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Energy Based Carbon Emissions – Section 9

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

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9. Specific Findings: Industrial Energy Efficiency

  Energy efficiency refers to the relationship between the output (service) of a device or system and the energy put into it. This case study focused on Canadian manufacturing and mining industries,66 seeking energy efficiency opportunities in energy-using equipment, major industrial processes, supply technologies and delivery networks. Fuel switching was considered in conjunction with efficiency options. Economy-wide energy intensity (unit energy per unit GDP) is influenced by two factors: energy efficiency itself and other factors such as structural shifts in the economy toward new industries or value-added commodities with different energy intensities of production and interaction effects. Past reductions in the energy intensity of the economy can be attributed in part to shifts in the composition of the economy, such as the growth of the service sectors and the relocation of manufacturing facilities to other regions. The design of EFR measures may affect the structure of the economy by encouraging a move in production up the value-added chain, toward value-added products that have greater price elasticity and hence the ability to absorb new environmental costs. From an analytical perspective, it is important to note that the electricity sector was not included in the study. The argument against including it was that most electricity in Canada is still produced by publicly owned utilities, and these are not subject to the same fiscal instruments as private corporations. Some participants thought the sector should be included, since it holds many opportunities for energy efficiency improvements. They also pointed out that, in many Canadian jurisdictions,67 electricity (and, in particular, electricity at the margin) will increasingly be generated by independent producers, and their choice of feedstock will have significant environmental consequences. Excluding electricity generation from the purview of the fiscal instruments could also create unintended perversities - for example, it could motivate industries to install high-efficiency boilers rather than cogeneration units, which would be better from a system-wide greenhouse gas reduction perspective. support other policy priorities, such as reducing energy demand.  

• improved product quality, quality of life, capital and labour productivity from energy- and material-efficient process substitution;dynamic effects of learning, economies of scale and technological competition between the new and the traditional technology;net employment effects because of import substitution and first-mover effects; and
• regional redistribution of net employment from the more equitable distribution of jobs in a resource-efficient economy.The benefits of these other aspects may in fact surmount the energy savings and mitigation benefits.68 

 

9.1 STATUS OF INDUSTRIAL ENERGY EFFICIENCY

The industrial sector, which includes mining and manufacturing activities, is a significant GHG-producing sector in Canada. The sector produced 237 Mt CO2e of direct GHG emissions in 2000, the majority of which were energy-consumption based.69 Total energy consumed by industry in that same year was 3,187.2 petajoules (PJ).70 Energy intensity (based on GDP) in Canadian industry decreased by about 27 percent between 1990 and 2002.71 Trends in carbon intensity are similar (as measured by GHG emissions per unit of GDP). During the same period, the carbon intensity (also based on GDP) of Canadian industry also declined, levelling off at approximately 34 percent below 1990 levels in 2002.72 The decline in energy and carbon intensity is due to improved efficiency among energy users and to structural changes in industry (a change in product or industry mix). It is also affected by factors associated with GDP monetary units, such as costs of labour or selling price of the final product. Composite indicators computed for aggregate physical energy intensity in Canadian industry between 1990 and 1996 suggest a smaller decline in energy intensity relative to the measure based on GDP.73 The potential for energy efficiency improvements can still be significant, particularly for some industry sectors. For example, a 1996 study prepared for Natural Resources Canada found that the technical potential for energy conservation in six major energy-consuming industries ranged from 3 to 25 percent of projected energy consumption in 2010.74 However, three decades of research show that consumers and firms forgo apparently cost-effective investments in energy efficiency. One reason for this is that energy efficiency projects must compete for capital within a firm and may simply not meet internal required rates of return. Another reason may be that firms hesitate to adopt new technologies, which carry a greater potential for failure. Since these investments are irreversible and can be delayed, this uncertainty can create a significant drag on investment. This so-called energy efficiency gap is a critical issue in evaluating the economic cost and potential of EFR to influence the uptake of energy-efficient technologies.

9.2 STATUS OF INDUSTRIAL ENERGY EFFICIENCY TO 2030 ASSUMING BUSINESS AS USUAL

Overall, emissions in the industry sector (as defined in this case study) grow by 50 percent over the 2000-2030 simulation period, with direct emissions increasing and indirect emissions decreasing.75 Total emissions grow at an average annual rate of 1.53 percent, which is faster than the average annual rate of growth in energy consumption of 1.48 percent (Table 2). This growth occurs because the production in a number of carbon- and energy-intensive sub-sectors is expected to grow significantly. The share of electricity produced by cogeneration in the industrial sector increases over the simulation period, particularly in oil sands operations. The oil and gas sector generates the largest quantity of GHG emissions driven by strong growth in exports to the United States.

Findings INDUSTRIAL ENERGY EFFICIENCY A $15/tonne CO2e shadow price would lead to a reduction of 46 Mt CO2e by 2030, compared with the BAU scenario. A $30/tonne CO2e shadow price would lead to a reduction of 58 Mt CO2e by 2030, compared with the BAU scenario.

Table 2: Baseline Forecast of GHG Emissions and Energy Consumption for 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%

Table 3: 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

9.3 INDUSTRIAL ENERGY EFFICIENCY SCENARIOS TO 2030 WITH GOVERNMENT INTERVENTION

The CIMS model76 explores an achievable potential, rather than one that may be only technically feasible. Energy efficiency actions are adopted according to a technology competition that represents firm purchasing decisions based not only on minimization of annualized life-cycle costs, but also on performance preferences, cost heterogeneity, option value and failure risk. The case study used two alternative forecasts, Low Carbon I and Low Carbon II, which model a shadow price for carbon of $15/tonne CO2e and $30/tonne CO2e respectively, to influence a shift in investment patterns over a 25-year period (2005-2030). The price was also applied to the electricity sector so that a carbon price can be reflected in the electricity price seen by the industry sub-sectors. Table 3 summarizes the results of the Low Carbon I and Low Carbon II scenarios relative to the baseline business-as-usual scenario in Table 2. In Low Carbon I, GHG emissions are reduced by 46 Mt CO2e; in Low Carbon II, GHG emissions are reduced by 58 Mt CO2e. 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 percent in 2030, while direct emissions decline by only 5 to 7 percent). Actions behind this strong indirect response include the greater adoption of cogeneration systems and actions that improve the overall efficiency of auxiliary motor systems. The metal smelting and refining sector, petroleum refining, and iron and steel sub-sectors contribute the most emission reductions because of improved energy efficiency. Ex ante financial costs are - $17.64 billion for the Low Carbon I scenario and  - $24.87 billion for the Low Carbon II scenario (2000 dollars). In other words, the value of energy savings (discounted to 2004 at a rate of 20 percent) is greater than any associated increase in upfront capital costs for all industry sub-sectors; this is revealed as a negative cost. These estimates do not account for risk, option value, market heterogeneity and perceived quantitative or qualitative advantage of product preferences; therefore, they do not reflect the full compensation required for firms to make the technology switch (i.e., the energy efficiency gap). The total monetary incentive needed to overcome baseline technology preferences (e.g., through a subsidy) is $2.012 billion for Low Carbon I and $4.885 billion for Low Carbon II (2000 dollars). Notably, this incentive is for a program perfectly designed to target cost-effective actions; it does not include expenditures required to subsidize firms that have already undertaken the technology switch in the baseline scenario, a group that can often be in the order of 40 to 85 percent of program recipients in previous evaluations of energy efficiency programs. Further detail on the case study findings is provided in Appendix A.

9.4 MACROECONOMIC IMPACT: INDUSTRIAL ENERGY EFFICIENCY CASE STUDY

The macroeconomic impact of the proposed instruments in the industrial energy efficiency case study can be summarized as follows:

• Aggregate macroeconomic impact: Insignificant from a national perspective.
• Distributional and competitiveness impact: Possible distributional impact varies with the specific type of instrument employed. Subsidies would produce no price increases and could even lower output prices. Emissions pricing (through taxes or tradable permits) will increase costs for industry. However, these costs will in part be offset by savings from energy efficiency and fuel switching, including cogeneration. Many industries experience cost increases of less than 1 percent of the value of output. Under a shadow price of $15/tonne, price impact varies from reductions of 0.4 percent in the chemical products and pulp and paper sectors to an increase of more than 5 percent in the industrial minerals sector. There are fewer cases of cost decreases at $30/tonne, and costs (as a percentage of the value of output) increase more than 12 percent in the industrial minerals sector. When the price responsiveness of domestic and international markets is considered, only the industrial minerals and the iron and steel sectors experience changes in output prices high enough to reduce output.

These impacts assume no mitigation policies are implemented.

• Effects on technological change: The impact on long-term technological change is very uncertain and will depend in part upon the types of instruments employed and the detailed design of those instruments. However, there is also empiricalevidence that the energy price shocks of the 1970s clearly stimulated investment in R&D for more efficient equipment.

Further detail on the macroeconomic impact of the proposed instruments can be found in a background paper for the EFR and Energy Program.77

9.5 POLICY IMPLICATIONS: INDUSTRIAL ENERGY EFFICIENCY

The strategic significance of having carbon emission reductions as a priority objective is well illustrated in the energy efficiency case study, where three related policy objectives can each lead to very different actions being taken:

• An emphasis on industrial energy efficiency alone can, in some cases, result in increased carbon intensity. While improved energy efficiency in industry is closely connected to fuel switching and other means of carbon emission reduction, there are instances where increased energy efficiency can also increase carbon intensity. For instance, an efficient coal-fired boiler is more efficient than a wood-fired or certain natural gas-fired boilers. This emphasis would support other energy policy priorities, such as the need to narrow forecast gaps between energy demand and supply.A dual emphasis on carbon efficiency and energy efficiency, as explored in the case study, would encourage only those energy efficiency actions that also provide carbon reduction dividends.
• An emphasis on greenhouse gas mitigation alone would open the door to non-efficiency means to reduce emissions such as fuel switching, reducing fugitive emissions, reducing process emissions, and the capture and storage of carbon dioxide. These emission reductions are sometimes more cost-effective than those occurring through energy efficiency.

These findings illustrate the importance of pursuing a dual objective - an approach that will also support a broader set of public policy objectives, including narrowing the supply gap. The underlying conclusion from the case study is that the issue of energy efficiency in the industrial sector is essentially an issue of project finance. Industrial firms are assumed to be generally more likely than households to have already pursued cost-effective options to reduce energy consumption. Nonetheless, research over the past 30 years has consistently shown that firms and consumers forgo apparently cost-effective investments in energy efficiency. The results of the energy efficiency case study's economic analysis confirm this general knowledge, identifying energy savings78 greater than the associated capital cost investments for all of the industry sub-sectors analyzed. Why do firms not make these investments? One reason is that energy efficiency projects must compete for capital within a firm and may simply not meet internal required rates of return - or may not be as attractive as alternative investments, such as investments in productivity improvement. These situations offer a sound business opportunity for third-party engineering and/or finance firms. Another reason may be that firms hesitate to adopt new technologies, which carry a greater potential for failure. The market setting within which a firm operates exerts a powerful influence on its energy efficiency investment decisions. In markets with strong growth and competition, efficiency with respect to energy and other inputs is necessary to survive. In contrast, stagnating markets are poor theatres for innovation and investment, and instead rely on already depreciated equipment to maintain low production costs.79 Projects designed to promote energy efficiency compete against a variety of other projects for corporate investment. In highly energy-intensive industries, firms have a strong incentive to invest in more energy-efficient systems. In other sectors, however, the most promising investments may lie in the development of new products or in modernization and restructuring projects that do not yield accompanying gains in energy efficiency. For small and medium-sized enterprises (SMEs) with very limited investment capital, there are especially strong economic pressures to avoid projects with the long paybacks that are typical of energy-saving measures.80 Furthermore, SMEs often do not have the internal expertise to identify and follow up on energy efficiency opportunities. These findings underscore the role that energy prices and market forces play in stimulating energy efficiency actions, as well as the need for a price signal given that current prices appear too low to stimulate major efficiency improvements. The choice of appropriate fiscal instrument is between targeted measures that relate to one set of technologies or one particular sector, or a broad fiscal instrument that does not assign technological or sectoral preference. In either scenario, the ultimate impact is largely a function of the level at which the instrument is set (in the case study itself, the "shadow carbon price"). This level must at the very least overcome the hurdle of the energy efficiency gap. The case study concludes that policy intervention would be most appropriate at the two ends of the product pipeline: (1) the market uptake of existing (and eventually emerging) technologies and processes and (2) the research and development related to the development of new energy efficiency technologies, particularly those that offer significant energy efficiency benefits. There is an obviously close relationship between the two stages, inasmuch as they involve a cycle of investment, development and market uptake, which is dynamic and ongoing. In this scenario, promoting the market uptake of "on the shelf" technologies leads to reinvestment into new generations of energy efficiency technologies, and so to a virtuous cycle of investment leading to R&D and continuous improvement in energy efficiency performance. Improvements in energy efficiency performance follow an incrementally positive trend, as seen in the cumulative impact of the 1 percent per year energy efficiency improvements observed under the Canadian Industry Program for Energy Conservation. For the mature industrial energy efficiency technologies, policy intervention should encourage market uptake of existing technologies and processes. The choice of EFR tools to do this will be influenced by the nature of the industrial energy efficiency opportunities. Energy use in industry can be categorized into generic or auxiliary services (steam generation, lighting, HVAC [heating, ventilation, air conditioning], and electric motors) and processes unique to each specific sector and even each facility. Within this latter category of use, the energy efficiency opportunity is characterized by countless specific and differentiated technologies and processes, not only among different sectors but also among the operations within one sector. Fiscal tools for industrial energy efficiency have been dominated by capital cost allowance tax measures, an approach that, for tax administration purposes, is technology-prescriptive. It is therefore well suited for generic and auxiliary technologies with widespread application. These tools are less suited to sector- and facility-specific processes, where the energy efficiency opportunity is characterized by countless, differentiated technologies and processes among different sectors and among the operations within one sector. They are also less suited to the system-based or sector- and/or process-specific technology opportunities, which are radical in nature. An example is process substitution using membrane techniques or biotechnology instead of thermal processes, or improvements to the material efficiency of production. These categories of opportunity are better supported through broad-based fiscal measures that are performance-based (as opposed to technology-prescriptive), such as an emissions tax or market-oriented regulation (tradable permits). Under this approach, government sets a target backed by regulation - which can be emissions-based (for certainty of environmental outcome) or technology-based (for certainty of market outcome) - and allocates tradable permits81 (by auction and/or by gratis) to all subject parties. This approach allows individual flexibility in achieving the compulsory limit or requirement - the party can either meet the target or pay others to do so. In addition, experience with this approach indicates that it is more efficient than subsidies in preventing rebound effects and in providing a long-term signal for technological innovation. Program participants felt that tax measures alone are unable to address the diversity of industrial energy efficiency technological opportunities or system-based improvements; in addition, there was concern about the large public expenditure per unit of effect typically experienced in subsidy programs, because of the presence of firms that would have undertaken the desired change even in the absence of the subsidy. At a theoretical level, participants favoured the emissions tax, and it has been shown in other research to be economically attractive, particularly when competitiveness concerns are addressed through the creative recycling of revenues, sectoral exemptions and border tax adjustments.82 However, an emissions price applied to the industrial sector was considered by most to be politically unviable despite its very limited effect on output: the macroeconomic assessment of the impact of the case study's $30/tonne CO2e price signal (with no mitigation policies) concluded that only the industrial minerals and the iron and steel sectors would experience changes in output prices high enough to reduce output. For these reasons, participants considered market-oriented regulation (similar to the LFE domestic emissions trading system) to be the most environmentally effective, economically efficient and politically acceptable means of encouraging market uptake of energy-efficient technologies and processes in the manufacturing and mining industries. Not all energy efficiency technologies are mature technologies. Others are at the demonstration stage 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 research and development programs. Technological innovation may be incremental (small and gradual innovation in existing technologies) or radical (the development and introduction into the marketplace of new technologies or processes that dramatically improve energy efficiency performance). It is not always possible to predict which type will be more effective in reducing energy over longer periods. Radical innovation is where the step changes in energy efficiency are to be found. At the same time, much greater capital stock replacement is required for these radical, process-based innovations than for incremental innovations that may only involve some technological components. The need for greater capital stock replacement presents an additional hurdle to the adoption of radically innovative technologies, since the energy efficiency marketplace, especially in the industrial sector, is bound by the timetables of capital stock turnover. It is thus difficult to predict how such innovation will contribute to decarbonizing the energy system. The impact of not including future radical innovation may make the analysis conservative.

		Recommendation To support long-term carbon emission reductions through the adoption of industrial energy efficiency, the federal government should: a) Integrate a carbon efficiency focus in activities to promote energy efficiency, so that these activities do not perversely increase carbon emissions. b) Implement a broad-based price signal for carbon emission reductions. c) If (b) is not possible, augment targeted tax measures (best suited to generic and auxiliary technologies) with broader, market-oriented regulation (either emissions- or technology-based) to capture system-wide opportunities. d) Provide R&D support for the development of new energy efficiency technologies, particularly those that offer radical energy efficiency benefits (e.g., through new production processes). Support, in the form of targeted tax measures, should continue through to commercialization of the technology.