EnviroEconomics.ca

Andrew’s comments from the last post dovetail nicely with my thoughts on this report in the Financial Post (here). Essentially, the article argues that emission trading is more effective than carbon taxes. Trouble is, this preference comes from constituents who are lining up to defend their stakes in the great carbon trading game:

“This is an industry that did not exist four or five years ago — an industry that has very rapidly emerged (with) products that you take for granted in other businesses are just being developed now.”

One of the NRTEE’s recommendations included the observation that an upstream trading regime would be more effective than a downstream trading regime (see the NRTEE report and Chris and Nic’s technical report available by request from NRTEE). Essentially, if you move the regime up closer to production and importation you get a wider transmission of the carbon price across the economy, a desirable outcome since costs tend to be more evenly distributed. With a broad based upstream system there is no need for a complementary tax as in the case of the current downstream large emitter system, where only 50% of Canada’s emissions see a price signal. Problem is, Canada would need to ultimately transition the current “proposed” downstream system to an upstream system sometime near 2020. But this would alter existing rights, and notably all those free allocations, trading fees and allied services making money off the downstream system (same^2 for offsets).

And thus the transition challenge — constituents. Like it or not trading is creating vested interests that will protect the status quo and lobby accordingly. This will make change hard, especially in time.

And now the fun…you have to love an article and a quote in the National Post, that bastion of conservative thinking, that basically says that individual decision makers need to be told what to do:

“You can tax me on gas, but I still consume gas and there’s nobody to tell me how much I should consume,”

I love it. Only in Canada, Eh.

Now that I am back from enjoying an over allocation of wealth that is the Holiday Season, my mind turns back to all things climate policy. I have long thought that a majour gap in the current climate policy debate in Canada is allocations — how the large final emitters will be granted emission rights. One can’t help but wonder how it will all shake out given the maturations in Europe over allocations during the first trading period. As many economists predicted, if firms can pass on the costs of the permits to consumers then firms could be better off. This is indeed happening in Europe as the electrical utilities simply pass all costs on to consumers. The result is windfall gains:

Electric utilities are passing on the costs of emission rights directly to the price of electricity, even though they get most of the emission rights for free, and even if the electricity is generated in ways that do not produce greenhouse gas emissions, such as nuclear energy and hydroelectric power.
The extra dividend has boosted both the price of electricity and the profits enjoyed by electric utilities.

The “cost pass through” is a tricky concept to get one’s head around, but essentially it is about opportunity cost. Although the permits are freely allocated, they have a value in the trading market and thus using them to emit a tonne involves a loss in potential earnings. This loss is like a cost of production, and hence firms, especially regulated utilities, add this to production costs and voila, a price increase for consumers. Now, in competitive markets, this value may not be passed on if market share is to be retained, but in markets that are less than competitive, it is likely that the consumer will see some portion of this cost. But, since there is not really a cost here given permits are freely allocated, firms are better off and profits rise to the extent the cost can be passed on.

This is what is happening in Europe and this could happen in Canada. Carolyn Fischer and I did some allocations work on the Ontario electrical market a few years ago and found that under free allocations and a regulated market, electricity producers could be better off under trading—even with abatement costs accounted. On average with free allocations in a monopolistic market, utility profits increased more than a little with the high emission intensity generating sources showing the highest increase. Perverse I know, but a reality nevertheless. The solution of course is to auction the rights, like we do with telecommunications, and capture some of that allocation rent. This is what is now proposed in Europe.

So, in the wake of all our collective holiday over allocation, we should be asking if Santa will be giving our wealth to some of the large emitters and leaving us to pay for that hypothetical cost embodied in that lump of coal.

While most of us usually ignore the footnotes, for the “Bali Roadmap”, one footnote is worth closer examination. This footnote emerged when consensus on “binding targets” was not reached and there was a need to compromise. What then emerged was an implication that industrializated nations would consider making reductions of -20% to -40% below 1990. And so this seemingly innocuous footnote will be a focus of international climate policy for some time.

With some time on my hands during this Christmas slowdown, I thought I would take a first stab at what this footnote could mean for Canadian GHG reductions, GDP and climate policy. So here goes…

To hit the least stringent Bali -25% target (implied in the footnote):

Canadian GHG emission will need to drop 48% below the BAU in 2020 from a forecast level of about 865 MT in 2020 to ~455 MT;

Carbon prices need to climb in excess of $245 in 2020 (using the CIMS energy and emissions model coupled with the macroeconomic Canadian General Equilibrium and Emissions Model (C-GEEM developed by Nic Rivers and myself)). This carbon price assumes the most economically efficient policy scenario, an economy-wide price on GHG emissions. This would most likely include cap and trade for the large emitters (50% of emissions) and a carbon tax on the remaining emission (transport, buildings and manufacturing, etc.). And yes, other regulatory standards would also be needed on transportation and buildings, and incentives to CCS and renewables;

Technology deployment will need to be massive. CCS in upstream oil would have to hit 65MT and in the electrical sector would need to be another 42MT. Grid-power renewable electricity would have to grow to account for about 20% of all electricity supplied nationally;

Fuel switching would be unprecedented: domestic coal consumption would need to virtually disappear (down 90%), low-emitting electricity would need to expand by 40%, gas consumption would drop by 40% and petroleum would drop 25%;

GDP impacts for all this could be in the order of 1.9% annually, assuming no tax shifting or recycling by the federal government and emission trading with no auctioning (i.e. permit wealth is transferred between trading entities). This drop is about equivalent to the forecast GDP growth in 2020 without climate policy (See thumb);

And to get all this done, climate policy would have to get real serious real fast. The “optimal” emissions price path that minimizes GDP losses would look very different from the current policy path. This implies that starting today, policy stringency would have to be much higher and then ramp up post-2010 (see Thumb);

While Canada needs to take action, its hard to envision the political and perhaps economic system delivering reductions of this magnitude. All this leads me to observe, yet again that the whole Bali thing may have been more surreal than real.

This Globe piece got me thinking about what the Canadian private sector should be freaking out over with respect to climate policy. Is it the emission targets to 2015? No, the price cap for the Technology Fund effectively caps the financial obligation for a given target out to 2017. One simply multiplies forecast emissions by the Technology Fund’s allowable contribution limit to approximate one’s obligation. Is it Bali? Clearly not, since Bali is more surreal than real at this point.

Then what? I think it is uncertainty and that 2020 “aspirational” target of -20% below current levels. Why? If I am sitting down now to plan a project I need an expectation of the price of carbon in the future. I need to know what this variable cost called “carbon liability” will do to my project economics and how I can minimize the liability through design.

But, what is that price? Recent modeling (thanks Chris and Nic) suggests that the carbon price will need to climb from $25 in 2015, the approximate price cap under the Technology Fund, to about $80 to $100 in 2020 to hit a -20% below current target (see thumb). This means that if policy is implemented to hit the target, the liability grows fast and in the order of three to four times between 2015 and 2020. And thus the uncertainty — will climate policy add a carbon liability of this magnitude to my project in 2020?

So I think industry is faced with a very open question and therefore stuck in some sort of mental loop that goes something like this:

The carbon liability could be significant. But, there is so much uncertainty right now I need to discount this liability somewhat. But, the risk is still there. But what is the size of the risk, and by how much do I discount it…repeat loop…

I think “no one is uttering a word about Bali” because they are to busy muttering incoherently to themselves.

Andrew Leach , an environmental economist out of U of A, has good article in the Edmonton Journal today on an issue that one can’t help but see in the media: a contradiction in Canada’s domestic and international climate policies. His point is simply that while Canada is calling for binding targets for all emitters internationally, only the large emitters domestically face a real incentive to take action. The rest of us are offered subsidies, that we may or may not respond to, and some sporadic technology standards, that may or may not touch our emissions.

Instead, we need a more comprehensive climate policy. Ideally, this would include a domestic carbon tax for the sectors not covered by the cap and trade for large emitters – that includes you, me, our buildings and cars. Practically, this implies a cap and trade and an emission tax implemented concurrently so that a price signal is seen and hopefully felt by all. These two price signals should form the basis of our climate policy, but would not get the job totally done, and thus other regulatory standards, say for vehicles and buildings will be required, as well a projects on CCS and subsides for innovation.

If we are really serious about carbon and want to minimize cost, we need a broad-based carbon tax to complement the proposed trading regime. Without it, we will continue to have one oar in the water. Rowing in circles is a bit of a rush and can be fun, but mostly it gets tiresome.

As word of the all night negotiating binge was broadcast far and wide, there was cause for celebration. It turns out that the developed world was not so far apart and that language in Bali could be agreed upon. So, instead of binding reductions of say 20% to 40% by 2020, they settled for “deep”. The US grooved, the Europeans waltzed and voila, a road map for more talks. But can we afford to dance?

The developing world says no:

“We need to grow, and we need to grow rapidly,” said Munir Akram, a Pakistani diplomat who heads the G77, the major bloc of developing countries at the Bali conference.
“It’s a question of justice and humanity,” he said. “We cannot afford to allow our development to be stalled or reversed.”

But in Canada does this affordability refrain make sense? For some, like the manufacturing sector or low income households, climate policy needs to be concerned with income effects. Practically, this means that climate policy needs to separate the emission signal from compensating due to income concerns. For example, a broad-based emission signal, like a carbon tax, could be complemented by measures to compensate on the income side. This could be done through recycling revenue from a carbon tax or auctioned permits (from cap and trade) to those most adversely affected, like trade exposed sectors or low income households. This does not mean that we exempt some sectors from the price signal all together, and shift the cost burden to the rest of us.

But what about the rest of us, can we afford “deep” reductions? Nic Rivers and I have been doing some modeling using a macroeconomic model of the Canadian economy and find that deep reductions will cost, but will not ruin. We find that at emission prices of say $100, national GDP impacts are small and in the order of 1% to 1.5%% below a “no climate policy” level, which is less than forecast growth. With some creative tax shifting and revenue recycling (reducing labour taxes for example), this can be more or less halved. For this cost, we get emission reductions of about 20% below current levels, which is the federal government’s Turning the Corner target.

So, even with deep reductions, we will continue grow and have the national income to compensate those most adversely affected. But, just like the Bali-two step, I suspect that climate policy will continue to be one step forward and two steps back.

On instrument choice, there has been a long-standing view of alternatives as substitutes. You either tax, trade or regulate a standard, or stage instruments in time say by taxing first to get movement in advance of a technology standard. This view is not surprising given much of the early environmental economics literature focused on the benefits of say trading over regulations and technology standards. But this has changed as the theorists have prodded and probed their analytical models and concluded that indeed there is a blurring of the lines, and that often, design elements can be merged to produce some sort of uber instrument. While theory says one thing, we can expect a lag in policy adoption as the policy wonks catch up. But in Quebec, somebody is paying attention:

Quebec Environment Minister Line Beauchamp announced Wednesday that her government has approved regulations to make the province the first in Canada to enforce the tougher emissions standards in cars, starting in 2010. The regulations require manufacturers to improve by 30 per cent the average emissions from their entire fleet of new cars by 2017…..Under Quebec’s plan, automakers would be forced to pay fines into the government’s green fund if they don’t meet their targets, while those that exceed the standard would be able to sell carbon credits to other companies.

What is astonishing about this is that we have elements of trading and taxes concurrently supporting a stringent regulatory standard in Canada. The monetary fines are a safety value that acts like a tax to recycle revenue and improve environmental performance, the trading provides cost-effective compliance through equalizing the marginal costs of producers and an on-going incentive through continuous improvement and the standard, well it is a North American first. And recall, Quebec has a carbon tax that is visible at the pump. Quebec through this “mixing and matching” of instruments seems to have technology change and consumer behaviour in transportation sector cornered. It’s all enough to make an environmental economist swoon.

Chris Green, that quirky economist, has a good article in the Globe today on why the focus on targets is bad, and a focus on action is needed. His basic premise is that targets, especially long-term ones, are set in a political arena, which operates in the absence of clear information on the doable. Targets are then set beyond what is technically or economically achievable, and thus set to fail. The setting of targets also detracts considerably from the focus on action, and the inevitable failure influences implementation. Both of these observations are borne out in Canada’s Kyoto experience.

Chris makes some good sense, but I also think the long-term targets provide a focus for action. A well balanced climate policy would have one track that looks forward to vision where we need to go and how we need to organize and transform ourselves to transition to a lower carbon future. Another parallel tract would focus on short-term action and on setting the stage for longer term strategies to move towards the targets.

So Chris is bang on when he states:

Someone has to lead. Another round of climate target-setting would be a prescription for another decade wasted. While it may be politically difficult to chart a new course, there is no alternative if we wish to cope with climate change. Canada could at least get out in front with projects and policies — putting a price on carbon, strengthening energy efficiency standards, and increasing carbon capture and storage — that have a strong probability of encouraging development of the green technologies that will be essential to reducing greenhouse-gas emissions, even if the timing and magnitude of these reductions is inherently uncertain

I just think part of that leadership also involves rallying around a vision of the future. And that vision has to be anchored in where we need to be. So, we are stuck with targets. But as Chris points out, if we channel some of that energy used to argue over targets into action, we would be one our way.

Like him or not, former Prime Minister Chrétien was a competent manager, and he is right on the current state of climate policy in Canada (see here):

“I signed Kyoto and I knew it was going to be tough to meet the goals of 2012. When I left, we were close to having a deal with the oil industry, but it was not implemented,” he said at a gathering of Liberal heavyweights in Toronto.
Mr. Chretien’s government agreed to cut greenhouse gas emissions by 6% below 1990 levels by 2012. By 2004, however, emissions had risen 27% over the 1990 level.
Mr. Chretien acknowledged the gap, but said “it would be better to be at 95%” than to have done nothing.

With a wholesale scrapping of the previous governments attempts (albeit weak) to move forward, Canada ended up further behind. As emissions grew primarily from oil sands and will continue to grow (see thumb below), this delay has been and will be costly. The post below discusses why delay has risks, but in a nutshell, emissions are higher, high emitting technology becomes locked-in, future reductions become more costly, and technology, innovation and learning by doing aren’t incented to lower costs in time.

A simple carbon tax phased-in a number of years ago would have gone virtually unnoticed from an economic perspective, but of course was DOA politically. And now, looking out to the future we will have carbon constants, and these constraints will be more costly because of political delay. While political blustering seems to be the centre piece of Canada’s climate policy, sometimes I long for a good old fashioned manager who gets things done….even at half measures.

When the Trade Ministers meet to talk climate change and trade, there is promise. These are the folks that generally get things done in government. Toby Heaps has a great account of a first, and very important meeting of international finance ministers on climate change and trade in Bali. One nugget from this account is a World Bank assertion that trade barriers could be removed that could improve the flow of “climate friendly goods” between countries by something like 7 to 13%. These are big numbers and underscore an area that needs more attention: the removal of non-price barriers to lower carbon emissions.

Despite the focus on emission pricing, there is also a need to systematically crawl through the way we regulate and control behavior and see what is distorting movement to a low emissions profile. In many cases, removing these barriers opens up a suite of low cost options.

One notable example that recently stuck me as significant are barriers in the cement sector to burning waste fuels and adding supplemental cementing materials (SCM’s are a cement “filler” that is waste fly-ash from burnt coal). In Canada, we regulate the industry’s ability to burn waste materials and add SCM’s, but in Europe things are different. With proper air pollutant controls, the European cement sector has become a waste burning powerhouse, while reducing emissions a tonne (ok many tonnes). Similarly, the industry is allowed to add waste materials to their cement products up to something like 30% while maintaining quality, which lessens total emissions (1/3 from energy and 2/3 process) on a ratio in the order of 1:1.

In Canada, our SCM standard is 1% and we burn about 5% waste fuels nationally. Changing these standards would mean we could reduce energy and process emissions from this GHG-intensive sector by a much larger number at a much lower cost than options such as fuel switching (more Nox) or upgrading the kilns (more cost). And banning the burning of tires in Ontario, but allowing them to be shipped to Michigan and burnt in Cement kilns owned by the same folks in the same airshed is absurd (yes we do this).

It is always puzzling to an economist to see something that makes economic sense but is undersupplied. But when we do, we generally know there is some sort of distortion at play. In Canada, finding and removing these distortions should be a priority for climate policy. So, while Canada’s climate change delegation drags our good name through the volcanic sand in Bali, take comfort. Some smart people are at least thinking about this stuff on our behalf, and when they are trade ministers, we may just be better off.