net energy emissions and costs associated with it. The CIMS model is used to construct the baseline scenario and to develop two alternative scenarios that estimate how changes in the energy efficiency, fuel type or emission controls of technologies can lead to different levels of GHG emissions in the industry sector. 7 BASELINE SCENARIO The baseline scenario is developed using the CIMS model according to simulation steps 1, 2, 3 and 6 described in the preceding section (steps 4 and 5 are not used in the case study). The baseline forecast period runs from 2000 (CIMS base year) to 2030. For this study, assumptions regarding economic growth (more specifically, region-specific growth rates for GDP for 2000 to 2020) and future energy prices are adopted from Canada's Emissions Outlook: An Update (CEOU).1 For the simulation past 2020, annual price and growth trends of the 2015-2020 period are assumed to continue to 2030. The emission forecast generated by CIMS is calibrated to the official GHG forecast (as of December 2003), which was formulated since the release of the CEOU. A summary of the baseline scenario for the industry sector in Canada is presented in Table 1. Overall, emissions in the industry sector (as defined for this case study) grow by 50% over the 30-year simulation period, with direct emissions increasing and indirect emissions decreasing. The share of electricity produced by cogeneration in the sector increases over the simulation period, particularly in oil sands operations. The oil and gas sector generates the largest increase in GHG emissions, which is driven by a strong growth in oil and gas exports to the United States. Table 1: Baseline Forecast of GHG Emissions and Energy Consumption, Canada

	2000	2010	2020	2030	Average Annual Growth
GHG emissions (Mt C02e)	288	343	396	453	1.53%
Direct	237	307	358	407	1.82%
Indirect	50	36	38	46	-0.30%
Energy (PJ)	4,239	5,030	5,783	6,579	1.48%

8 ALTERNATIVE SCENARIOS Two alternative forecasts are produced by simulating two different shadow prices over a 25-year simulation period (2005-2030). We model one price of $15/tonne CO2e and one of $30/tonne CO2e to influence a shift in investment patterns. In addition to applying this shadow price to the industry sector sub-models, we also apply the price to the electricity sector so that a carbon price can be reflected in the electricity price seen by the industry subsectors. Emerging technologies have a greater ability to gain market acceptance in a 25-year time frame. In order to capture the long-term promotion of these technologies through R&D and commercialization support, we adjust the "intangible costs" of a selection of emerging technologies in the model to reflect a more targeted R&D and commercialization effort. Simulating a carbon emission shadow price in the industrial sector sub-models indicates the emission reduction potential from energy efficiency actions. This type of simulation reveals the potential for emission reductions that could occur from energy efficiency actions up to a specified marginal abatement cost for carbon. This methodology is built on the principle that the goal (decarbonization) would drive the formulation of an alternative GHG scenario (as simulated by a shadow price for GHG), which would indicate what role energy efficiency investments could play in decarbonization compared with other options. The choice of carbon prices reflects a relatively modest "achievable potential' that could be influenced by fiscal policy. The Low Carbon I and II scenarios result in GHG reductions of 46 Mt CO2e and 58 Mt CO2e by 2030 (see Table 2). Direct emissions make up most of these emission reductions, though the response of indirect emissions to the imposition of a shadow price is stronger than the response of direct emissions (indirect emissions decline by 53% to 62% in 2030, while direct emissions decline by 5% to 7%). Actions behind this strong indirect response include the greater adoption of cogeneration systems and improvements to the overall efficiency of auxiliary motor systems. The metal smelting and refining sector and the petroleum refining and iron and steel subsectors realize the most emission reductions from improved energy efficiency. Where energy-efficient technologies achieve substantial market penetration, the resulting lower cost of energy services produces a rebound effect, driving up energy service demand and increasing energy consumption. The alternative scenarios do not incorporate this effect. Table 2: GHG Emissions and Energy for Alternative Scenarios, Canada

	2000	2010	2020	2030
Total GHG emissions (Mt C02e)
BAU	288	343	396	453
Low Carbon I	288	322	365	407
Low Carbon II	288	316	355	395
Direct GHG emissions (Mt C02e)
BAU	237	307	358	407
Low Carbon I	237	292	339	386
Low Carbon II	237	293	335	378
Indirect GHG emissions (Mt C02e)
BAU	50	36	38	46
Low Carbon I	50	29	26	22
Low Carbon II	50	23	20	17
Energy (PJ)
BAU	4,239	5,030	5,783	6,579
Low Carbon I	4,239	4,822	5,537	6,298
Low Carbon II	4,239	4,818	5,497	6,232

9 ECONOMIC AND POLICY ANALYSIS The alternative scenario simulations reveal that reductions of up to 58 Mt CO2e could be achieved by 2030 in part by actions leading to greater energy efficiency by industry. We calculate ex ante (expected) financial costs of the scenarios (shown in Table 3), which represent the difference in the net present value of capital, energy and operating and maintenance costs in 2004 (2000 $), discounted at a social discount rate for the period 2005-2030, between the baseline and each alternative scenario. All subsectors show negative costs because the value of energy savings is greater than any increase in upfront capital costs from adopting these measures. Welfare costs may be, and usually are, much higher and are embodied in the technology choices of firms and households. Because the CIMS simulation did not incorporate final demand feedbacks (step 5 of the CIMS simulation), the results provide only a partial equilibrium portrayal of the response to the shadow price of CO2e. Pursuing long-term carbon emission reductions by targeting industrial energy efficiency may be accompanied by benefits that go beyond reducing GHG emissions and the ecological harm associated with global warming. First, declining energy intensity will reduce the energy costs per unit of service output, and economic growth will be less constrained by future energy costs. Second, the innovation of more efficient technologies will be encouraged, which may serve as an opportunity to increase exports. Third, negative health effects associated with poor air quality may be reduced. Table 3: Ex Ante Financial Costs for 2005-2030 ($ billion)

	Low Carbon I	Low Carbon II
Chemical products	-4.98	-4.04
Coal mining	-0.99	-2.19
Industrial minerals	-1.16	-2.08
Iron and steel	-1.84	-1.93
Metal smelting and refining	-1.42	-1.76
Mining	-0.26	-0.59
Other manufacturing	-1.92	-2.75
Petroleum crude extraction	-0.04	-0.03
Petroleum refining	-0.19	-0.38
Pulp and paper	-3.39	-4.80
Natural gas industry	-1.45	-4.32
Total	-17.64	-24.87

  Ecological fiscal reform as defined in this study (see Introduction) is a broad approach, which can employ suites of instruments in a reinforcing package to support the shift to sustainable development. As described in the NRTEE's report Toward a Canadian Agenda for Ecological Fiscal Reform: First Steps, the common purpose of these instruments is to provide incentives for producers and consumers to alter their decisions and behaviour. These instruments either internalize environmental costs or reward more sustainable practices. We relate three key policy tools to the modelling analysis: the application of environmental taxes, tradable permits (as part of market-oriented regulation) and subsidies. 9.1 Environmental Taxes and Tax Shifting The modelling results directly suggest the application of a GHG tax - a charge paid on each fossil fuel, proportional to the quantity of GHG emissions emitted when it is burned.2 However, because the carbon price was applied to all GHG emissions represented in the industry subsectors (including process and fugitive emissions), non-fuel combustion emissions were also subjected to the carbon price. The Low Carbon I scenario describes a tax of $15/tonne CO2e, and the Low Carbon II scenario represents a tax of $30/tonne CO2e. A GHG tax applied across the industry sector causes each subsector to increase or decrease its emission reduction efforts until each is facing the identical incremental cost for the next unit of reduction. Revenues from environmental taxes can be used for different purposes: they may be part of general revenues, earmarked for specific environmental projects, redistributed as rebates or used to reduce other taxes. Each option has different costs for different members and sectors of the economy. In practice, environmental tax designs have used varying degrees of refunds, differentials in the tax rates applied to industry and households, and exemptions to address equity and competitiveness concerns. 9.2 Tradable Permits (Market-oriented Regulation) An important area of policy innovation has been the development of market-oriented regulation, which like a GHG tax allows individual flexibility in achieving a compulsory limit or requirement. Unlike traditional command-and-control regulation, the manner of participation is at the discretion of the firm or household (whether to reduce emissions or acquire the designated technology, or pay others to do so). The modelling results suggest an emissions cap and tradable permit system applied to all industry sectors through auctioned permits, with a cap equivalent to the emission levels reported in the alternative scenarios: 407 Mt CO2e in 2030 in Low Carbon I, and 395 Mt CO2e in Low Carbon II (Table 2). The tradable permit prices correspond with the shadow prices applied in those simulations ($15/tonne CO2e and $30/tonne CO2e respectively). Market-oriented regulation can also be applied in different contexts by, for instance, specifying the desirable market outcome rather than the environmental outcome. Considerable design options also exist with emissions cap and tradable permit systems. 9.3 Subsidies EFR can support decarbonization through the removal or redirection of existing subsidies and through the provision of new subsidies. Financial support in the form of direct grants, guaranteed or low-interest rate loans, and tax incentives can be used to directly support the greater adoption of energy-efficient technologies and long-term research and development in new energy-efficient technologies. The alternative scenarios suggest the impact of a subsidy program that is perfectly designed to target cost-effective actions. The size of the incentive required to target the actions inherent in the model simulation is estimated by calculating the perceived private costs of the alternative scenarios (shown in Table 4). The estimates are made by calculating the area under a curve that plots cumulative emission reductions against rising CO2e shadow prices. The area under the resulting marginal cost curve, up to the shadow price of the alternative scenario, represents the compensation required to have firms undertake actions that they would not have undertaken otherwise (their perceived private cost). Table 4: Costs of Incentive (Perceived Private Cost) for 2005-2030 ($ billion)

	Low Carbon I	Low Carbon II
Chemical products	0.528	1.284
Coal mining	0.026	0.104
Industrial minerals	0.047	0.194
Ironand steel	0.070	0.158
Metal smelting and refining	0.124	0.309
Mining	0.015	0.036
Other manufacturing	0.189	0.436
Petroleum crude extraction	0.101	0.093
Petroleum refining	0.003	0.026
Pulp and paper	0.203	0.608
Natural gas industry	0.707	1.636
Total	2.012	4.885

These estimates do not include expenditures required to subsidize firms that would have purchased energy-efficient technologies in the baseline scenario ("free riders"). If this effect is incorporated, the subsidy cost of the program is greater. Evaluations of energy efficiency incentive programs suggest that the proportion of free riders can be significant, often in the order of 85% of program recipients. Subsidy programs can therefore require relatively large public expenditures per unit of effect. The administrative costs of program delivery and the transaction costs of firm participation, which depend significantly on the design of the specific measure, have not been considered. Potential avenues for new subsidies include direct financial transfers (as grants or preferential- or low-interest loans) and tax incentives (e.g., the expansion of CCA 43.1 to include more energy efficiency technologies). The use of revolving loan programs has gained popularity in the commercial and institutional sector in Canada and could be applied in an industry context. The amount spent on a subsidy will have different effects depending on program design. Financial incentives can be directed to reduce the upfront or the operating costs of energy-efficient investments, and they can be based on prescriptive or custom (performance-based) criteria. Subsidies directed at upfront capital costs recognize that the higher capital cost of energy-efficient technologies can deter investment. Measures that target upfront costs are not based on the actual performance of the investment in meeting the desired policy objective. Performance-based subsidies can be more flexible in allowing firms to meet "demonstrated" improvements in energy efficiency or carbon emission reduction. Another factor to consider in designing subsidies is differences in how firms respond to incentive tools. Small and medium-sized enterprises, which may not have the capital required to make use of tax incentives, may find more value in loans, loan guarantees and interest rate subsidies, as well as the support provided by private sector incentive mechanisms such as energy performance contracts, leases and venture capital. 10 POLICY DESIGN CONSIDERATIONS The choice of fiscal policy tools and the ultimate design of a policy package involve many considerations. For instance, the policy package that realizes environmental benefits in the most cost-effective way may be difficult to administer or politically unfeasible. We offer a general assessment of how the fiscal policy tools discussed above stack up against common policy design criteria. 10.1 Effectiveness in Reaching Environmental Targets An emissions cap and tradable permit is the most effective policy tool for realizing the environmental objective, because it specifies the emission reduction. A subsidy, on the other hand, may fail to achieve sufficient reductions if it is too low or not directed properly. In both cases, poor design can weaken the intended policy impacts. Broad-based economic instruments (taxes and permit systems) are more efficient than subsidies in preventing the rebound effect, encouraging a long-term carbon emission reduction in the energy system. 10.2 Economic Effectiveness A uniform carbon tax or an emissions cap and tradable permit system is theoretically the most efficient way to achieve a decarbonization objective, because the least expensive reductions throughout the economy are undertaken first. A subsidy may go to firms with higher reduction costs (unless it is allocated via a bidding process), and it can require large public expenditures per unit of effect due to free riders. Also, a subsidy requires that revenue be raised somewhere else in the economy, which can also produce "dead weight" losses. 10.3 Administrative Feasibility Fiscal policy design should consider the burden on firms in either complying with a tax or market-oriented regulation, or in applying for grants and submitting tax credit claims. This burden may be particularly onerous for smaller firms. Data must be available to ensure proper program monitoring and evaluation, which should focus on impacts (i.e., carbon emission reductions) rather than processes and outputs (e.g., number of applications, program recipients). 10.4 Political Acceptability Concern about political acceptability has limited the use of policy tools such as GHG taxes to achieve decarbonization, even in countries where they are currently applied. The use of subsidies avoids imposing costs on firms by instead enhancing the ability of energy-efficient technologies to compete. However, the government must acquire the funds from somewhere else in the economy, which has led to criticism. Tax incentives are a less visible form of public subsidy. Industry groups have generally lobbied for voluntary and tax incentive approaches in climate change policy, arguing that new measures must be situated within an overall framework that is consistent with the broad fiscal and economic direction of the country. 10.5 Distributional and Competitiveness Impacts With a GHG tax or emissions cap and tradable permit, the manner of participation is at the discretion of the firm. Competitiveness impacts will arise if the policy imposes different levels of costs on competing firms; this may occur if policies and regulations differ at the country or sub-national levels or if firms have different specific carbon intensities, substitution possibilities and trade levels. Policy design is critical in minimizing distributional and competitiveness impacts. For instance, sector-specific market-oriented regulation can minimize average price increases, because only a small percentage of the market is devoted to the newer, higher-cost technologies and manufacturers will average these costs with their lower-cost, conventional technologies in determining prices. 10.6 Technological Innovation The level of technological innovation of environmentally related technologies will be below the theoretical socially optimal level in the presence of externalities such as environmental damage. This reality provides an argument for the use of environmental taxes and market-based instruments that internalize this externality and provide a "pull" to innovation and deployment. Other policies that support innovation directly by lowering the costs of R&D (e.g., by subsidizing R&D expenditures or encouraging joint ventures) may be most valuable at the earliest stage of deployment. However, subsidies run the risk of supporting private R&D that would have taken place anyway and supporting inappropriate technologies. 11 CONCLUSIONS The potential for industrial energy efficiency actions to contribute to the decarbonization of the energy system is complex: it depends on the degree to which technical potential can be further developed through innovation; the degree to which energy efficiency technology and habits can be adopted; the degree to which this adoption translates into reduced aggregate energy use; and the carbon intensity of conserved energy. The adoption of energy efficiency as a way to lower energy-based carbon emissions in industry is further complicated by the fact that energy efficiency is only one among a number of options that industry can use to reduce carbon-based emissions. In developing policy recommendations in this case study, it was important to evaluate the specific focus on promoting industrial energy efficiency in the context of a broader focus on the objective of decarbonization. The alternative scenario simulations demonstrate that improved energy efficiency in industry is closely interrelated with fuel switching and other means of reducing carbon emissions, suggesting that energy efficiency should be considered among other actions in moving toward a decarbonized energy system. However, focusing on energy efficiency alone as the means of achieving decarbonization in industry may run the risk of orienting incentives and efforts in a direction that is not cost-effective. Our evaluation of specific policy tools indicates that no one policy tool is optimal in its performance against the criteria of environmental effectiveness, economic efficiency, administrative feasibility and political acceptability. Rather, it suggests that a portfolio of policy instruments can enable a government to combine the strengths, while compensating for the weaknesses, of individual policy instruments. Such a policy package should focus on measures that would be politically acceptable today while nonetheless influencing technological innovation. Considerable potential exists to use ecological fiscal reform to create conditions under which "winners" can emerge and attract sufficient investment in order to develop and be widely adopted. With this in mind, we recommend an emphasis on tradable permits (as part of market-oriented regulation) to drive fundamental change, with a complementary role for subsidies in supporting energy-efficient technologies. Subsidies, and tax incentives in particular, score well on public acceptability and may be effective if designed carefully and with an understanding of relative costs in different sectors and activities in the economy. Nevertheless, the impact and cost (including free-rider costs) should be realistically assessed in the design of any program. Tax incentives and direct grants should also be designed to minimize government's role in picking technologies (by being more performance-based) and to minimize the transaction costs of program participation. There is a history of policy support for promoting energy efficiency through information and awareness programs and through subsidies for research and development. Voluntary programs have laid the groundwork for EFR policies in stimulating awareness of ecarbonization opportunities; they will also provide needed complements to any new fiscal policy initiatives that are developed. There may be a role, too, for EFR to connect with traditional command-and-control policy. While fiscal policy can drive technological gains, standards that phase out the sale of inefficient equipment can serve to consolidate change. 12 LESSONS LEARNED While energy efficiency can be considered a path toward long-term carbon emission reductions of the energy system that can be targeted immediately through the greater diffusion of technologies already in the market, it is also important to consider how energy-efficient technologies can fit into the long-term picture through continued innovation and commercialization. Energy efficiency is not necessarily the most cost-effective option available for reducing carbon emissions in the industry sector. Other means include fuel switching, reducing fugitive emissions, reducing process emissions, and the capture and storage of CO2. While a significant share of the emission reductions occurs through increased energy efficiency in the modelling results, considerable reductions also occur through other means. Focusing on energy efficiency alone as the means of achieving decarbonization in industry may run the risk of orienting incentives and efforts in a direction that is not cost-effective. Promoting greater energy efficiency is not a new policy objective, but it has been actively pursued in many countries over the past 30 years. Considerable experience can be gained from understanding the successes and failures of these efforts. For example, research shows a gap between the level of investment in energy efficiency that appears cost-effective and the lower level of investment that is actually occurring. This "efficiency gap" is a critical issue for this case study, particularly in estimating an alternative carbon emission scenario, as well as evaluating the economic cost and potential of fiscal policy to influence the uptake of energy-efficient technologies. This is an emerging analytical area that has only recently been incorporated into technology simulation modelling. Technical energy efficiency gains do not translate directly into reduced carbon emissions. The potential for industrial energy efficiency actions to contribute to long-term carbon emission reductions in the energy system is complex and is based on the following four factors. 1 The degree to which technical potential can be further developed: Our energy system is far from its maximum technical potential for second law efficiency, but how and when will technologies and systems be developed? 2 The degree to which this potential can be adopted: Mature energy-efficient technologies that appear cost-effective are available but have not transformed the market. To what degree will energy-efficient technologies, systems and practices be adopted? 3 The degree to which this adoption translates into reduced aggregate energy use: Lower-cost energy services from energy efficiency investments elicit a rebound effect of increased energy service demand and thus greater energy consumption. 4 The carbon intensity of conserved energy: Reductions in carbon emissions will depend on the carbon intensity of energy. For instance, the impact of improved electrical end-use efficiency will be considerably different depending on whether that electricity was generated by hydropower or thermal generation. The modelling work in the case study sought to analyze the complex relationships noted in the preceding point. Models are inevitably wrong in that they cannot possibly incorporate all information and relationships of potential importance, nor accurately depict all uncertainties.3 Still, one can look to the modelling results to suggest the ability to harness the energy efficiency potential of current and emerging technologies, the role energy efficiency can play among other options to decarbonize industry, and the relative long-term carbon emission reduction potentials of various subsectors. Modelling the long-term potential for policy to increase energy efficiency adoption suggests a dynamic analysis that could consider how technological innovation and perhaps even consumer and firm preferences may be influenced by policy. This analysis was beyond the capability of the case study, but it is an emerging research direction that should be noted. The results of the alternative scenarios reflect the magnitude of the carbon price that was modelled; that is, a $250 price for carbon would have revealed a different reduction potential. While higher carbon prices have greater long-term carbon emission reduction potential, they tend to show diminishing returns (less additional emission reduction for each additional dollar per tonne of carbon). The long-run potential for energy efficiency to contribute to a decarbonized energy system will be constrained by what it will cost to produce a clean energy supply. Energy price represents an upper-bound constraint on the contribution of energy efficiency.