Cleaner transportation (summary)

Table of Contents

1.1 Objective
1.2 Methodology
1.3 Issue context
1.4 Research and discussion summary
1.4.1 Encouraging the purchase of Phase II PM prior to 2007
Table 2: Summary Evaluation of Instruments
1.4.2 Increasing sales of full Phase II above the 50% requirement, 2007-2009 period
1.4.3 Encouraging retrofits and accelerating scrappage
1.4.4 Accelerating demand and supply of ULSD
1.5 Areas of agreement and disagreement
1.6 Key observations

1.1 Objective

The Cleaner Transportation Working Group (CTWG)'s mandate was to:

design fiscal instruments to facilitate the adoption of cleaner fuels and engines to promote the transition to cleaner transportation in the diesel-based freight and mass transit sectors.

During the project, the mandate was broadened slightly to also consider off-road trucks and diesel. The CTWG specifically investigated EFR measures to complement the large trucks and buses and diesel components of the February 2001 Canadian Environmental Protection Act's Notice of Intent for Vehicles, Engines and Fuels.¹

1.2 Methodology

The CTWG identified technical opportunities to reduce emissions from diesel-based trucking and transit, barriers to the take-up of these opportunities, and "straw dog" fiscal measures for further research. Four objectives, and fiscal options for addressing them, were identified for further design and research. The research involved:

• a literature survey on the experience with the instrument in other developed economies;
• gathering data bearing on the effectiveness and cost of the instrument in Canada;
• examination of alternative designs for the instrument;
• consideration of implementation problems that might arise in Canada; and
• consideration of the distributional effects of the instrument among those directly affected, including trucking firms, shippers, customers, engine manufacturers, and the petroleum industry.

Limited time, budget, and readily available data precluded quantitative analysis. Instead, the analysis was descriptive, focusing on design issues, implementation problems, lessons to be learned from similar measures applied elsewhere, and a more subjective assessment of relative costs and effects.

The CTWG reviewed the consultant's report and reached conclusions about the measures, as well as about the lessons the case study offered for the general applicability of EFR in Canada. These are noted in the final part of this section.

1.3 Issue context

The United States has proposed regulations for on-road heavy-duty diesel (HDD) vehicles that will substantially reduce emissions of particulate matter (PM) in the 2007 model year and will phase in substantial reductions of nitrogen oxides (NOX) and non-methane hydrocarbons (NMHC) between 2007 and 2009. During that time, half of the engines sold must meet the 2007 standard for NOX and NMHC (full Phase II), while the other half may meet previous standards plus the 2007 standard for PM (Phase II PM). The engines that will meet these "Phase II" standards will require fuel with less than 15 ppm sulphur (i.e., ultra-low sulphur diesel fuel-ULSD), so a limit of 15 ppm will be imposed on on-road diesel fuel sulphur content in 2006. Canada has announced its intention to match these standards, although it is not clear that Canada will apply the 50% market share rule in 2007-2009.

1.4 Research and discussion summary ²

The set of instruments selected for investigation fell into two groups: those affecting engines and those affecting fuels. Emissions from vehicles and engines depend upon vehicle/engine technology and the properties of the fuels. In some cases, vehicle emissions control systems cannot operate properly without the right fuels. Fuels and engine emissions were therefore approached as an integrated system, consistent with the approach being taken under CEPA. For engines, the intent was to accelerate take-up of new generation clean engines and retrofit technologies, and to encourage scrappage of more polluting engines. The measures analysed were:

• accelerated capital cost allowance (ACCA) for cleaner engines and retrofit technologies, fee/rebate for new vehicles, or tax credit for cleaner engines and retrofit technologies; and
• fiscal instruments to accelerate the scrappage of older vehicles.

For fuels, the intent was to accelerate penetration of ULSD. The two approaches studied were:

• a tax on the sulphur content of diesel fuels; and
• ACCA for refinery and infrastructure upgrades to supply cleaner diesel.

These fiscal instruments operate by changing the after-tax prices of engines, retrofit devices, and fuels for the buyer, thereby creating incentives to change behaviour. The effectiveness of the instrument depends on the responsiveness of buyers (trucking companies) and sellers (vehicle manufacturers and fuel refiners) to price changes, which depends on the structure of the market. Since the Canadian market for trucks and truck engines is only 10% of the North American market, the markets are integrated and the industry is reasonably competitive. Prices should, therefore, be similar in both countries and should reflect production costs in the absence of regulations. However, the emissions control regulations considered here will substantially alter some prices.

1.4.1 Encouraging the purchase of Phase II PM prior to 2007

To induce production and sales of Phase II PM engines prior to 2007, Canada would require a fiscal incentive at least as large as the extra cost of producing these engines. Current estimates of these costs range from about $1,100 for a light HD truck to over $1,700 for an urban bus. If the ULSD fuel required by these Phase II PM engines is more costly than regular diesel fuel, the fiscal incentive to induce truckers to buy these engines would increase to between $1,350 and $3,660. If there is a serious intention to encourage the early sale of these engines in Canada, a substantial fiscal incentive will be required, and it will be very helpful if another fiscal incentive is used to eliminate any price penalty for using ULSD fuel.

Whether or not Phase II PM engine production could be advanced prior to existing regulatory timelines was not known. Sufficient time would be needed to test for roadworthiness in addition to actual production. This is a key consideration. Unless there is the ability to supply market-ready engines, no fiscal instrument will work.

Use of the full Phase II vehicles and engines requires access to ultra-low sulphur diesel. Some operations, such as municipal transit or off-road operations, function in a limited geographic area and could use cleaner vehicles and engines as long as ULSD were available regionally or locally. Other operations, such as long-haul trucking, would require access to ULSD across large territories and sometimes into the U.S. Since the supply of ULSD will not be required under regulation until 2006, this may present a significant barrier.

1.4.2 Increasing sales of full Phase II above the 50% requirement, 2007-2009 period

When manufacturers are required to meet the full Phase II standards in half of the engines they sell, they will have to price them no higher than Phase II PM engines or they will not sell. This means that manufacturers will make high profits on Phase II PM engines and low profits or losses on full Phase II engines during 2007-2009. If Canada does not adopt a market share requirement to match the U.S. requirement, we should expect to see few full Phase II engines offered for sale here and more higher-emission Phase II PM engines. It is, therefore, assumed that Canada will adopt a 50% market share requirement to match the U.S. situation.

Increasing sales of full Phase II engines during 2007-2009 will be more difficult because the manufacturers will already be constrained by the 50% market share requirement. If manufacturers cannot supply half of the market with full Phase II engines in 2007, no fiscal instrument will increase their sales in Canada. If there is excess full Phase II capacity, a fiscal incentive applied to the price of a vehicle will still not induce manufacturers to increase their production of full Phase II engines unless it fully compensates for the increased costs associated with this engine compared with a Phase II PM engine. The incentive would have to be worth between $2,000 for a light HD truck and $3,200 for a heavy HD truck based on recent cost estimates. This assumes that ULSD fuel is the only on-road fuel available or that ULSD is priced no higher than higher sulphur diesel fuel if the latter is also available. However, with ample manufacturer capacity, a fiscal instrument that more than offsets these costs could greatly increase the proportion of full Phase II engines sold in the Canadian market.

The cost to the federal treasury of a fiscal instrument for the pre-2007 period will be proportional to the number of vehicles sold with Phase II PM engines, so it will be modest unless the program is very successful. In the 2007-2009 period, the instrument will apply to all full Phase II engines sold, and half of all engines must be of this type. Thus, the fiscal cost of the policy for 2007-2009 may be as high as $100 million per year even if the program fails to increase market share beyond 50%, unless the instrument is revenue-neutral.

In looking at the specific fiscal instruments to achieve the above goals, there does not appear to be a federal excise tax that could be reduced to have this effect. The GST is not appropriate, since trucking firms reclaim their GST through an input tax credit and the non-profit MUSH (municipal, university, schools, hospitals) sector pays only a fraction of the GST. A new tax on high-emission vehicles would be administratively feasible but perhaps politically difficult. A fee/rebate would require a new tax, but at least the taxes on high-emission vehicles would be balanced by rebates on low-emission vehicles, so it could be designed to be revenue-neutral. The fee/rebate could be tailored precisely to give the desired incentive for any number of vehicle classes. An income tax credit could work well for new vehicle purchases and could be tailored to match the incentive needed for different vehicle classes; however, it would not affect the MUSH sector. An accelerated capital cost allowance would be feasible, but it would be hard to tailor to the incentive needed for different vehicle classes and would not affect the MUSH sector. The rigidity of the ACCA makes it appear inferior to the tax credit. Both the income tax credit and the ACCA involve pure tax expenditures; they are not revenue-neutral. Subsidies are also feasible. They could affect both the for-profit and MUSH sectors and could be tailored as precisely as a tax credit. Emission-reduction credits can be tailored precisely and are feasible in jurisdictions where there is an active market, which does not include most of Canada. The fee/rebate, therefore, seems the dominant instrument, with subsidies ranking next, the tax credit third, and ACCA and emission-reduction credits last.

Discussion within the working group centred on the design challenge for a fiscal instrument to encourage the sale of full Phase II engines above the 50% threshold mandated by regulation. The challenge was how to avoid a "windfall" situation, where buyers of the first, mandated, 50% would qualify for an incentive intended to motivate buyers beyond that threshold. One option discussed was for a tax credit whose size would be estimated retroactively, based on the increment of sales above 50% achieved in the overall market. This approach was criticized because it could not provide consumers with certainty about the size of the incentive they would obtain and would, therefore, lose much of its motivating value. Another option was to move the incentive up the supply chain, from the purchaser to the point of manufacture or point of sale. A manufacturer or seller's incentive could be designed to apply in proportion to the amount by which manufacturer's sales exceeded the 50% mandated threshold. Unfortunately, the CTWG did not have enough time to explore this idea in more detail.

The majority of operators in the trucking sector are small companies and family businesses, which often run at a very small margin of profitability. It would be critical, therefore, to ensure that any EFR instrument be both effective and equitable in its application to small businesses.

1.4.3 Encouraging retrofits and accelerating scrappage

Today's heavy-duty diesel engines emit far less pollution than engines built a decade ago, and the engines of 2007 will be far cleaner still. The emissions of old, dirty engines, therefore, represent an increasing proportion of total vehicle emissions. This problem can be attacked through the retrofit of pollution control devices on old engines and by encouraging scrapping.

Some of the fiscal instruments that can influence the purchase of new vehicles are less effective for retrofit. There is no federal excise tax to reduce, and even if there were it could not make retrofit economical. A fee/rebate seems inapplicable to retrofit costs. A new excise tax cannot induce the purchase of retrofit devices. Income tax credits could be effective for for-profit owners, but not for the MUSH sector. An annual registration fee or tax could be used to help induce retrofit, but the amount of the tax would have to be large and a federal registration tax would be problematic in Canada. Subsidies and rebates have been effective elsewhere in encouraging retrofit and could work here, but they are not revenue-neutral. Of these alternatives, a subsidy program seems best, as it would appeal to all types of vehicle owners and it could be designed to provide just the right amount of incentive for different vehicle classes and ages.

Scrapping the oldest or dirtiest vehicles can be a cost-effective means of reducing emissions. The principal instrument used to encourage scrapping of old vehicles is the "buy back" program. Automobile buy-back programs have retired tens of thousands of vehicles in the U.S., while smaller numbers were retired in British Columbia under its Scrap-It program. Firms that wanted to create emissions reduction credits for their stationary sources developed many of the U.S. programs, but some have been publicly funded. A buy-back program for trucks could be effective, but it might be useful to conduct further study and perhaps run a pilot program before launching such an initiative. Age-based registration fees could also be used to encourage scrapping of the oldest vehicles, but there is little experience with this instrument and it would be problematic at the federal level in Canada.

The working group concluded that the instruments for encouraging retrofits and accelerating scrappage seem to hold the most potential for reducing emissions from HDD trucks and engines. From the purchaser's perspective, the equal increase in the price of all new vehicles forecast for the 2007-2009 period (as the economic analysis concludes, above) may lead the purchaser to decide not to purchase a new truck at all. Accordingly, an EFR instrument to encourage scrappage is an essential component of an overall cleaner HDD package. Vehicles qualifying for pilot scrappage programs have usually been those failing to meet provincial emissions tests. A federal program might want to allow more vehicles to qualify, in order to accelerate the shift toward adoption of the cleaner HDD trucks and engines. Any cost-benefit analyses of the retrofit and accelerated scrappage programs should include evaluation of the health benefits and greenhouse gas emissions impacts in addition to clean-air benefits.

While the analysis of the working group was conducted from a national perspective, looking at clean air issues from a regional health perspective might lead to greater emphasis on specific EFR instruments. Where there exist regional and local air pollution "hot spots," more costly subsidy or expenditure programs, such as scrappage and retrofits, could be considered for targeted implementation. These could be part of a regional package that would also include transit system improvements. There are also regional variations in the provincial policies being used to address clean air issues. For example, emissions reduction credits (ERCs) are in place in some parts of the country, notably in southern Ontario. ERCs enable private firms to participate in financing retrofit and scrappage programs. Another example is the pilot scrappage programs in B.C. A national retrofit or scrappage program would need to include some sort of equivalency clause to allow existing provincial or municipal programs to substitute for the national program.

1.4.4 Accelerating demand and supply of ULSD

It was assumed that Canada would adopt regulations requiring that all on-road diesel fuel sold beginning in September 2006 contain no more than 15 ppm sulphur, with no exception for small refiners. In this case, the role of a fiscal instrument could be to encourage the introduction of this ULSD fuel prior to 2006 or to encourage the reduction of sulphur in fuels other than on-road diesel fuel. A number of countries have found differential fuel taxes that increase the cost of high-sulphur fuel relative to low-sulphur fuel to be effective. The pace at which the industry responded in Europe and Asia, however, is not very relevant to Canada, because the different refining and shipping situation there allowed them to cross-ship available low-sulphur fuel from one country to another more readily than can be done in North America. It was determined that an increase in the tax on on-road diesel fuel that has more than 15 ppm sulphur might accelerate the date of introduction of that fuel. This increase could be coupled with a temporary reduction in the tax on ULSD fuel, to maintain revenue-neutrality. With respect to off-road diesel fuel, its sulphur content is likely to fall when ULSD becomes mandatory, because some companies may find it uneconomical to supply two different fuels to all locations.Further reductions could be achieved by applying a tax to off-road diesel fuel that had more than a specified sulphur content, perhaps 50 or 100 or even 500 ppm. There is some advantage to maintaining a higher sulphur level in off-road fuel than in on-road fuel, as significant costs may be saved with little loss in benefits. Further U.S. regulations of off-road diesel fuel are expected to be proposed toward the end of 2001, which may influence plans here in Canada.

The application of an accelerated capital cost allowance as a way to accelerate or broaden the reduction of sulphur in fuels would be unlikely to have much effect and may be complex to administer. The discussion on accelerating demand for ULSD centred on the logistical issues associated with advancing its supply. As noted above, certainty of ULSD supply is a determinant for the successful introduction of cleaner engines.

The early supply of ULSD may run up against two barriers. First, the majority of fuel in Canada is distributed through common-carrier pipelines. These pipelines cannot distribute ULSD through the system at the same time as higher sulphur diesel without contamination. However, in some parts of the country, notably Atlantic Canada, fuel is also distributed through proprietary pipelines or by truck. This means that ULSD can be distributed in advance of the 2006 timeline, but in limited quantities and only in limited geographic areas. Second, the 2006 deadline for ULSD supply will be implemented in Canada at the same time as in the United States, requiring the upgrading of 194 refineries on the continent-18 in Canada, and 176 in the U.S. These upgrades draw on the same labour supply as the expansions of the oil sands and offshore sites. A continental labour shortage is already being felt in this sector. The 2006 deadline will put Canadian refineries in competition with U.S. refineries, the oil sands, and offshore oil developments. Members of the CTWG had different views as to whether Canadian refineries would be able to advance their construction dates to provide an early supply of ULSD in response to a market signal. Some felt it was not possible, while others thought that an instrument to encourage the staggering of refinery upgrading would be beneficial.

Those against a tax differentiation felt that such a measure would be in conflict with the one-step regulatory approach, which the industry has supported in Canada. This system requires all refiners to meet the same standard on the same date, unlike the U.S. system. Concerns about distribution and about capacity to implement the refinery upgrades are reasons why the Canadian refinery industry has supported this one-step approach. Another argument was that it would not be possible to precisely tailor a tax to the exact sulphur levels found in diesel. The tax could differentiate fuels with concentrations of sulphur above 15 ppm from those with concentrations below this level, but there exists a wide variation in the sulphur content of diesel fuels above the 15 ppm level. It varies by refinery, by season, and by batch. It would be administratively complex for a tax to reflect these actual levels.

Members of the CTWG who supported a tax differentiation focused on reasons for providing incentives for an advance ULSD supply. These are as follows: earlier health benefits from reductions in the sulphate contribution to PM; providing market signals that reward firms making an early transition to ULSD production; early availability makes possible more aggressive retrofits of existing HDD trucks and buses, and enables lower-emission vehicles to be operated sooner; and providing incentives for earlier construction of ULSD production facilities encourages staggered construction prior to the 2006 deadline.

Unless it is well designed, it is possible that a tax differential could simply lead fuel suppliers to pass on price differentials to consumers, negating any after-tax price differential at the pump. This scenario is plausible since the drivers of Phase II vehicles are "captive" to their need for ULSD and must buy it whatever the price. The intensely competitive fuel market will determine the price at retail, based on many factors of which taxes are only one. Thus, it cannot be predicted with certainty how a tax differential would affect final price at the pump.

1.5 Areas of agreement and disagreement

The working group agreed that the following EFR instruments should undergo further analysis:

• either a tax credit or a fee/rebate instrument, to encourage sales of the full Phase II engines above mandated thresholds in the period prior to 2009. For fiscal and policy reasons, the instrument would need to be designed to avoid a "windfall" for the Phase II engines required by law in the 2007-2009 period;
• a subsidy program for vehicle retrofits; and
• a buy-back program to accelerate the scrappage of more polluting HDD trucks and buses.

All of these instruments should be designed to be effective and equitable for the large number of small operators in the trucking industry.

The CTWG was not able to reach agreement on a recommendation regarding the use of a differentiated tax to accelerate demand and supply of ULSD prior to 2006.

1.6 Key observations

Three key context factors were found to have intense influence on the "real life" applicability of the instruments that were explored:

• For some issues and in some sectors, it may be more difficult to use EFR in Canada than in the U.S. The continental nature of the truck and engine manufacturing industry, combined with the comparatively modest size of the Canadian market, leaves little room for autonomous Canadian policy. We are effectively policy takers in this field. But having fewer actors in the Canadian market and/or fewer regional sources of environmental impacts makes some of the economic instruments being used in the U.S. clean air agenda (such as averaging, banking, and trading) less relevant here.
• In the context of a highly competitive market and a regulatory requirement for 50% of engines sold to meet the full Phase II standard during the 2007-2009 period, the market will move to eliminate any price differential between traditional engines and the full Phase II engine, and maintain their production at the 50% balance. In order to be effective, an economic instrument would have to send a signal larger than the increased cost of manufacturing full Phase II engines. In order to be equitable, the economic instrument would likely have to apply to all purchases of full Phase II engines, not only those above the 50% quota, since these would not be readily identifiable. This begins to look like a very costly program.
• Even if this issue is addressed, technological rigidities-such as the state of technologies, or the lead times required to road test and produce the new engine lines or to bring ULSD on-line-may preclude a rapid market response. In the CTWG's case study, the vehicle technology depends on parallel action on the fuels side. There is no point in speeding up production of cleaner vehicles if the cleaner fuels are unavailable. The U.S. EPA estimates that ULSD must have an 80% market availability in order to ensure that misfuelling of new engines does not occur.

These "real life" factors have a strong influence on the effectiveness of EFR tools.

While the sector focus of the CTWG's mandate encouraged it to delve in some depth into market and technology characteristics, it excluded consideration of some broader measures. For example, the CTWG looked specifically at how to reduce emissions from HDD truck and bus transportation. But some tools, such as differentiated fuel taxes, could be applied more widely within the petroleum products sector to all fuels. Other tools, such as vehicle scrappage funded by private industry seeking emission-reduction credits, may work best between sectors. The case study also revealed the importance of thinking through where in the supply chain it is most effective to target the EFR instrument. In the case of a market with few, large actors, engine manufacturers and fuel refiners are in a position to determine what product is supplied. Demand from individual purchasers is much less able to effect changes. The challenge for EFR analysis and design is to maintain breadth in the application of possible instruments.

Market characteristics matter, and attention must be given to the availability of close substitutes, especially where fiscal measures are contemplated that would encourage or discourage purchase of a given class of goods. Due attention must be given to supply-and-demand conditions. An example is the case of differential taxes on low- versus high-sulphur fuels. If relatively few people are operating vehicles that require the low-sulphur sort, the representative user will be indifferent between types. This means that, whatever the tax regime, consumers will not permit price differences between the two to persist. And presuming different cost structures, this means that two fuels will not coexist on the market.

The economic analysis revealed that the backdrop of the existing and planned regulations has a significant influence on the effectiveness of EFR measures. They should, therefore, be designed to take into account known features of pending regulations and be consistent with them. Some of the EFR options proved difficult to introduce in advance of the regulations coming into effect in 2006 and 2007. This suggests a long lead time is needed if EFR is being used to accelerate incrementality-to move beyond compliance. This means that EFR must be considered at the inception of the policy maker's discussions of management options.

The experience in exploring the potential use of EFR as a complement to regulation might have been different had the regulatory framework not already been largely determined and, in fact, set by U.S. initiatives. If Canada were able to exert more policy independence, and if the management options were still in development, more opportunities for EFR as a substitute for certain aspects of the regulations might have been found. For instance, could EFR substitute for the mandated 50% sales of full Phase II engines in the 2007-2009 period? Could it do so in a way that would avoid the apparent rigidity of this 50% target and create an incentive for continuous improvement beyond 50%?

Another useful role for EFR measures would be to ensure that they continue to deliver on the incrementality front even if the regulatory backdrop fades away. "Error-tolerant design" would allow for the fact that regulatory targets might be postponed or cancelled (indeed, successful EFR could trigger just such a thing by obviating the regulatory target).

Notes:

1. Environment Canada, “Taking Action on Vehicles, Engines and Fuels to Clean the Air and Protect Human Health,” www.ec.gc.ca/air/taking-action_e.shtmlhttp://www.ec.gc.ca/air/taking-action_e.shtml
2. For the full research report, see Dewees Consulting Limited, “Fiscal Instruments for Diesel Emission Reduction: A Preliminary Analysis,” Report to the Cleaner Transportation Working Group, NRTEE, Toronto, October 1, 2001.