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Energy Based Carbon Emissions – Executive Summary – Section 5

Executive Summary - Economic Instruments for Long-term Reduction in Energy-based Carbon Emissions: State of the Debate

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5. Using Economic Instruments for Long-Term Carbon Emission Reductions and Technology Development

Economic instruments (including charges, tradable permits, tax measures and government expenditure) are a favoured policy tool for driving emission reductions because of the broad-based and diversified nature of greenhouse gas emission sources.5 There is also an important place for other tools such as regulations, disclosure requirements and educational programs, but these were outside the boundaries of this program. The efficiency and effectiveness of economic instruments should always be tested against regulatory and stringent voluntary alternatives. Many experts believe that regulatory approaches are more efficient and effective for low-intensity, non-industrial sectors; these approaches include building construction codes, appliance standards and auto efficiency standards. Economic instruments often also need to be complemented by other policy measures to be effective. For instance, access to transmission grids is essential for renewable energy deployment. Regardless of the economic instrument, a few general principles apply to their design:

• The costs of fiscal policies are generally lower when they are expected, gradual, continuous and well designed.
• All things being equal, broad instruments that provide more flexibility with respect to the form of response are generally less costly than more-targeted or prescriptive instruments for achieving the same reductions.
• Instruments that encourage firms and households to invest in more-efficient equipment and processes when they are replacing existing equipment or considering new equipment purchases are less costly than instruments that require them to accelerate capital replacement.
• Instruments that avoid transferring wealth between parties and/or regions are more likely to receive public support. (A carbon charge, for example, would need to be accompanied by targeted revenue recycling or transition measures to avoid transferring wealth from fossil fuel-intensive regions to those with hydroelectric resources.)

In developing packages of instruments, it is important to consider the interactions among policies and the resulting impacts of these interactions on desired outcomes. Another key consideration in designing policy packages is staging - both to reduce costs by enabling adaptations to follow the natural rate of turnover in long-lived capital stocks and to tailor the fiscal instrument to the development stage of the technology.

5.1 APPLICATION OF BROAD MEASURES

Participants in the EFR and Energy Program acknowledged that, in theory, broad-based price signals (e.g., emission charges such as taxes and tradable permits) supplemented by targeted relief offer the best combination of effectiveness and efficiency in reducing long-term carbon emissions and are a necessary element in a long-term carbon emission reduction strategy. These instruments increase the relative cost of emission-intensive technologies and products, creating a continuous incentive for innovation to improve emission efficiency or to shift to lower-emission substitutes. The precise response to a price signal cannot be predicted; hence, price signals do not ensure the achievement of a specific emission reduction target. However, the level of the price signal can be increased or decreased over time, depending on the impact it is having. Broad-based measures will stimulate the most immediate response from mature technologies, but when applied in a predictable and continuous fashion, they will also stimulate the gradual uptake of emerging technologies and investment in the development of new ones. These measures were considered to offer a better approach than the alternative array of complex and possibly arbitrary individual regulations and standards. During discussion of broad-based measures, participants noted that fluctuating market prices for energy will likely overwhelm most signals sent by policy and be a stronger influence on the choice of fuel and technologies - an example is the hikes in the price of oil in 2004. However, since the fuel switching provoked by fluctuating prices could result in the use of more carbon-intensive fuels (such as coal or heavy fuel oil), such a market price signal should not be considered a substitute for policy action in achieving long-term carbon emission reductions. The primary appeal of broad-based measures is that they are technology-neutral, leaving the choice of response to the subject parties. Because these instruments are by nature performance-based, they avoid the risks inherent in "picking winners" and instead enable winners to emerge through continuous improvement and innovation. This will occur because it will always be in a party's interest to lower the marginal cost of abatement. However, broad-based price signals have received virtually no thoughtful discussion, let alone application in Canada. Among the reasons:

• Broad-based price signals affect energy-intensive sectors or regions more than others and, depending on their design, tend to have disproportionate effects on low-income households. This makes them unpopular in the Canadian political context.
• International competitiveness concerns mitigate against the imposition of a price signal, particularly in commodity-based sectors where the market price is set internationally (such as oil) and that are not able to pass on this cost. Although revenue recycling can in theory address competitiveness impacts, there is little practical experience with this, except in the case of the U.K.'s Climate Change Levy program. While competitiveness has been a dominant concern shaping public policy in Canada, some findings from the industrial energy efficiency case study suggest that the concern is overplayed. Modelling carried out as part of the study examined the effects of a price signal of $30/tonne of carbon dioxide equivalent (CO2e) with no mitigation policies. The results showed that only the industrial minerals and the iron and steel sectors experienced changes in output prices high enough to reduce output.
• Revenue-generating price signals, such as taxes or auctioned permits, run counter to the prevailing political movement to lower taxes. There is widespread public distrust regarding how governments will use new revenue and, in particular, whether they will fairly redistribute it. Tax shifting can be used to ensure that the net level of taxation remains the same, but there has been little discussion of this approach in Canadian climate change policy.

On the other hand, incentive instruments, such as subsidies, are also likely to face significant resistance unless they have a funding base. Revenue-generating price signals can provide that base. For this reason, a low charge on energy or carbon, paired with incentive programs in a tax-shifting model, warrants serious discussion and attention. Given these dynamics, is there any room for the future use of broad-based measures in Canada - Participants in the EFR and Energy Program did identify one possible application. The U.K. Climate Change Levy (and companion Climate Change Agreements) elicited interest due to its simplicity and targeted revenue recycling. This levy is a tax on the use of energy in industry, commerce and the public sector. The revenue raised is recycled to business through three streams: (1) offsetting cuts of 0.3 percent in employers' National Insurance contributions; (2) additional support for energy efficiency (technical support plus a 100 percent first-year capital allowance for certain energy-saving investments, which is expected to be worth up to £70 million a year); and (3) programs to stimulate the uptake of renewable sources of energy (£50 million a year). The objective has been no net gain for the public finances and no increase in the tax burden on industry as a whole (although it may not be cost-neutral at the individual firm level). Under the companion Climate Change Agreements, energy-intensive industries receive a rebate of up to 80 percent of the Levy if they agree to a program of energy savings, negotiated sector by sector.6

		Recommendation 1   The option of a broad-based price signal should be given serious consideration. The case study experience shows that this type of instrument (such as a charge or a permit market) is the most effective in delivering on the policy objective to which it is explicitly tied (in this case carbon emissions) and the most cost-efficient to society in that it allows for the greatest degree of flexibility in societal response. A key feature of such instruments is that they are also effective in ensuring that some of the government's other policy objectives - notably in the area of innovation and technology development -are promoted. At the same time, the consultation conducted during the Program revealed serious concerns about the competitiveness impacts of such a price signal. Another concern centred on the design and implementation challenges posed by a broad instrument of this sort and on the very high standard for "getting it right." Finally, there was acknowledgement of the lukewarm political interest in such instruments. An existing model for Canadian policy-makers, if they are to consider a broad-based signal, is the U.K.'s Climate Change Levy and companion Climate Change Agreements.7

5.2 APPLICATION OF TARGETED MEASURES

While opinions differ over the viability of broad-based measures for long-term carbon emission reductions, there is no doubt as to their effectiveness. The charge for policy-makers using other approaches, therefore, is how to capture the performance-based benefits of broad-based measures. Targeted economic measures focus on a technology or a class of technologies. They do so in two ways:

• Through subsidies (expenditure instruments such as tax incentives and credits, loan programs and grants) that reduce the relative cost of technologies and products with lower emission intensities, making them as or more attractive than incumbent technologies. Subsidies may target current decisions by reducing upfront capital costs, or they may target long-term cost competitiveness through funding for research, development and commercialization of new technologies.
• Through so-called market-based regulation, such as renewable portfolio standards or the planned large final emitters' domestic emissions trading system.8 Market-based regulation requires designated firms to meet certain targets but allows them to trade with other parties in meeting this commitment.

Market-based regulation imposes the costs of emission reductions on consumers and shareholders. Subsidies transfer this cost to taxpayers, a less economically efficient approach but one that may be politically more feasible. Subsidies can also play an important role in complementing other economic instruments, when used to alleviate transition-stage distributional impacts. Subsidies have three main weaknesses: High cost per unit of effect. Subsidies tend to require relatively large public expenditures per unit of effect, due to the presence of firms and individuals that would have undertaken the desired change even without the subsidy. This number can be large (as high as 40 to 85 percent in evaluations of energy efficiency programs) but is often underestimated. The total cost of subsidies also often exceeds the direct costs to government, since governments must raise funds from other taxes, and these have dampening effects on economic activity. Uncertain results. The precise response to subsidies, like the response to emissions charges, cannot be accurately predicted. Hence, neither of these instruments is able to assure a specific emission reduction target. Tendency to be technology-prescriptive. Subsidies targeting current decisions, such as accelerated capital cost allowances or consumer rebates, usually aim to reduce the upfront capital costs of investments in specific technologies. This raises three issues: (1) there is a greater risk that subsidies support more costly options for achieving the desired environmental outcomes; (2) the administrative need to designate specific technologies dampens innovation and new market entrants; and (3) the reduction of upfront capital costs favours technology-specific responses rather than systems innovation and substitution. Market-based regulation in the form of a tradable permit market avoids all of these weaknesses. Overall costs are minimized through the use of trading. The target is specified by the regulation, and depending on the design, the regulation can be performance-based and technology-neutral. The possible limitation in applying market-based regulation in Canada is the need for the market covered by the regulation to have adequate supply and demand to ensure liquidity. In addition, these instruments require the same complexity of infrastructure (program design, reporting, monitoring and enforcement) as any other regulation.

		Recommendation 2As an alternative to broad-based price signals - and consistent with current policy approaches - economic instruments targeted to specific types of technology should be used, but they would need to be broadened. They could also be designed to link directly to the policy objective being pursued (in this case carbon emission reductions). This linkage would allow the targeted measures to share the key characteristics of broad-based instruments, notably their promotion of innovation. An example of such an instrument is the U.K.'s Enhanced Capital Allowance for vehicles with low carbon emissions.9

 

Unique Risks Promoting the development and adoption of new technologies may require greater incentives than suggested by economic models. There are many reasons: existing capital stock may not be ready for replacement, capital markets demand high premiums for taking risks in early commercial applications, and new technologies are not always perfect substitutes for the incumbent technology. In very limited cases, there may be unique risks that merit an extra level of public investment, because of the public good arising from successful adoption of a high-risk technology. One approach, adopted in other countries, is the use of loan guarantees. Other fiscal examples are targeted tax credits, direct subsidies, repayable and contingently repayable contributions, and grants to university technology incubation centres.

5.3 TRANSITION MEASURES

The EFR and Energy Program case studies did not examine transition issues. However, EFR literature highlights transition measures as a key aspect in achieving acceptance, particularly of new charges. Among the transition mechanisms identified are use of pilot projects, predictability and continuity, modest pace of implementation and targeted subsidies or credits to support transition costs. Further discussion of economic instruments to support the development of the specific technologies examined in the case studies is found in Section 6, below.