1. INTRODUCTION

The National Round Table on the Environment and the Economy (NRTEE) has initiated a program to examine the role of ecological fiscal reform (EFR) in meeting the challenges of implementing sustainable development in Canada. The first phase of the EFR program, which focussed on the agricultural, transportation and chemical sectors, demonstrated that fiscal policy is one of the most powerful means at the government’s disposal to influence outcomes in the economy; if used in a consistent and strategic manner, EFR can promote objectives that have simultaneous economic and environmental benefits.

• the goal of the EFR program specifies that the “decarbonization” of the energy sector not increase other pollutants; and
• an implied goal of this initiative is the promotion of innovation.[For readers not familiar with the ECP, the links between these two points and the use the ECP definition of RETs may not be obvious. Suggest adding a short explanation.]

• wind turbines;
• low impact hydro;
• grid-connected photovoltaics (PV);
• landfill gas (for electricity generation);
• biomass (for electricity generation);
• ocean energy, including wave and tidal power conversion technologies; and
• geothermal.

• CURRENT STATUS. What is the current status of each technology in terms of installed electricity generating capacity (connected to the Canadian grid), technical maturity and costs?
  
• POTENTIAL IN CANADA. What is the long-term maximum generating capacity for each technology and how much of this capacity is achievable by 2010 and 2020?
  
• FUTURE COSTS AND LEARNING TRENDS. What is the projected cost of each technology and what are the learning trends that affect this cost ?

• overview of the fiscal instruments assessed;
• overview of the model used to assess the instruments;
• summary of results;
• detailed discussion of the base case and each fiscal instrument; and
• sensitivity analysis results.

• An emissions price, which is analogous to an emissions trading permit system or a carbon tax. Under this scenario, a shadow price of $10/tonne is placed on CO₂ emissions; this is the cost of an emissions trading permit or the tax rate on carbon. The emissions price is applied uniformly across all fossil fuel generation in Canada in 2010.
  
• A renewable portfolio standard (RPS), which requires that utilities purchase green certificates, or the equivalent, so that renewables generation increases relative to fossil fuel generation. The model compares the uptake of renewables attributable to an RPS relative to generation from fossil fuels (i.e., not relative to all electrical generation). Constraints are not placed on technologies or regional shares of the total RPS. Instead, prices are used as the determinant for the type of technology that is supplied at the prevailing electricity price.
  
• A renewable generation subsidy, which is modeled as a direct subsidy for grid-power RET producers on a per kilowatt hour (kWh) basis. In practice, this subsidy could include any fiscal instrument that lowers the cost of production for producers, such as a direct production subsidy or a capital cost allowance.
  
• A combination of RPS and generation subsidy, modelled in tandem. We let the RPS be the dominant policy, since the RPS is meaningless if the subsidy encourages more renewable generation than required. The price of the green certificates is offset in part by the subsidy. This outcome will therefore trigger distributional shifts in terms of cost imposition.
  
• A subsidy for research and development (R&D), which is a program to reduce the future cost of renewable generation. The model identifies the annual increase in renewables R&D required to achieve the emissions reduction target.

• improved ambient air quality and reduced carbon in the atmosphere;
• avoided ambient air quality impacts on sensitive ecosystem and health receptors and the associated economic value of the avoided damages; and
• the benefits of mitigating climate change, such as avoided ecosystem, health and economic damages stemming from extreme weather events, temperature changes and sea-level rise, and the associated economic value of the avoided damages.

• renewable penetration displaces fossil generation when an instrument reduces renewable generate costs relative to fossil generation costs;
• the carbon intensity of fossil fuel generation is reduced when carbon is priced in the fossil sector (i.e., abatement from natural gas generation that displaces coal); and
• an increase in the electricity price reduces total electricity demand, which displaces fossil fuel generation.

13. Welfare (excluding environmental benefits) ($million/year). This is the change in social welfare, and is a proxy for the societal cost of the instrument. It is the sum of government transfers and consumer and producer surpluses. It is an important metric, since all scenarios achieve the same emissions reduction target yet have differing social costs.

14. Welfare relative to emissions price. This is simply a ratio that indicates the welfare costs of each scenario compared with the emissions price scenario. The emissions price is selected as the basis for comparison because it has the lowest welfare cost.

Table 7
Summary of Modelling Results
($CAN, 2000)

	Base Case	Emissions Price	Renewable Portfolio Standard	Renewable Generation Subsidy	Combination RPS and RGS	Renewable Research Subsidy
1. Policy level for 12% emissions reduction		$10/tonne of CO2	24% of all generation (excluding major hydro and nuclear) is renewable *	$0.006	RPS = 24.21% RGS = $0.002	61% increase
2. Electricity price ($/kWh)
1st stage	$0.092	$0.097	$0.095	$0.092	0.095	0.092
2nd stage	$0.092	$0.097	$0.093	$0.092	0.092	0.092
3. Carbon emissions (MT CO2)
1st stage	106	98.10	91.00	98.97	91.08	104.00
2nd stage	106	84.40	91.60	83.50	91.95	77.40
4. Renewable generation (MWh 10^11)
1st stage	0.29	0.40	0.54	0.42	0.55	0.31
2nd stage	0.38	0.66	0.55	0.72	0.55	0.83
5. Fossil generation (MWh 10^11)
1st stage	2.00	1.85	1.71	1.87	1.72	1.98
2nd stage	1.91	1.59	1.73	1.57	1.73	1.46
6. Total electricity generation (MWh 10^11)
1st stage	2.29	2.25	2.26	2.29	2.27	2.29
2nd stage	2.29	2.25	2.28	2.29	2.29	2.29
7. Renewable R&D ($ million)	$129	$450	$320	$533	$325	$1,576
8. Additional renewables cost reduction (%)	0%	15%	13%	16%	13%	26%
9. Consumer surplus ($ million)	$0	($11,690)	($4,521)	$0	($3,533)	0
10. Producer surplus ($ million)	$0	$2,215	$3,480	$2,846	$3,547	$1,590
11. Transfers ($ million)	$0	$8,896	$0	($3,557)	($1,072)	($3,890)
12. Welfare - no benefits measured ($ million) (9+10+11=12)	$0	($579)	($1,041)	($711)	($1,058)	($2,300)
13. Welfare relative to emissions price	-	1.00	1.80	1.23	1.83	3.97

Source: Marbek and Resources for the Future.
Note: Figures may not add because of rounding.
* This is 9% of all annual Canadian generation.

4.4 DETAILED RESULTS BY INSTRUMENT

BASE CASE

The base case provides the reference from which the percentage changes are estimated in Table 6. Renewables penetration is forecast based on the relative costs of fossil fuel and renewable generation. Renewables penetration increases over time as innovation reduces the cost of renewable generation.

Total electricity generation is fixed in both stages in the base case;³ increased renewables penetration therefore decreases the carbon intensity of all generation, from 106 megatonnes/year in the first stage to 101 megatonnes/year in the second stage.

EMISSIONS PRICE

An emissions price works to reduce emissions by reflecting their cost, either in terms of environmental damages (as with a carbon tax) or in terms of opportunity cost elsewhere in the economy (as with an emissions cap-and-trade system). This price sends a signal to everyone in the energy market to conserve carbon. Fossil energy producers can reduce costs by boosting efficiency or switching to lower carbon fuels and processes. Because the price of fossil energy includes the cost of the carbon associated with that form of generation, the price of electricity rises. This signals consumers to reduce their energy use (by, for example, using more energy efficient appliances). It also increases the price received by renewable energy producers, encouraging production and investment in RETs.

• Consumers face the highest electricity prices and consumer surplus loss under the emissions price scenario. Because many consumers are also taxpayers, the amount of government transfers also affects them.
  
• For renewable electricity generators, the emissions price has a modest but significant impact on renewable generation, production costs and the producer surplus. This impact is relatively consistent across both stages.

• For fossil fuel electricity generators, the emissions price is the only instrument with an incentive to reduce emissions intensity. Although profits for the fossil sector are not modeled—rather, they are assumed to be driven to zero in the long run by the market—the potential costs to the fossil sector of an emissions price would depend on its ability to pass on to consumers the production costs increases from carbon abatement (i.e., moving from coal to gas), as well as any windfall gains from being allocated emissions permits.
  
• For government, significant revenue could be raised under the emissions price, either through a carbon tax or through the allocation or auctioning of carbon permits under an emissions trading system. This is the only scenario with the potential for significant increases in government revenue. It also represents the value of the emissions rents, which are available to be allocated to consumers, generators and their shareholders, funds for transition assistance, or taxpayers more generally.
  
• From society’s perspective, welfare costs are lowest with the emissions price, making it the preferred option. One negative consequence of this scenario, not incorporated into this single-sector analysis, is that the increase in electricity prices could lead to economy-wide competitiveness. Reserving some permits for allocation to trade-exposed sectors that are electricity intensive could mitigate this impact.
  

• Consumers experience some electricity price increase and consumer surplus loss under the RPS. This effect is about 80% as large as with the emissions price in the first stage, and nearly negligible in the second. The electricity price rise is the result of the purchase of renewable power in the form of green certificates (or the equivalent) by the fossil sector. Since renewables become cheaper with technical innovation, the cost of green certificates (and, thereby, electricity) is higher in the first stage but lower in the second.
• For renewable producers, the RPS increases renewable generation at a uniform rate in both stages, which is not surprising since the RPS fixes the share of renewables in both stages. Producer profits are high. While there is certainty in terms of market share for the renewables sector, there is less stability in terms of prices, and less flexibility in terms of the timing of renewable generation. Furthermore, the fact that the implicit subsidy falls over time with cost decreases means that incentives for innovation may be muted—indeed, our model predicts less R&D spending than under the emissions price. Although more renewable generation is needed overall, so much is done in the first stage that the return to lowering costs in the second stage is lower, both because of the lower second-stage output (relative to the other policy scenarios) and also possibly because of greater learning by doing in the first stage, which can substitute for R&D.
• For fossil fuel generators, the share of all generation remains steady in the two stages; it’s lower than in other scenarios in the first stage and higher in the second. In other words, cost reductions in renewables allow for fossil sector expansion. Still, short-term transitional costs could be expected to be greater under the RPS than in other scenarios. Actual potential costs to the fossil sector under an RPS will be higher if the sector is not able to pass along the full costs of green certificates to consumers.
• For government, the RPS has no impact.
• From society’s perspective, the welfare costs are greater than under the emissions price and generation subsidy, but lower than under the R&D subsidy and the combined RPS and generation subsidy. This ranking does not necessarily hold under all circumstances, but rather depends on the particular trade-off between the extra costs of encouraging more effort up front and the inefficiencies of not giving consumers incentives to conserve. Indeed, if one coped with the former problem by optimally designing the RPS requirement to increase over time, the RPS could be made to dominate the subsidy always, due to the presence of the modest conservation incentive.
• Looking beyond the electricity sector, the increase in electricity prices could cause economy-wide competitiveness (which could lead to decreased productivity or reduced exports, for example). This economy-wide competitiveness would not be as severe as under the emissions price, particularly in the second stage of the RPS.

• Consumer prices are not affected because all of the reductions are supplied through lower renewables costs, which do not affect the fossil fuel sector directly. Consumers are indirectly affected because their tax revenue funds a portion of the subsidy.
• For renewable producers, the generation subsidy has the largest impact on profits, since it encourages the displacement of fossil fuel generation more than the preceding scenarios. On-going innovation is stimulated by the greater scope to reduce production costs at the higher output levels induced by the price premium.
• For fossil fuel generators, the generation subsidy has a similar impact on fossil generation as the emissions price, since the additional renewable generation is partly offset by additional demand. The decline in fossil fuel generation is slightly larger in the second stage because innovation dramatically increases the competitiveness of renewables. That fossil fuel generation may be lower with the subsidy than with the emissions price—with no increase in electricity prices—may seem surprising. However, since the fossil sector lacks an opportunity to adjust its own emissions, the full burden of reductions falls on renewables to displace fossil output.
• For government, the subsidy required to achieve the emissions reduction target is a significant disbursement.
• From society’s perspective, the welfare costs are greater than under the emissions price, but less than under all other scenarios. There is more uncertainty, however, that the emissions target will be met with the generation subsidy than under the preceding scenarios, for two reasons:
  • The scope and speed of cost reductions in renewable generation is likely more uncertain than the cost of abatement in the fossil sector or the extent of conservation by consumers.
  • Even if all cost uncertainties were similar, reliance on only one method of emissions reductions raises the overall uncertainty. In a broader scenario, if innovation does not lower renewable generation costs significantly, one could engage in relatively more emissions abatement or conservation, whichever turns out to have the lower costs.

• Consumer prices are slightly lower. Despite the additional electricity demand, emissions are also lower in the first stage—this results from the fact that the standard must be raised to offset the loss of conservation incentive, leading to even more reductions in the first stage and less in the second.
• Renewable generation is 0.5% higher and R&D spending is 1.5% higher.
• Fossil fuel generation is almost exactly the same as under the RSP alone.
• The government spends just over $1 billion on a subsidy that has little or no effect on behaviour, given the presence of the RPS.
• From society’s perspective, to the extent that the subsidy does affect behaviour, it tends to lower prices and raise welfare costs. The weaker conservation incentive and the additional front-loading of emissions reduction efforts by increasing the RPS are the cause of the increase in welfare costs, from 1.8 to 1.83 times that under the emissions price.

• Consumers do not experience electricity price increases and consumer surplus losses under the R&D subsidy. As with the generation subsidy, they indirectly contribute to the renewables sector through tax revenues that fund the R&D subsidy.
• For renewable producers, the second stage of the R&D subsidy induces the highest increase in renewable generation of all the scenarios. This increase is driven exclusively by innovation that decreases the cost of renewable generation. However, the degree to which Canadian learning by doing and R&D can drive cost decreases is uncertain. Although such cost decreases are observed in Canada and internationally, it is not certain that Canadian R&D alone will decrease costs enough to increase renewable generation by the amount predicted in this scenario. One reason for this uncertainty is that innovation in renewable generation generally occurs internationally and is imported into Canada. This uncertainty in the ability of domestic R&D subsidies to achieve the penetration predicted in the model only reinforces the result that this policy is a much more costly method for achieving emissions reductions.
• For fossil fuel generators, the R&D subsidy does not affect electricity prices, but does significantly reduce fossil fuel generation in the second stage. Fossil fuel generators could therefore face costs associated with stranded assets or variable costs resulting from lower capacity utilization (these costs are not modelled). But transaction costs associated with decreased fossil demand are likely lower in this scenario since a majority of reductions occur in the second stage. Thus, the transition period for the fossil sector to adjust to decreased demand is long and has the potential for costs to be minimized.
• For government, the R&D subsidy requires the largest disbursement of all the instruments. That said, promoting innovation is a government policy and therefore R&D subsidies are generally part of the desired policy approach to decarbonization. However, given the longer term nature of the reductions associated with R&D, a government faced with a carbon reduction target would likely not achieve significant reductions in the short term with an R&D subsidy.
• From society’s perspective, the welfare costs are greatest under the R&D subsidy.

• An increase in the baseline electricity price. The sensitivity analysis shows that the price differential between renewables and the electricity price is an important determinant of the size of the welfare cost. This price differential also affects the desirability of an RPS versus a renewable generation subsidy. These results can also be expected when the price of renewables changes, where a decrease in the price of renewables would produce results that are directionally similar to an increase in the electricity price.
• An increase in the baseline price of natural gas. The sensitivity results indicate that increasing natural gas prices have a minimal impact on the results. Increasing gas prices could, however, increase the price of electricity.
  
  THE SENSITIVITY TESTING CONCLUDES THAT THE RESULTS ARE ROBUST TO CHANGING KEY VARIABLE ASSUMPTIONS. INDEED, OUR CORE OBSERVATION HOLDS: THE ECONOMIC EFFICIENCY AND ENVIRONMENTAL EFFECTIVENESS OF THE FISCAL INSTRUMENTS IS LINKED TO THEIR ABILITY TO INFLUENCE THE ENTIRE ELECTRICITY MARKET AND THE THREE DECARBONISING DRIVERS IN PARTICULAR. A FISCAL INSTRUMENT WILL GENERALLY BE MORE EFFICIENT AND EFFECTIVE IF IT SIGNALS TO MULTIPLE AGENTS IN THE ELECTRICITY MARKET THAT CARBON IS MORE EXPENSIVE: FOSSIL FUEL PRODUCERS WILL REDUCE THEIR EMISSIONS INTENSITY, RENEWABLE PRODUCERS WILL PRODUCE MORE WHEN THE PRICE DIFFERENTIAL BETWEEN RENEWABLE GENERATION AND FOSSIL FUEL GENERATION DECREASES, AND CONSUMERS WILL CONSERVE. THIS FINDING HOLDS UNDER MULTIPLE INPUT ASSUMPTIONS AND EXPLAINS WHY AN EMISSION PRICE IS PREFERABLE TO AN RPS OR RENEWABLE GENERATION SUBSIDY [AND TO THE COMBO AND R&D SUBSIDY?]. A GOOD EXAMPLE OF THE INCREASED RISK IN USING A SINGLE INSTRUMENT IS HIGHLIGHTED BY THE R&D SCENARIO, IN WHICH THE REDUCTION OF EMISSIONS RELIES ENTIRELY ON THE ABILITY OF DOMESTIC R&D INVESTMENTS TO PRODUCE INNOVATION THAT REDUCES THE COST OF RENEWABLE GENERATION. ALTHOUGH R&D SPENDING IS EXPECTED TO REDUCE THE COST OF RENEWABLE GENERATION, THERE IS UNCERTAINTY ABOUT THE SCOPE OF THE REDUCTIONS AND THEREFORE THE EFFECTIVENESS OF THE FISCAL INSTRUMENT.

Notes

1 It is widely recognized that issues related to grid access, grid capacity and the costs of grid extension will be particularly influential in determining the practical potential of grid-power RETs. While these issues are beginning to be addressed in some regions, they are far from being resolved at this time. Further consideration of these issues is well beyond the scope of this case study.

2 While it is not strictly true that fossil fuel technologies will experience no technological advance, incorporating a rate of advance in the model would complicate the analysis without adding substantial insight.

3 It is recognized that electrical production is increasing over time, but total electricity generation in the model is fixed in both stages so that the effects of the instruments on demand and supply can be better understood.