Costs of Kyoto - What we Know

1. Introduction

The Government of Canada does not have an official estimate of the economic impacts of meeting our Kyoto target at this point. This note refers to a variety of estimates that are on the public record. Further work from the federal/provincial/territorial Analysis and Modelling Group (AMG) is expected in April. All of this work, and other studies that may be carried out in 2002, will be input into the decision-making process. A complete estimate of costs can only be made once the plan for meeting the target has been specified.

There are several different types of cost that are relevant in considering climate change action. One is the direct cost to industry or consumers or government of reducing emissions. A second is the more general cost to the economy as a whole, measured in the impact on Gross Domestic Product (GDP). A third is the cost of taking no action - in other words, the cost of climate change itself - which is the reason for the Kyoto Protocol in the first place. This note deals only with the first two types of cost.

There are also benefits from taking action. One type of benefit is the energy savings that result from an investment in energy efficiency - these benefits are taken account of in estimates of direct cost and GDP impact. A second type of benefit is the other environmental improvements (e.g. cleaner air) and associated health benefits that result from taking climate change action. This note takes account of these benefits to a limited extent. A third type of benefit is the innovation and competitive advantage that accrues to companies that invest in new technologies that reduce emissions. These benefits are generally not reflected in economic modelling exercises and are not addressed in this note.

Since this note only deals with some of the costs and some of the benefits, it provides only a very partial view of the implications of taking climate change action. This is also true of even the more complete cost estimate that will be available once the Kyoto plan has been specified. These cost estimates must therefore be set against other considerations, including issues of principles and values. The public debate has centred around the question of direct costs and GDP impacts, which is why those are the focus of this note.

2. Direct Costs

The direct cost of emission reduction could be measured in a number of ways. One measure is simply the out-of-pocket cost to industry, consumers or government of investing in an emission reduction, e.g. expenditures on equipment and materials, minus the energy savings that will result from the investment. Studies show that many of the emission reductions in Canada that are being considered in this note would actually pay for themselves, so that according to this measure, reducing emissions would not lead to costs but actually to benefits. Analysis undertaken for the federal, provincial and territorial analytical working group shows that under $10/tonne or $25/tonne permit price scenarios, the net benefits of emission reduction would amount to about $3 billion/year.

A second measure of cost is out-of-pocket costs, minus energy savings, plus a series of adjustments that are sometimes called transactions or welfare costs. One such adjustment reflects the fact that individuals and firms may face higher borrowing costs, or require a higher rate of return on investment, than is assumed in the economic models. Examples of other adjustments include taking into account the costs of finding the necessary information to make an investment; the time needed by a householder to actually carry out a home retrofit; and costs associated with lifestyle changes, e.g. less leg-room in smaller cars, relocation from the suburbs to city centres.

This second measure of cost can be considered conservative in that it is at the upper bound of direct costs. Using such a conservative measure, and under a scenario where the domestic and international permit price is $10/tonne of CO₂, the direct cost to industry, consumers and government of achieving Canada's Kyoto target is estimated by Environment Canada to be in the order of $1.1 billion per year, or about $40 per person. This estimate draws on analysis conducted for AMG. If domestic and international permit prices rise to $25/tonne of CO₂, then the cost of achieving the Kyoto Target could be as high as $2.8 billion per year or about $90 per person.

3. GDP Impacts

Another type of cost estimate is the GDP impact. This is calculated by taking direct costs, and adding in the indirect impacts as those costs wind their way through the economy. GDP impacts are calculated in terms of the reduction in GDP in 2010 relative to a business-as-usual scenario; since GDP is a measure of national income, these cost estimates measure how much income Canada gives up in 2010 in order to meet its Kyoto target. They are not reductions from current GDP. In fact, in both business-as-usual and Kyoto implementation cases, GDP in 2010 is projected to be significantly higher than current GDP (by some 30%).

Subsequent to the negotiation of the Kyoto Protocol in December 1997, the international and domestic modelling community undertook analyses of the economic impacts of implementing the Protocol. However, key provisions of the Protocol, in particular the rules relating to sinks and use of the Kyoto Mechanisms (international emissions trading, Joint Implementation and the Clean Development Mechanism) were still under negotiation. These provisions were not finalized until the meetings in Bonn and Marrakech in 2001. As such, modelers undertaking analysis prior to Bonn and Marrakech generally had to make an assumption about the final content of these provinsions

I. Analysis pre-Bonn and Marrakech

AMG

The AMG produced a report published in November 2000. Its primary objective was to provide policy-makers with "order of magnitude" guidance on some fundamental issues related to the achievement of the Kyoto Target, including:

• the economic implications of different broad policy approaches, such as using various combinations of a suite of specific measures and a major economic instrument, and the consequences of requiring each sector to achieve a common target versus an overall national target;
• the potential benefits and costs of greater access to the Kyoto mechanisms;
• the sectoral and regional distributions of emissions reductions and costs of achieving the target;
• the degree to which Canada's competitive position might be affected by the achievement of the Kyoto commitment; and
• the relative importance of the co-benefits of greenhouse gas (GHG) mitigation, in particular those related to improvements in air quality.

The AMG reported impacts on GDP in the range of 0-3% in 2010. Since under business-as-usual assumptions the economy is projected to grow by about 30% between 2000 and 2010, a reduction in GDP in 2010 of, say, 1% would mean that, over the decade, the economy would grow by about 29% instead of 30%. In such a scenario, compared to business-as-usual, the economy would be about $11 billion smaller (GDP of $1137 billion instead of $1148 billion) and per capita GDP would be about $400 lower ($33,360 instead of $33,740).

The $40 billion estimate that has found its way into the public domain is based on a worst case and unrealistic scenario that assumed that Canada was the only country in the world that took action to reduce emissions. This would never be the case in reality as Kyoto can only be brought into force when a minimum of 55 countries ratify it. The 450,000 job loss estimate is based on the same scenario.

At the other end of the spectrum, the AMG report outlines a scenario where the GDP impact in 2010 would be slightly positive, and implementing Kyoto would result in 65,000 new jobs.

Most analysts favour neither extreme of the range of 0 to 3%. Moreover, the previous AMG work does not reflect the successful international negotiations in Bonn and Marrakech where Canada received an important credit for carbon sinks and which provided assured access to the international market which dramatically reduces the cost of compliance. Neither do these results reflect current expert estimates that the international carbon price is likely to be reduced significantly due to US withdrawal from Kyoto. Both of those factors would significantly reduce impacts from previous estimates.

The AMG has been working for about a year on an update of its previous analysis. This has been a comprehensive analytical process involving consultations with industry, environmental and academic experts. The updated AMG results, which will reflect recent developments such as the Bonn/Marrakech sinks deal, will be available in April.

Other estimates for Canada

Following the signing of the Kyoto Protocol in 1997, a series of studies by academic economists and independent consultants looked at the costs to Canada of ratifying and implementing emission reductions along with all of our major trading partners. These studies typically assumed efficient policy instruments like emission taxes or tradable permits would be used domestically. Cost estimates from economic models ranged from 0.2% to 2.5% of GDP, depending mainly on whether permits could be traded globally. Since these provisions are now in the Kyoto agreement, the lower end of this range would seem more likely.

As can be seen from Table 1, scenarios in these studies that assumed the kind of international trading system that Canada successfully negotiated at Bonn yield GDP impacts that are consistently below 1%.

One of the most detailed of these studies was released in March 2001 by Industry Canada. The study, entitled Sectoral Impacts of Kyoto Compliance, was prepared by Randall Wigle of Wilfrid Laurier University. It has received considerable coverage in the press, but has frequently been mis-quoted. The main conclusions from this study were:

• Under a scenario where Canada achieves the Kyoto Target entirely through domestic abatement and using a cost-effective approach to emissions reduction, the cost of compliance for Canada is estimated to be less than 1.5% of Gross National Product (GNP). However, Canada's most energy-intensive sectors can expect to decline markedly. This domestic-only scenario is no longer relevant given the agreement in Bonn and Marrakech.
• If the Kyoto Protocol is implemented with significant international trading, the GNP impact falls to about 0.5% and the negative sector impacts largely disappear. In some cases, energy-intensive industries may expand modestly even if their energy intensities exceed those of industrialised country competitors.

Some commentary has suggested that the costs of reducing emissions are higher for Canada than for other countries. The following table summarises results from studies using a number of international models, including ABARE, conducted prior to the Bonn/Marrakech agreements. These results indicate GDP impacts on Canada that are well below 1% of GDP in the presence of international trading. They also indicate that the impacts on Canada are in the range of those for other countries.

II. Analysis Post-Bonn and Marrakech

The international modelling community is beginning to publish results of the cost of Kyoto under assumptions that reflect the Bonn Agreement and Marrakech Accords. The results of these studies indicate that, as a result of the US not ratifying the Kyoto Protocol, the international permit price will be significantly reduced, e.g. by a factor of two, leading to significantly lower compliance costs for Annex B countries such as the European Union, Australia, Japan and Canada. For example, a report prepared by Dr. Nordhaus - The Economics of the Kyoto-Bonn Accord, August 2001 - concludes that permit prices will be sharply lower compared to the pre-Bonn case, declining from US$40/tonne of CO₂ to US$11/tonne of CO₂.

The chart below sets out results from an informal survey of other countries' price projections, as well as from a recent survey conducted by NatSource of 34 companies with operations in Canada, the United States, Japan, the European Union and Russia (the NatSource survey indicated average price expectations of $11/tonne of CO₂). It also sets out the permit prices from recent modelling estimates of the Kyoto Protocol - these show an international permit price range from US$0-24/tonne of CO₂ assuming a fully efficient market, and from US$9-38/tonne of CO₂ in a market where Russia and other permit sellers exert a high degree of market power.

That these lower permit prices significantly reduce compliance costs is supported by a recent report from the RIVM (Netherlands) National Institute of Public Health and Environment which finds a GDP impact for Canada that is under 0.05%. This estimate suggests the impact would be in the order of $300 to $500 million on an estimated economy of about $1.1 trillion in 2010. As well, a report by the National Institute for Environmental Studies (Japan) found that, with access to international trading, the cost to Canada of complying with the Kyoto Protocol is a reduction in GDP of 0.3%.

The most recent publicly available analyses on the cost of Kyoto are based on the ABARE model. A report issued by the New Zealand Government in November 2001 found that the impact on Canada's GNP would be 0.73%, which is similar to that for Australia.

A March 2002, study by the Australian Bureau of Agriculture and Resource Economics (ABARE) finds that while Canada's cost of compliance with the Kyoto Protocol is higher than that for other Annex B countries, the GDP/GNP impact in 2010 is still less than 1% -- GDP is some 0.3% lower and GNP is some 0.7% lower than in the business-as-usual case. This is despite the fact that the study assumes the successful exercise of market power in the international permit market by Russia and the Ukraine (the study assumes that Russia and the Ukraine withhold permits from the international market place, thereby increasing the international permit price and reducing the value to Canada of some of the provisions of the Bonn and Marrakech Accords).

4. Competitiveness

There are three relevant elements to the implications for Canada of US withdrawal:

• a potential cost disadvantage for Canadian firms competing in US markets
• a benefit in terms of sustained US demand for Canada's exports
• a benefit in terms of a lower international carbon price.

Some experts (including the Japanese and Netherlands studies referenced above) believe that the net effect of these three elements is positive for Canada. In other words, the net effect of the US withdrawal from Kyoto may make it easier for Canada, and Canadian industry in general, to meet its overall target. This requires further analysis.

The AMG is conducting an in-depth assessment of the competitiveness implications associated with Kyoto ratification. The results of this assessment are expected to be available in April.

There are a number of possible mechanisms for moderating the competitiveness impacts on specific industries. These include methods for allocating permits in a domestic emissions trading scheme, and the use of targeted measures such as incentives. Federal, provincial and territorial Ministers will be addressing the design of such measures.

5. Size of the Challenge (the Emissions "Gap")

In January 2002, the AMG increased the size of the gap from 199 MT to just under 240 MT. This increase was to accommodate new projects proposed by the provincial representatives on the AMG; 25 MT of the 40 MT adjustment was to reflect new projects in Alberta, 2 MT reflected expanded East Coast offshore oil and gas production, while 3 MT was added to reflect increased natural gas production in British Columbia.

The new round of AMG analysis will be based on the 240 MT gap. This means that three new coal-fired electricity generation units (EPCOR, Keephills and Enmax), oil sands production at over 2.1 million barrels per day, and natural gas production at 9 trillion cubic feet, are now reflected in the business-as-usual scenario.

6. Risk Management

As the price of carbon will continue to be a significantly uncertainty, it is important to develop strategies for managing this risk. The federal government is reviewing approaches that other countries are taking in this area, including the potential role of hedging strategies and forward contracts, and the potential establishment of a reserve of international credits.

7. Elements not Included

The majority of the results being reported in the media do not include co-benefits of climate change mitigation actions or the costs of inaction.

There are co-benefits associated with actions to mitigate GHG emissions. In particular, actions to reduce GHG emissions also typically reduce other atmospheric emissions. The AMG focused on the clean air and related health benefits associated with reductions in these pollutants, and estimated the co-benefits at between $300 and $500 million per year. The estimates can be considered conservative, since they do not cover all of the pollutants and omit the contribution of sulphate reductions in western Canada. The estimates also exclude non-environment-related benefits, such as economic and safety benefits from reduced traffic congestion.

Another important cost not included in the analysis is the cost of inaction. If climate change goes ahead unchecked, Canada could suffer enormous costs; social, environmental and economic. Recent experience underscores the implications. Recent analysis from the University of Manitoba indicates that last year's devastating drought cost the Canadian economy more than $5 billion of which the direct impact on the prairie economy was $1.5 billion. And in eastern Canada, the 1998 ice storm cost the regional economy over $6 billion.

8. Limitations of Modelling

Modelling is just one input into the decision-making process. Regardless of the modelling methodology employed, there are still big gaps between the assumptions that modellers use and the reality of how the Canadian economy actually works. These models are attempting to forecast the economy, energy prices and many other factors for 10 years. This is beyond the normal time horizon for most forecasts, including provincial and federal budgets.

While the models provide insights on the direction of the economic impacts, the models are necessarily incomplete. One implication of this is that results become less reliable the more detailed they are. Moreover, modelers necessarily have to make certain assumptions about the future course of events, some of which are likely to be proven wrong. In addition, many of the models do not incorporate a realistic assessment of how market forces drive innovation; a more realistic treatment of innovation would lower the estimated costs of addressing climate change. As well, most models represent firms as having static behaviour, whereas economic history tells us that firms readily adapt to changing circumstances.

A review of the business literature illustrates that superior economic and environmental performance can be achieved through technological and organisational innovation. For example, the Pew Center on Global Climate Change released a report in October 2001 on successful corporate greenhouse gas reduction by six members of its Business Environmental Leadership Council -- ABB, Entergy, IBM, Shell, Toyota and United Technologies Corporation.

Finally, it is to be noted that, in the case of several important environmental initiatives (a prime example being the US acid rain control program), actual costs of implementing the initiative proved to be significantly lower than projected costs. For example, the cost of reducing SO₂ continues to be lower than anticipated when the Clean Air Act Amendments were enacted. The cost of compliance was initially estimated at US$400/ton to US$1000/ton; however, during 2000, SO₂ allowances ranged in price from US$130/ton to US$155/ton.

Environment Canada

March 4, 2002

Selected Bibliography

Australian Bureau of Agriculture and Resource Economics (ABARE), The Kyoto Protocol: An Economic Analysis Using GTEM, 1998. Reproduced in The Energy Journal, Kyoto Special Issue, 1999.

Australian Bureau of Agriculture and Resource Economics, Economic Impacts of the Kyoto Protocol - Accounting for the three major Greenhouse Gases, ABARE Research Paper Report 99.6, May 1999.

Jakeman, Hester, Woffenden and Fisher, Australian Bureau of Agriculture and Resource Economics (ABARE), Kyoto Protocol: The first commitment period and beyond, Australian Commodities vol. 9 no. 1, March 2002.

Charles River Associates Incorporated, Analysis of the Impact on the Canadian Upstream Oil and Gas Industry of the Global Implementation of the Kyoto Protocol, September 1999. Prepared for the Canadian Upstream Oil and Gas Working Group of the Industry Issues Table. (MS-MRT Sept. 1999).

Critiqui and Viguier, Trading Rules for CO2 emission permits systems: A proposal for ceilings on quantities and prices, Institut d'économie et de politique de l'énergie, February 2000. (POLES, 2000).

Den Elzen and de Moor, The Bonn Agreement and Marrakech Accords: An Updated Analysis, 2001, RIVM report 728001017.

Edmonds, J., MacCracken, C., Sands R. and S. Kim, Unfinished Business: The Economics of the Kyoto Protocol, 1998. (SGM, 1998).

Edmonds, J., MacCracken, C., Sands R. and S. Kim, The Economics of the Kyoto Protocol, 1999. Reproduced in The Energy Journal, Kyoto Special Issue, 1999. (SGM, December 1999).

Dr. Gusbin (Coherence) and N. Kouvaritakis (ECOSIM), Kyoto Protocol and Emission Trading: Potential Cost Savings and Emission Reduction. (POLES).

Kainuma M., Matsuoka Y. and Morita T., Analysis of Post-Kyoto Scenarios based on AIM Model, September 2001.

Nordhaus, William - The Economics of the Kyoto-Bonn Accord, August 2001.

White, James and Wallace Richard, Climate Change Working Paper: Assessment of Economic Modelling, November 2001, Zealand Climate Change Programme.

Wigle, Randall, Sectoral Impacts of Kyoto Compliance, October 1999. Industry Canada Working Paper Number 34, March 2001.