kyoto canada case

7/31/2019 Kyoto Canada Case

1/41


2/41

The Study in Brief

The Kyoto Protocol mandates a set of country-specific reductions of emissions of "greenhouse" gases that

absorb and re-emit infrared rad iation. Canad a h as agreed to a target of six percent below 1990 levels by

the end of the decade, wh ich w ill require about a 30 percent absolute emissions cut. Canadian Pr ime

Minister Jean Chretien recently pledged that his governm ent w ill ask Parliamen t to ratify the Kyoto

Protocol before the end of the year. In light of the sparse information about how Kyoto will be

implemented and how mu ch it will cost, this timetable is, at best, precipitous; at w orst, it risks serious

economic damage.

The federal government released a Discussion Paper last April outlining four hyp othetical optionsfor achieving compliance. We discuss some of the economics behind the estimated policy impacts, and

conclude, amon g other things, that the Discussion Pap er does not p rovide an ad equate basis for making

an informed decision on Kyoto. Given the scale of the policy comm itment an d the p otentially far-

reaching economic effects, without a more th orough un derstand ing of the economic imp acts a decision to

ratify on the basis of wh at has been presented thu s far w ould be p recipitous.

The Authors of This Issue

Ross McKitrick is Associate Professor, Depar tment of Economics, at the University of Guelph . Randa ll M.

Wigle is a Professor in the Dep artm ent of Economics, Wilfrid Laurier Un iversity.

The Border Papers

The Border Papersis a p roject on Canad as choices regarding North Am erican integration. It is prod uced

with financial support from the Donner Canad ian Found ation and guidance from an ad visory board w hose

members are draw n from business, labour, and research organizations.

* * * * * *

C.D. Howe Institu te Commentary

is a periodic analysis of, and comm entary on, current pu blic policy issues. The man uscript was copy ed ited by

Kevin Doyle and prepared for publication by Marie Hu bbs. As with all Institute pu blications, the views expressed h ere are those of the authors,

and do not necessarily reflect the opinions of the Institutes mem bers or Board of Directors. Quotation with ap propriate credit is p ermissible.

To ord er th is pu blication, plea se conta ct: Renouf Pu blishing C o. Ltd., 5369 Canotek Rd., Unit 1, Ottaw a K1J 9J3 (tel.: 613-745-2665;

fax: 613-745-7660; e-mail: order.dept@reno ufboo ks.com), or the C.D. How e Instit ute, 125 Ad elaid e St. E., Toron to M5C 1L7 (tel.: 416-865-1904; fax:

416-865-1866; e-mail: cdh owe@cdh owe.org).

$12.00; ISBN 0-88806-574-4ISSN 0824-8001 (print); ISSN 1703-0765 (online)


3/41

Canad ian Prime Minister Jean Chretien recently p ledged that h is

government w ill ask Parliament to ratify the Kyoto Protocol before the

end of the year. In light of the sp arse information about how Kyoto willbe implemented and how mu ch it will cost, this timetable is, at best,

precipitous; at w orst, it risks causing serious economic damage.

This treaty mandates a set of country-specific reductions in emissions of

greenh ousegases that absorb and re-emit infrared rad iation. The rationale for

the policy is the belief that increasing concentrations of these gases in the air

affects the global climate in ways that m ay be harm ful to hum ans and the

ecosystem.

The Kyoto Accord grew ou t of studies done by th e Intergovernmental Panel on

Climate Change (IPCC), which was formed in 1988 to help coordinate research in

scientific and socio-econom ic aspects of climate change. The organ izations Second

Assessment Report, released in 1996, concluded that climate change had taken

place and that at least some of it could be attributed to hu man activity. As a result,

governments around the world, includ ing Canad as, ad opted a goal of redu cing

so-called g reenhouse gas em issions. This led to the Kyoto Protocol in 1997. In 2001,

the IPCC released its Third Assessmen t Report (IPCC 2001), restating itsconclusion that there w as a hu man influence on climate.

The major gases involved are w ater vap our, carbon d ioxide and methan e. The

Kyoto Protocol names several other gases as well. For policy purposes, attention is

focused on CO2 (carbon dioxide), because it is emitted in large volumes

worldwide. Canadas obligation is to reduce emissions of carbon dioxide six

percent below 1990 levels. The target mu st be attained on average over the p eriod

2008 to 2012.

Prime Minister Chretien has now committed the federal governm ent to ratifythe treaty before year s end. This Commentary w ill outline the reasons w hy that

timetable is an un realistic and un sound policy.

The govern ment released a Discussion Paper (DP) called Canada s

Contribution to Add ressing Climate Ch ange.It outlines four policy p ackages

(called h ere the Options) that could be u sed to imp lement the treaty shou ld it

become binding on u s.

The three-fold p urp ose of the DP is to:

prop ose four Op tions for m eeting Kyoto obligations

present economic cost estimates of the Options

provide a basis for pu blic consultations on whether Can ada should r atify

Kyoto.

C.D. Howe Institute Commentary 1


4/41

2 C.D. Howe Institute Commentary

Box 1:Glossary of Terms

Annex B Countries Annex B of The Kyoto Protocol lists the countries w hich have m adecommitmen ts to reduce carbon dioxide emissions. This group of nations is mad e up o f

high-income Western nations, in add ition to several Central European nations.

Cap-and-Trade Permit Program Under a cap-and-trade permit system, the regulatory authority

sets a limit (cap) for emissions an d allocates or auctions that am oun t of perm its to emitters.

In the US, wh ere this has been used most, the rights to emit (allowan ces) are for the most

par t allocated (or grand -fathered) to firms at no cost. Firms w ith allowances that exceed

their actual emissions can sell the difference. Compan ies with emissions that exceed th eir

allowance must p urchase the d ifference.

Carbon S inks Carbon d ioxide can be kep t out of the atm osphere if the associated carbon can be

stored in a forest or in the soil. The Kyoto Protocol perm its credit to be gained wh en

nations expan d th e size of their carbon sinks.

Clean D evelopment Mechanism The Clean Developm ent Mechanism or CDM is one of the

Kyoto Flexibility Mechanisms. It allows Ann ex B nations to fund greenhou se gas

abatement p rojects in developing n ations and ap ply the emissions reductions achieved

toward meeting th eir Kyoto Protocol Target.

CGE Mode l A Comp utable General Equilibrium (CGE) mod el is an economic model of a real

wor ld economy. Firms an d consu mers in su ch mod els act to maximize profits or welfare

wh en given know ledge of how the tax and regulatory p olicies in place work. They are

par ticularly useful for evaluating the imp act of policies which are new in form or stru cture.

Double Dividend An environmental tax is said to generate a double dividend when the

revenu e from the tax is used to red uce other more d istorting levies in such a w ay as to

enable economic activity to expand .

Flexibility Mechanisms The Kyoto Protocol has a n um ber of Flexibility Mechanisms intend ed

to help red uce the cost of compliance. These includ e the Clean Developm ent Mechanism

(CDM) and Joint Imp lementation (JI) and international p ermit trad ing.Grand-fathering Allocating em issions perm its (or allowances) to existing p olluters, usually

based on their past emissions history.

Hot Air The Kyoto P rotocol specifies Russias emission target a s 100 percent of 1990

emissions. How ever, since 1990, the Russian economy has alm ost collapsed . As a result, it

is expected that Russias emissions of GHGs will be significantly below 1990 levels, even if

no effort is mad e to redu ce emissions. Hot air is the am oun t of permits Russia could sell

even without engaging in any emissions reduction plan.

Joint Implementation The process whereby an investor Annex B country can fund abatementprojects in host Ann ex B coun tries and get credit toward the investor countrys Kyoto

target.

Revenue Recycling If tax revenue from an environm ental tax is used to redu ce other taxes or

redu ce the debt, the revenu e is said to be recycled.

Social Costs Costs incurred by som e agents in the economy as a resu lt of a policy, which do n ot

h


5/41

Part 2 will examine th e economic issues and Part 3 w ill focus on th e Op tions

themselves. Part 4 will commen t on the m odeling techniques u sed. Part 5 will

discuss the policy implications. From this discussion it will be clear that there is nosolid information on the social or economic costs or the environmental benefits, if

any, of implementing Kyoto.

Some of the jargon and terminology we u se are summ arized in Box 1.

We will focus on evaluating the proposals as stated in the federal Discussion

Paper. We conclude, am ong other things, that the Discussion Pap er d oes not

provide an ad equate basis for making a decision on Kyoto. That is, the analysis to

date d oes not provide sufficient information to un derstand the economic

consequences and risks of accepting the Kyoto target as legally binding. Given the

scale of the policy commitment and the potentially far-reaching economic effects,

without a m ore thorough un derstand ing of the economic imp act a decision to

ratify on the basis of wh at has been presented thu s far w ould ind eed be

precipitous.

A key problem is that th ere is no cost of Kyotoestima te. The cost estimates in

the DP and in related stud ies are very sensitive to the specific tools used to achieve

compliance. To d ate, the federal governm ent h as not committed itself to anyspecific policy p ackage, so cost num bers have been hyp othetical and based on

implementation strategies that Ottawa h as not embraced and in some cases has

explicitly rejected, as in the case of carbon dioxide taxes. A key message of this

stud y is that seemingly minor changes to the p olicy regime can ad d man y billions

of dollars to the overall imp lementation costs. As a result, the paper does not

prod uce a genera l cost of Kyotoestim ate. Kyoto is a target, n ot a p olicy. One can

only estimate the costs of specific policy choices that might be made for achieving

the Kyoto target.

The four Options p resented in the Discussion Paper prop ose policy tools that

have th e potential to be very expensive, depen ding on certain contingencies that

have not been fully analyzed.1 Costs are provided for only two of the four Options,

and the results that are available suggest that small changes in th e policy m ix or

the international context can h ave large imp acts on the economy.

Moreover, seemingly minor changs to the p olicy can add man y billions of

dollars to overall costs, the m ix of policies proposed in the DP are un likely to beeven remotely cost-effective. This means that whatever they achieve can be done at

lower economic cost w ith better-designed instruments.

The motivation for Kyoto is that many credible scientists believe carbon

dioxide accumu lation in the atmosphere will change th e climate in ways harmful

to hu man s on a global scale. The Kyoto options are ultimately intend ed to add ress



6/41

wh ether th e estimated benefits (on a global or country scale) exceed th e estimated

costs is something that the DP does not ad dress. Consequently, we do not

comment on this aspect of the p olicy issue. However it ought to be given p roperconsideration as part of the process of deciding on ratification.

PART 1: The Kyoto Protocol

The Particular Challenge of Carbon Dioxide

Canada has long experience in air pollution-control policies, however carbondioxide is in some ways different than smog-related air pollutants. First of all,

other than its possible role in changing climate, carbon dioxide is not considered a

pollutant an d is not p art of conventional provincial air qu ality regulations. Second ,

most smog-related pollutants can be controlled through end-of-pipe treatment,

such as scrubbers on smokestacks, or more efficient burning technology. This is not

the case for CO2.

While improving energy efficiency can reduce CO2

emissions as well as other

air emissions, there is virtually no scope for reducing CO2 emissions by improving

the burning efficiency of the fuels (see, for instance, Jacques 1990). End -of-pip e

treatments for CO2 tend to be expensive because they involve captu ring the gas

and storing or sequestering it. The m ain ways of redu cing CO2 emissions involve

redu cing fuel consumption or switching to fuel typ es that generate less CO2 per

unit of energy. Of the three main fuels types, coal generates the most carbon

dioxide per un it of energy, folwloed by oil and natu ral gas.

Kyoto: Some Details

Treaty participants are divided into Annex B and non-Annex B countries. The

distinction refers to w hether th e country h as accepted an em issions reduction

target. Non-Annex B countries, such as Ind ia, China an d other d eveloping

countries, can join and ratify the treaty, though they are n ot required to cut

emissions.Annex B countries include the industrialized West and some former Soviet Bloc

mem bers. The treaty w ill enter in to force if it is ratified by 55 coun tries, includ ing

enough Annex B members to account for 55 percent of the Annex B emissions. As

of July 2002, 75 count ries had ratified th e Protocol, includ ing 23 Annex B members

ti f 36 t f A B i i Th US t f 36 1 t



7/41

issue in several years. Japans ratification does not seem to involve imminent

formal imp lementation plans.

Canada s Annex B share is only 3.3 percent, so its decision on its own is notparticularly influential in the larger context. However, if the Russian Federation

ratifies, then Canad a, Poland or a combination of smaller countries could p ush the

total emissions share over the 55 percent cut-off.

The US pullout from Kyoto has several contrasting implications. For one thing,

if Canada goes ahead with ratification on Mr. Chretiens timetable, there is a risk

that Canad ian ind ustr ial activity, especially energy-intensive activity, will decline

as emission-control policies begin to raise opera ting costs relative to the US. Foranoth er, if an international m arket for em ission p ermits forms an issue

discussed later in th is pap er the absence of the US will cause the m arket p rice to

be lower than wou ld otherw ise be the case. Since Canada expects to be a net buyer

this wou ld be h elpful. Third, if the US economy grows m ore quickly than it

otherwise wou ld because the US is not boun d by Kyoto this may translate into

greater export sales for Canada.

For the pu rp ose of the DP, emissions are measu red in megatonnes (tonnes are

metr ic tons) carbon dioxide equ ivalent,or MT. Canad as emissions as of 2010 are

projected to be 809 MT, while the Kyoto target is 571 MT. This creates a gap of

abou t 240 MT. The trea ty requ ires compliance, on av erage, over the p eriod 2008 to

2012 and treaty mem bers mu st subm it eviden ce of having mad e substantial

progresstoward s meeting th eir goals by 2005. The treaty does n ot specify w hat

hap pens after 2012, though p lans are being m ade for a subsequen t treaty that

wou ld tighten the targets furth er. There are no financial pena lties for non-

attainment of ones target, however a recently proposed ru le would require deeper

cuts in subsequent periods by par ties failing to meet their goals in the cur rent

compliance period.

Following the signing of the original treaty, negotiations at Bonn and

Marrakech in 2001 au thor ized the use of sinkscred its. Und er this arran gement,

Canad a, Japan , Russia and other countries are allowed to claim credits for the fact

that forest and plant growth within their boundaries draws CO 2 from th e air. In

Canadas case the original target was relaxed by 10 percent. That is, the country

can claim 24 MT worth of sinks from existing plant and forest growth.

Since then , Canad a has also sou ght 70 MT wor th of cred its for so-called clean

energy exports.Under this prop osal, if another country, for example, the United


If Canada goes

ahead on Mr.

Chretienstimetable

Canadian

industrial activity

will decline.


8/41

The Kyoto Effects

The original form of Kyoto required countries responsible for about half the

worlds CO2 emissions to reduce them to just under five percent below 1990 levels.

Because of economic growth, by 2010 emissions among participating countries

could be abou t 30 percent above th eir aggregate target. Consequently the original

Kyoto wou ld have led to a nom inal target amoun ting to a 15 percent cut in global

emissions as of tha t date (half of 30 percent).

However, there are leakage effects to consider. Redu ction in fossil fuel

consump tion in Annex B countries would lower the w orld p rice of fuels and

indu ce higher consum ption in non -Annex B countries. That development, as wellas migration of energy-intensive capital, would cause emissions to increase in non-

Annex B countries, partly offsetting the original emission reductions. The process

is known as the leakage effect.Global economic simu lations have found the

leakage rate to be anywhere from below 10 to almost 50 percent (see, for example,

Oliviera-Martins et al., 1992, Smith 1994). If the leakage rate is 30 percent, th en the

emission cuts in Annex B countries will induce emission increases elsewhere that

offset 30 percent o f the cuts. Und er the o riginal term s of Kyoto a 30-percent

leakage rate w ould imply total global emissions w ould fall by abou t 11 percent (15

times 70 percent).

The US withdraw al from Kyoto redu ces the imp act of the treaty furth er,

because the United States is responsible for over one-third of Annex B emissions.

While the United States proposed some unilateral initiatives, the countrys

withd raw al means abou t two-thirds of the w orlds emissions are not covered by

Kyoto. If the remaining participants reduce their emissions by 30 percent, this

amoun ts to a 10 percent cut in global emissions (one-third of 30 percent) as of 2010.But if the leakage rate is 30 percent, global emissions will only be reduced by about

seven percent against 2010 levels. Once we add in the credits for sinks given to the

remaining p articipants w e get an expected global emissions redu ction of about six

percent of 2010 emissions.

Kyotos climate impact was analyzed in a simulation model by Wigley (1998).

The original form of the treaty, und er the assum ption that add itional accords are

developed subsequently to keep em issions from going back u p to bu siness-as-

usual levels after 2012, only slowed the accumulation of CO 2 in the atmosphere bya sma ll amoun t. The concentration of CO2 reached at 2100 un der business-as-usual

wou ld be reached abou t five years later und er Kyoto-plus-subsequent treaties.

With 60 percent of the original emission reductions undone, this small delay

shrinks as w ell. Consequently Kyoto can, at best, only delay by abou t a few years

wh atever wou ld hap pen as a result of increasing CO in the atmosph ere un less the


The United States

withdrawal from

Kyoto means two-

thirds of world

emissions are not

covered by Kyoto.


9/41

backed up by regulation, and th ose that work by creating economic incentives.

Regulatory m easures, also know n as comman d-and -control,includ e such th ings

as emission regulations, requirements to install particular technologies,requirements to limit fuel use or reduce energy intensity. Incentive-based measures

include emission taxes and trad able emission perm its. Other m easures also exist

that are not so easily categorized. Subsidies for emission control are like incentive-

based m easures, whereas subsidies to ad opt p articular technologies can resemble

comman d-and -control, especially if the subsidy is only p artial reimbu rsement for

actions forced by regu lation. Ad vertising, aw areness-raising and moral suasion

are sometimes u sed in combination w ith other m easures. Their effectiveness is

hard to predict or measure.

Microeconomics of Pollution Control

Firms and consumers gen erate pollution because the emitting activities are

valuable in some way. If emissions are constrained by a policy measure, valuable

activity is foregone. This is what m akes p ollution control costly. These costs mu st

be w eighed against th e benefits of the em ission redu ctions. At a p articular target,there will be some am ount that a firm constrained by th e emissions policy w ould

be willing to pay for the right to increase its emissions by one unit, that is one

tonn e. This is the marginal value of the emissions, or altern atively, the margina l cost

of abatement.

Cost-Effectiveness

In the case of carbon dioxide there are millions of activities that generate

emissions. Each individual activity will have its own marginal value. It is

un reasonable to assume th at they are all the same or tha t they change at the same

rate. Ind eed w e w ould expect there to be large variations in these values. There is

no w ay to get enough informa tion to comp ute all these different values; however,

the fact th at th ey d iffer affects the choice of emissions control p olicy.

If a set of emission control p olicies is put in p lace, it allocates emission

redu ction targets across the various sources in some w ay. Once people have come

into compliance with these rules, it is possible that there will be wide variations in

the marginal values of the emitting activities at the constrained levels. For instance,

one compan y might be willing to pay C$500 for the right to emit one m ore tonne

while another would be willing to pay only $50. By implication the second



10/41

satisfy the equ imarg inal criterion. If it does, then once the p olicy has taken effect itwill not be possible to reallocate emission targets in a w ay that maintains the same

overall environmental effect, wh ile redu cing th e total abatement costs borne by

polluters. If the policy is not cost-effective then there would be some way to

reallocate emissions targets that reduces total compliance costs without increasing

total emissions. The equimarginal ru le thus ensures tha t society gets the most


Table 1: Summary of Emission Reductions Assuming $10 Permits

Option 1 Option 2 Option 3 Option 4

Megatonnes

Command-and-Control

Action plan 2000 45 45 45 45

Budget 2001 5 5 5 5

New targeted measures (*) 22 104 25 25

Total 72 154 75 75

Sinks

Previously credited 24 24 24 24

Additional sinks 10 10 10 10

Total 34 34 34 34

Permit Trading

Pricing-induced reductions (*) 16 0 23 25

Private purchases ofinternational permits 128 0 76 10

Government purchase ofinternational permits 0 62 42 16

Total 144 62 141 51

Adjustments

New sinks included initems marked (*) 10 10 10 10

Transport target differencebetween runs#

5 5 5 5

Credits for othercountries actions 0 0 0 +70

Offsets 0 0 0 +20

Total 15 15 15 75

Total Reductions 235 235 235 235

Estimated Kyoto Gap 238 238 238 238

# Tables 4 and 5 in the DP reported on runs that assumed lower targets for the transport sector than was the case forruns discussed elsewhere in the DP.


11/41

each source. It is possible that by assigning sp ecific targets th e regu lator forces

some companies to levels where marginal emission values are hun dred s of dollars

higher than they are for other sources. Within the comm and -and-control structureno information is generated to allow these departures from cost-effectiveness to be

corrected.

The federal DP prop oses a m ix of incentive-based instruments (specifically

trad able perm its) and comm and -and -control, called Targeted Measures.We

asked for informa tion about the marginal costs of the many targeted m easures

being proposed, but this request was turned down on the grounds that the

nu mbers w ere not solid enough to pu blish. This illustrates the problem that leads

to cost-inefficiency under command-and-control. Targeted Measures are significantelements of each Opt ion (see Table 1). The fact that their m argina l costs are too

un certain to pu blish mean s that the cost estima tes in the DP are likewise very

uncertain.

Transfers versus Social Costs

Some of the policy compliance costs incurred by individuals are actually transfers,that is, they are incurred privately by some economic agents, but accrue as revenu e

to others. Costs incurred by some agents th at do not become revenue to oth ers are

true social costs. A policy that minimizes the social costs mu st be configured in such

a way that the cheapest emission abatemen t options will be und ertaken first,

followed by progressively more costly ones. In this sense emission control policies

have rising marginal costs.

Und erstanding th e distinction between tran sfers and social costs is importan t

for several reasons. True, social costs can be quite a bit smaller than transfers, butat the same time they are often hidden and more difficult to quantify. Also, it is

sometimes the case that those policies that involve large and visible transfers,

emission taxes, for examp le, generate comparatively small social costs. Conversely,

policies where the transfers are hidd en, such as comman d-and -control, often hav e

relatively high social costs attached to them.

The total value of transfers created by a pollution-control policy can be

estimated from the prod uct of the emissions target and the marginal value of

emissions. If carbon dioxide emissions are constrained to 571 MT and at that level

are w orth , say, $100 per ton ne, the tr ansfers w ill be abou t $57 billion dollars

annu ally in Canada. Depend ing on the design of the policy this amoun t might be

grand -fathered to the emitters themselves or accrue to others, includ ing, possibly,

the government.


A request for

information about

costs of proposed

measures wasturned down on

grounds that they

are not solid

enough to publish.


12/41

charging em ission fees, this pool of mon ey becomes a valuable asset or liability.

Both those wh o end up with a claim to some of the transfers and th ose with a

liability to pay them soon realize this.In the case of comm and -and-control measures the same m agnitud e of transfers

are involved, creating winners an d losers, but the p ool of mon ey does not become

visible to the same extent. The tran sfers hap pen through changes in consum er

prices, real wages and the rates of return to capital in some sectors. These effects

are real enough at the macro level, but are easy to overlook wh en considering the

up -front costs of a policy. While the m icroeconom ic effects of the p olicy are not

affected by where the transfers go, the macroeconomic effects are, as will be

discussed below.The social costs of an emissions-control policy can be approximated using the

old Harberger tr iangleform ula from p ublic economics. If emissions are redu ced

by 240 MT and go from a m argina l value of 0 to $100, the social cost of the p olicy

will be approximately $12 billion annually, assuming the emissions reduction

required for Kyoto are done domestically.

International Permits Purchases

If carbon dioxide emission reductions sufficient for Kyoto compliance are done

domestically, analysts have generated marginal values in excess of $200 per tonne,

but not typically below $30. Consequently, a big question in studying Kyoto is

whether Canada could get away without doing much domestic emissions

redu ctions, instead p urchasing perm its at a low cost on an international market.

The four O ptions in the DP all rely heavily on this assum ption, as we w ill explain

below.

If emission p ermits can be purchased on an international market, the marginal

value of emissions would likely fall because the international price would likely be

lower than that for just a dom estic emissions m arket. At the same time, how ever,

there would be less abatemen t at home. Estimates in the DP suggest that if the

world price of emission p ermits were $10 per ton ne, between 26 and 34 MT of

abatement (includ ing sinks) would occur dom estically at this p rice (see Part 3

below). The rest of the gap w ould be closed by p ermits pu rchases. The Op tionspresented in the DP use combinations of tradable permits with other policies.

Macroeconomic Aspects of CO2 Emissions Control



13/41

a forward-looking rational expectationsmod el, something that has n ot been

app lied to Kyoto policy simu lations in Can ada.

With carbon d ioxide taxes or auctioned perm its, emitters must p ay a p enaltyproportional to their total emissions. This is a source of revenue for the

government, though it raises concerns abou t the p rivate cost of compliance to large

emitters. Cap-and -tradeu sually refers to a p rogram in wh ich em itters are

granted a fixed am oun t of tradable credits free, thereby reducing private

compliance costs while preserving the incentives to find an equimarginal cost

allocation of emissions across all sources. The Op tions propose d ifferent ru les for

this allocation, in one case (Option 3) based on p ast emissions an d in anoth er

(Option 4) based on a formula that takes account of outpu t levels and trends.

If a sources emissions exceed the amount of their permits allocation they are

required to p urchase ad ditional credits from other sources, but if their emissions

are less than th eir granted credits they can sell the excess. The cap-and -trade

program redu ces the comp liance costs of individu al firms, but m ay lead to h igher

social costs. Because the system does not raise revenue for the government, it

leaves no room for offsetting tax cuts elsewhere.

In the case of policies like command -and-control or cap-and -trade that do notcapture the transfers for the government, the tax interaction effects still occur. But

the government has no new mon ey with wh ich to redu ce factor income taxes and

thereby offset the tax interaction costs. So the m acroeconomic impact of such

policies is worse. This has been borne out in numerous empirical simulations (see,

for example, Par ry, Williams and Gould er 1999, McKitrick 1997, Bovenberg and

Goulder 1996, Beausjour, Lenjosek and Smart 1992).

PART 3: Description and Analysis of the Kyoto Options

The Four Kyoto Options

While the federal governm ent has stud ied man y implementation scenarios and

other technical matters, there has not yet been a commitment to specific emission

redu ction p olicies. Hence, the d iscussion to d ate has on ly provided hyp otheticalparam eters for d etermining the costs to Canada of meeting the Kyoto

requirements. Comp aring sp ecific costs and benefits w ill require stud ying w ell-

defined m easures that stakeholders governm ents, industry and individua l

citizens wou ld be prep ared to imp lement an d wh ich w ould be likely to attain

the requ ired em ission red uction targets The Discussion Paper of April 15 2002



14/41

Canada can claim sinkscred its of 24 MT for biomass grow th following

concessions w on at the Bonn and Marrakech m eetings.

The 2001 federal bu dget and the Action Plan 2000are togeth er assumed togenerate 50 MT of emission reductions.

This leaves a gap of 166 MT to be closed through new measures. The way each

Option p roposes to do this w ill be described below. The DP claims that Budget

2001 will reduce em issions by 5 MT (p. 15) There is no explanation in the

Discussion Pap er of how the Budget w ill actually d o this. Some p rograms are

mentioned on p age 22, but there is no information about w hen they w ill be

implemented , how m uch they w ill cost or wh at w ill each accomplish. As well, twoof the mechanisms, Technology Partnerships Can ada and the Infrastructure

Programs, are not designed as emission-redu ction p rograms.

Action Plan 2000 includes proposa ls such as a national refuelling

infrastru cture for fuel-cell veh icles(AP2000 p. 5). There are no pro ject-specific

emission reduction or cost estimates in Action Plan 2000, instead the introduction

asserts without explanation that the package will yield 65 MT of emission

redu ctions. This amou nt w as redu ced to 45 MT for the p urp oses of inclusion in thenew Discussion Pap er, becau se 20 MT of AP2000s 65 MT are achieved throu gh

pu rchase of CDM and JI credits, which are already d etailed in those options.

Achieving these reductions presumes the existence of the domestic emissions

trading system.

A minimu m of 72 MT of emission cuts through command -and-control

measu res is required in a ll simu lations. Ideally, none of these program s w ould

conflict with each other and they m ust all be assumed feasible in the given time

frames and , because m any rely on subsidies, the public budget is able to expan d to

accomm odate th em. Representing all these options in an economic model is

challenging. For instance, the increased cost of motor vehicle transport due to road

tolls, bio-fuels requirements and traffic speed reduction may affect the affordability

of any of the major capital investments, but this is difficult to calculate in an

economic model.

The mix of policy instruments is summarized in Table 1. The figures are based

on the assum ption that the p rice of emission p ermits on the international market is$10. If the p rice is different, that w ill change the relative cost of dom estic and

foreign action, which will change the distribution of measures in the Table.

Domestic and international tradable permits are used in some of the Op tions.

Where both instruments are traded , the price mu st be equal in the two markets so

the only distinction between them is whether th e sale transfers mon ey



15/41

add ition to th ese, 22 MT of emission redu ctions are brou ght abou t throu gh

Targeted Measures.

It is noteworthy tha t only 16 MT of domestic emissions are d one in respon se to

a p rice of $10 per ton ne. This suggests th at over 90 percent (200/ 216 MT) of the

emission reductions required to close the Kyoto gap, if done domestically, would

cost more th an $10. Since 72 MT of reductions are forced throu gh on the Action

Plan 2000 and Targeted Measures lists, this makes it highly unlikely that the

equimarginal criterion is satisfied and that Option 1 is cost-effective.

That said, the reliance in Op tion 1 on a broadly d esigned perm its trading

system m ake it likely that it is the least costly of the four. Cost estimates a re not

provided for Options 2 and 4 so we cannot p rovide a full ranking. But evid encefrom the reported simulations and consideration of the th eory of policy d esign

suggests that Option 1 is the least costly proposal.

Option 2

This app roach relies even more h eavily on comman d-and -control measures. There

is no domestic emissions trading market; instead 104 MT worth of new TargetedMeasures are forced th rough. The federal governm ent also pu rchases 62 MT of

perm its on the international perm its market. The DP does not provide cost

estimates for this option. How ever the lack of a perm its-trading m echanism w ill

likely make this Op tion dramatically more costly than Option 1.

Option 3

Comp ared to Op tion 1 this app roach slightly ad justs the m ix of permits trading

and comman d-and -control, and also distributes the perm its freely rather th an

auctioning th em. The perm its distribution is based on past em issions, as estimated

by emission intensity and outp ut levels. Comp ared to Option 1, the comman d-and -

control measu res account for 75 MT rather than 72 and it permits trading accounts

for 141 MT rather than 144. Unlike Option 1, only large emitters are involved in the

trading system, covering abou t 40 percent of d omestic emission sources. A total of

23 MT worth of emission red uctions are un dertaken dom estically at the $10 price,compared to 16 und er Option 1.

Option 4



16/41

within the trad ing system, subject to aud iting and app roval. It is assumed that at a

$10 market p rice, in ad dition to 25 MT of reductions induced by the p ermit p rice

an ad ditional 20 MT of emission redu ctions are imp lemented by compan ies

wanting to sell offsets. There are no model simulations of this option.

The specific comman d-and -control measures to be imp lemented u nd er Options

1 and 3 are listed in App end ix 1. As mentioned above, ou r requests for cost

informa tion on these m easures w ere refused , comp licating ou r task. The reader

mu st therefore assume th at these measu res can be imp lemented a s early as 2008

and that there will not be significant problems of compliance, affordability or

conflict among the measures. These questions are central to whether the DiscussionPaper has su cceeded in setting ou t credible estima tes of feasible and adequ ate

options for Kyoto comp liance. An overall jud gment on th is point therefore

involves a certain am ount of guesswork.

The major comm and -and-control prop osals listed in the Discussion Paper

A h i B 2 Th l 69 MT f i i


BOX 2:Major Command-and-Control Initiatives Implemented Under Options 1, 2 and 3

Road tolls on m ajor highw ays and enforcement of current sp eed limits

(4.1MT)

Increase ethan ol content of gasoline to 50 to 100 percent (1.8 to 6.0 MT)

Expansion of p ub lic tran sit (3.4 MT)

Retrofit of 20 percent of the existing h ousing stock (1.5 MT) and

comm ercial buildings (1.2 MT)

CO2 capture and storage in oil and gas sector (2.2 MT)

Reduce flaring and improve energy efficiency in oil and gas extractionequipment (8.0 MT)

Increase role of renewable sources in electricity prod uction (13.0 MT)

Imp roved East-West power transm ission (6.0 MT)

CO2 capture and storage on coal-fired plants (19.5 MT)

Invest in energy efficiency and low-emissions cap ital stockfor indu stry

(6.0 MT)

Incitethe gen eration of electricity in locations wh ere the w aste hea t can

be captured and utilized (2.0MT) Workshops and aw areness initiativesto p romote best pr acticesin

comm ercial vehicle u se (1.0 MT)

Urban Show case Renewalprogram (1.0 MT)


17/41

Team 1998) and claims that flaring has been reduced by almost 40 percent below

1996 levels alread y (Govern ment of Alberta 2002).

The fiscal rule for the tw o modeled Op tions is to adjust p ersonal income taxes

so as to keep the federal bud get unchanged . Under Op tion 1 the introdu ction of a

perm its auction in 2008 raises enough revenue for the governm ent to allow income

taxes to be reduced. In other Options income taxes mu st be increased.

The Discussion Paper is silent on the income tax implications of the Options.

Based on information sup plied to us, we grap hed the projected chan ges in the

effective tax burden, or average income tax rates (see Appendix 2). There is an

obvious question of whether future federal and p rovincial governm ents will

commit to raising income taxes to pay for these policy Options. This is somethingthat ou ght to be brought out into th e pu blic debate m ore explicitly.

If provinces are not willing to raise their personal income tax rates, it is

possible for the federal governm ent to shoulder th e wh ole burden. How ever, this

wou ld am ount to a d ifferent fiscal rule and, since this wou ld hav e a substantial

impact on th e federal bud get, it is imp ortant to an alyze how th is contingency

would be handled.

All options assume the governm ent or the p rivate sector pu rchases inter-

national emission permits, totalling 26 MT (Option 4), 62 MT (Option 2), 118 MT

(Option 3) and 128 MT (Option 1). The Kyoto Flexibility Mechan ismsinclude a

nu mber of avenues for low-cost abatement projects in on e country (either Annex B

or Non-Annex B) to be financed by an Annex B country in exchange for credits

against its Kyoto target. The best known of these are Joint Implementation, the

Clean Developm ent Mechanism and International Permit Trad ing (IPT). In order

for these mechanisms to be workable, a num ber of international legal and

enforcement mechanisms m ust be established and associated institutions created.The likelihood of an international m arket being created is increased the fewer the

nu mber of participan ts because it is easier to coordinate d evelopm ent of these

institutions. It is conceivable, for instance, that a market might initially only

involve the developed coun tries of Western Europe, Canada and Japan . How ever

all these regions expect to be net pu rchasers, so the market p rice wou ld hav e to

rise high enou gh tha t some of these regions w ould begin to overshoot their Kyoto

commitments and generate excess permits for sale.

If Russia, the Ukraine and other former Soviet countries join, as most recent

stud ies assume, there will potentially be an am ple sup ply of cheap perm its. In

particular, if Russia joins the treaty an d institutional barriers to setting u p a trad ing

market can be overcome, having permits available at an initial price of $10 is a

reasonable assumption (Lschel and Zhong 2002). This is because the collapse of


The question is:

will future

governments

commit to raising

income taxes to

pay for

implementation.


18/41

Flexibility Mechanisms, which in turn require the existence of these institutional

and legal mechanisms.

We see in this a chicken-and-egg problem, since the establishment of theperm its market requires the treaty to enter into force, but for that to h app en

countries must believe it is economically feasible. However, for that to happen, a

perm its market w ould h ave to exist. It is conceivable that Canad a m ight decide to

ratify based on th e expectation that international trading mechanisms w ould keep

dow n imp lementation costs, only to find ou t later that the trading m echanisms are

not feasible or emerge on too limited a basis to supply low-cost credits. This being

the case, it is importan t that an alyses be prod uced exploring not just thecontingency of $50 international permits, but also the contingency of no inter-

national perm its at all. Full informa tion about th e functioning of the va rious

Flexibility Mechanisms is likely to follow, rather than precede ra tification. These

broader ana lyses would both illuminate wh ether Canad a should ratify the Protocol

in the first place and give us some gu idance about the conditions und er wh ich

Canad a might later withdraw from the Protocol.

Is There A Cheaper Option?

It is worth pointing out th at there is another option besides the ones p resented in

this Discussion Paper. If the international permits market really becomes

operational and practically unlimited n um bers of permits are available at $10 per

tonne, the federal governm ent could levy a $10 per tonn e carbon d ioxide tax on a ll

fossil fuels, yielding an expected 30 MT emission reduction, then buy 210 MT ofinternational permits at th at p rice to m eet the rest of the Kyoto target. If the CO2tax were revenu e-neutral and income taxes w ere redu ced by $0.3 billion as an

offset, the net economic impact of the tax shift would be very small. The overall

cost then wou ld be $2.1 billion annu ally for the p ermits, and even taking into

account the social costs of the taxes needed to raise this money th is would be mu ch

cheaper than anything p roposed in the DP.

The analysis of the four Op tions suggests that at $10 per tonn e only about 16 to

24 MT of new em ission red uctions w ill be cost-effective at hom e, as well as a small

nu mber of sinks p rojects amounting to app roximately 10 MT. It is assumed in the

modeling exercise that all the Action Plan 2000 measures are already in place when

the pricing system is introduced. This means that about 26 to 34 MT of emission


There actually is a

cheaper way of

achieving Kyotos

goals.


19/41

The Status Quo Option

While not stated in the DP, there is of course the option of doing none of the above

and deferring action un til the costs and benefits are more thorough ly und erstood.

Because of the scale of the potential economic impact of any of the Options

proposed this should not be dismissed without due consideration.

Will These Options Meet the Kyoto Targets?

As shown in Table 1 all the options yield estimated red uctions that pretty m uch

close the Kyoto gap. The question is whether the strategy in this Discussion Paper

is likely to generate the p romised d omestic emission red uctions. We have noted the

possible overlap between the Discussion Paper and the Action Plan 2000, as well as

with existing initiatives like the Alberta gas flaring reductions. In addition, the

time scale is exceedingly tight for ambitious projects such as retrofitting 20 percent

of the domestic and commercial building stock, repaving 6,500 kilometres of

highways with cement, retraining 250,000 truck drivers, buying 20,000 alternate

fuel vehicles for the govern ment and getting a 30 percent m arket pen etration ratefor alternate fuel city buses. Even if a decision on ratification were to be made by

the end of this year that w ould only leave seven years to d o all these things. Also,

the Protocol requires that parties show dem onstrable progresstoward s their

commitments by 2005 (Article 3.2), further tightening the time frame.

The specific policies in th e Discussion Pap er p resupp ose cooperation amon g

indu stry, the p rovinces and the federal governm ent. So far, Alberta and , to a lesser

degree, Ontario, have been vocal opponen ts of speedy ratification. Overall, none of

the Op tions will be easy to imp lement, in the man ner d escribed in the Discussion

Paper, within the p roposed time frame. The key obstacles includ e:

coordinating federal an d provincial tax increases to pay for the measu res.

implementing the long list of projects and measures in all major sectors of the

economy (including hom eowners and motorists).

developing an international perm its trad ing market that w ill make a lot of

emission credits available at a low price. developing the pu blic sector infrastructure to au dit an d verify the em ission

reduction initiatives.

Before turn ing to the estimates of the economic imp act we d iscuss the structure

of the models used in the DP and some possible implications of the par ticular



20/41

how th ese models work and how th ey were used to estimate the economic imp acts

of two of the Op tions.

Models Used for the Discussion Paper Cost Estimates

Economic mod els can be d ivided into those based on assum ptions of optimizing

behavior and those based on recursive macroeconomic structures. Optimizing

models start with the assumption that consumers and producers minimize the cost

of achieving their goals, which for consumers means maximizing utility given

current income and for comp anies means m aximizing profits. An ou tcome in

wh ich consumers and p rodu cers have all implemented privately optimal strategies

is called a general equilibrium.Und er these circum stances if an energy-saving

technology can yield net pr ivate benefits it w ill be adopted without the need for a

regulatory pu sh.

Comp utable General Equilibrium (CGE) mod els are based on an examination

of the price system and market activity. They do not usually incorporate a specific

description of technology types in the energy sector, but instead represent the

availability of different types of energy at different hypothetical prices.The cost estimates in the Discussion Paper are provid ed by a m acroeconomic

mod el know n as TIM The Informetrica Mod el. This is a recursive forecasting

tool that captures aspects of the transition between before- and after-policy states,

including un emp loyment and capital stock reallocation. Recursivem eans th at

agents are assum ed to make decisions based on current and past information,

rather th an on expectations about the future. TIM resolves the final-deman d sector

in detail, using multiplier coefficients to translate p olicy shocks into final macro

changes. It uses input-output coefficients to downscale those changes to specific

indu stry outpu ts and inp uts and a sub-mod el called RIM (the Regional

Informetrica Model) to down scale on a p rovincial grid. Indu stry outp ut p rices are

built up using u nit cost functions.

Because the social costs of policy changes are transmitted through the price

system, p olicy evaluation is usu ally done with CGE mod els rather th an or in

ad dition to macroeconomic models like TIM. The conv entional measure of the

social cost of a policy change is called utilityin economic theory. Utility chan gescan be evaluated in CGE models, but not in macroeconomic models like TIM.

Hence the d iscussion that follows w ill look at w hat can be learned from the m acro

mod el app roach, but evaluation of the true social costs of the Kyoto options will

have to aw ait app lication of a CGE modeling app roach.

TIM i d i h b d l ll d E 2020 Thi



21/41

the capital stock changes in the energy sector

the cost of buying foreign perm its

the energy savings in the a ffected indu stries.

The Informetrica Model then simulated th e economic changes for the economy

as a whole on this basis.

Potential Shortcomings of the Approach Used

This one-way linkage has tw o potential shortcomings. First, the m odels do not

impose th e assum ption of cost-minimizing behav iour in the base case. Second ,macroeconomic changes ought to feed back into affected industry sectors, which

wou ld in turn change the inpu ts to TIM, implying an iterative process shou ld be

used. Work on mod el iteration is now u nd erway an d the results may give

guidan ce as to the imp lications of this particular mod eling stru cture.

The first point illustrates the difference between using a macroeconomic fore-

casting tool and a CGE model. In a CGE mod el it is assum ed th at all agents in the

economy are cost-minimizers. Policy shocks can only improve general welfare by

redu cing d istortions in the p rice system, increasing return s to factors of produ ction

and other such efficiency enhancing changes. Of particular note here is the fact that

it is not p ossible to generate an economic benefit by simp ly requiring a comp any to

change its factor or material inp uts so as to redu ce energy use. The reason is that if

a compan y could really save money by u sing some new energy-saving technology,

a profit-maximizing organization w ould h ave un dertaken it already. Compan ies

are assum ed to hav e exhausted all such economically beneficial innovations.

Further su bstitutions between capital and en ergy are costly to the compan y.In the TIM/ Energy2020 framework, how ever, the starting point is not a cost-

minimizing equilibrium . Thu s it is possible that a regu lator could order a firm to

adop t some new energy-saving technology that w ould increase the rate of return to

capital in th e sector. It is not necessarily the case that targeted m easures have this

effect, but they are not ruled out as they are in CGE analyses. In short there is a

possibility of a free lun chin the macro-modeling ap proach because the

informa tion transmitted to TIM m ay includ e the claim that capital rates of return

have risen as a result of comp lying w ith the Kyoto plan. On its own this means the

mod eling framew ork used for the Discussion Paper m ay un derstate some of the

economic costs of the Kyoto options.

The second p oint, that m acroeconomic changes wou ld cause changes in ou tpu t

and inpu t usage in th e energy sector, implies that information shou ld be iterated


There is a

possibility of a

free lunchin one

of the modelling

approaches.


22/41


Figure 1 $10 world: Changes in Real Gross Domestic Product in percentage change from

base case, 2005 to 2020, assum ing $10 per tonne inte rnational permits. Case 1

correspond s to Op tion 1, Case 2correspond s to Op tion 3.

Figure 2 $50 world: Chan ges in Real GDP (in p ercentage change from base case), 2005 to

2020; assum ing $50 per tonne international p ermits. Case 1correspond s to Op tion 1, Case

2corresponds to Op tion 3.

Source: From The Economic Impa cts of Kyoto,backgrou nd m aterial for Joint Ministers Meetin g, May 21,

2002, prepared by the Analysis and Modelling Group.

2

1

0

1

2

32005 20202010 2015

Case 1 GDPCase 2 GDP

2

1

0

1

2


23/41

The Estimated Economic Impacts

The proper measu re of the aggregate cost of a p olicy is not the change in real gross

dom estic produ ct (GDP) but the chan ge in total potential consum er u tility in eachperiod after a policy change has occurred. This is related to, but not necessarily

equal to, the change in total potential GDP. One of the main differences arises from

the treatment of the labour sup ply, since changes in u tility take account of

substitutions in consumption and leisure. The change in utility can also differ from

the change in GDP if other a spects of environmental qua lity, specifically urban air

quality, are improved as a result of the p olicies adop ted and this is factored into

the utility function.

Not all models can provide estimates of changes in terms of utility changesand , as a result, comp arisons rely on GDP changes instead. H owever, some policy

experiments can yield an increase in GDP wh ile redu cing aggregate welfare or

utility. Therefore it is essential that the p olicy Op tions in the Discussion Pap er be

further stu died in a CGE framew ork in ord er to assess their welfare imp lications.

F h f h i i l i h DP $10


Figure 3: Changes in Per Capita Real Disposable Income, 2005 to 2020, in dollars. Case 1

correspond s to Op tion 1, Case 2correspond s to Op tion 3.

Source: From The Economic Impacts of Kyoto,backgroun d mater ial for Joint MinistersMeeting, May 21, 2002, prepared by the Analysis and Modelling Group.

2005 20202010 2015

3500

2500

1500

500

500

1500

2500

Case 1 $50

Case 2 $50

Case 1 $10

Case 2 $10


24/41

Inferences About Marginal Costs of changing the Policy Mix

There are striking differences between the results for Option 1 (Case 1) and Option

3 (Case 2). In Figures 1 and 2 for instance, notice that as of 2010 the change from

Option 1 to Option 3 increases the aggregate cost by one-to-two percent of GDP.

Comp aring the m ix of instrumen ts in the tw o Op tions in Table 1, however, they are

not all tha t d ifferent. The differences are:

in Op tion 3 only about 40 percent of emitters participate in th e market

in Op tion 3 there is slightly more reliance on targeted m easures

in Option 3 perm its are given away rather than auctioned.

It is this last feature that generates the most significant differences between the

Options. Giving aw ay perm its means the p otential transfers accrue to the

recipients rather than going to the state, so a fiscal rule cannot be used to offset the

social costs of the em ission control policy (see Par t 1).

Figure 3 show s that free perm its distribution rath er than auctioning, (with

revenu e recycling via income tax redu ctions, costs betw een $1,100 and $3,000 per

capita as of 2010. This show s that small chan ges in the form of the Kyoto policycan have large effects on the estimated final costs. Along this same theme, the

Analysis and Modeling Group (2002) reports th at if the revenu e from p ermits sales

in Option 1 is app lied tow ards the federal deficit rather than tow ards cutting

income taxes, the GDP gains for $50 perm its turn into losses of one-to-two p ercent

of GDP, in the context of a macro mod el.

How do These Results Compare with Previous Studies?

To re-cap, the overall target is 240 MT, or about 30 percent of base case emissions

as of 2010. In both Op tions 1 and 3 abou t half the gap is dealt with by pu rchasing

international permits. This leaves a d omestic emissions redu ction requ irement of

about 15 percent of the base case and the aggregate costs in terms of GDP as of

2010 are estim ated to be 1.6 to 0.2 percent of GDP. The difficulty of comparing

earlier results to those of the DP is that other stud ies generally simu lated emission

taxes or an equ ivalent p olicy, rather than th e mixed ap proach in th e DiscussionPaper. Also, a variety of models have been u sed and the results need to be

interpreted in the light of the specific assum ptions and structures emp loyed.

Some stud ies that p re-date Kyoto (Beausjour, Lenjosek and Smart 1992;

McKitrick 1996) used static CGE mod els to examine th e costs of a 12.5 percent



25/41

Following the signing of the Kyoto Protocol in 1997 a series of stud ies yielded

social cost estima tes ranging from 0.2 to 2.2 percent of GDP, dep end ing mainly on

whether permits could be traded globally (see Wigle 2001). With global permit

trading the costs are usually below one percent of GDP. In 2000 Industry Canada

commissioned a study (Wigle 2001) that looked at a range of policy options. This

stud y u sed th e MRT-C mod el, wh ich is of the CGE variety. A un iform emissions

charge to attain the Kyoto target was found to cost between 1.0 and 1.5 percent of

GDP if there were no international emissions perm it trading. How ever, if

exemptions were given to certain sectors the costs quickly rose. Exempting the

non-energy inten sive sectors led to econom ic losses in th e ran ge of 1.5-to-2.0

percent, while exempting energy intensive sectors and focusing policy elsewheremight cost up to 7.5 percent of GDP. The costs of such exemptions are reduced

markedly how ever by the availability of international permit trad ing. In th at case,

instead of raising th e d omestic cost of comp liance, the exemp tions led Canad a to

buy m ore permits in the w orld market and do less abatement at home.

Finance Canad a p rodu ced a set of CGE simulations using the CasGEM model

to consider the mix of industry-specific policies proposed by the Issues Tables.

They estimate a 0.9 percent contraction in GDP to achieve the Kyoto target, on the

assumption that targeted measures are successfully deployed at relatively small costs.

To get a sense of these numbers, note that one percent of Canadas GDP is

about $10 billion. This is an annual cost. These findings taken together imply that

the aggregate GDP changes estimated by TIM/ Energy2020 are similar to those

produced by earlier studies when they modeled programs with zero or very

limited targeted measu res. However the p olicy experimen ts are different and the

models are all sensitive to small changes in the policy design. Predictions of the

economic impact depen d strongly on specific assum ptions about the p olicy designand since none of the earlier stud ies have simu lated the four Op tions from th e DP

it is not possible to comp are the results d irectly.

PART 5: Forming a Basis for Making a Policy Decision

What Information is Needed?

The government presented th e Discussion Paper as th e basis for d eciding on a

significant policy innovation in Canada. Adopting the Kyoto Protocol will likely

affect all regions and all sectors of the economy one way or another. As a policy

change it is almost comparable in its total economic impact to that of the 1988

C d S d A h h i d d l i d


The Kyoto Protocol

is almost

comparable in

economic impact to

the 1988 Canada-

US Free Trade

Agreement .

C C


26/41

and changes involved. The exact text of the policy was available and several

groups studied the adequacy of labour market adjustment programs.

The amou nt of information available about the four O ptions in this Discussion

Paper is much more limited. Two specific issues need to be clarified in greater

detail:

the exact design of the policy package

the d istribution of the cost burd en across ind ustries and regions

Before there w ill be an adequ ate information basis for deciding if Canada

should ratify Kyoto it is necessary to cost out all relevant Options, under all

reasonable contingencies. So far we have cost estimates for only two of four

Options, u nd er optimistic contingencies.

A Wider Range of Methods

The use of a recursive macroeconomic mod el has advantages in terms of

generating information about the adjustment p ath. It is ironic then that there is no

dyn amic information given in the Discussion Paper; just a post-imp lementation

snapshot. But th e TIM/ Energy2020 framework d oes not capture op timizing

behaviour or the transmission of social costs through the p rice system, so its results

dep end in key ways on its particular structural assum ptions. This is not to say that

it should n ot be u sed, only that it shou ld n ot be the sole mod eling strategy. It is

essential that a w ider ran ge of methods be u sed to look at the general equilibrium

consequen ces of the p olicy prop osals. Implementation in a CGE framew ork w ill

also allow for a check on w hether th e structure in the TIM/ Energy2020 pair allowsfor free lunch effects that un derstate th e costs of comm and -and-control measures.

Conclusions

The federal Discussion Pap er is a starting p oint only for und erstanding the costs to

Canada of achieving compliance with the Kyoto Protocol. The four Options all

involve a mix of incentive-based an d comman d-and -control instruments. Ourconclusions are as follows.

The costs of compliance depend in a sensitive way on the specific policy design. Small

changes in instrument choice can lead to large changes in th e aggregate costs and

i ifi ff Thi h i h i f O i 1


C D H I tit t C t 25


27/41

implementation costs could includ e a lack of volun tary cooperation from p rovinces

or indu stries and the failure of international permit trad ing institutions to emerge.

All four Options include targeted measures that are unlikely to be remotely cost-effective.

Under the $10 emission pricing scenario, less than 10 percent of the emission gap is

closed by actions taken in response to that price. In other w ords, very few

domestic-emission reductions have marginal costs below $10. The heavy reliance

on Targeted Measures means m any emission red uction strategies are being forced

through that hav e potentially very high m arginal costs. Unfortunately, the DP does

not p rovide u seful information to evaluate th e extent of this policy design problem.

Because the Options require a lot of domestic emission reductions they are needlessly costly.

A pu re pricing system, based solely on international permits purchases, wou ld

achieve Kyoto compliance at a fairly low cost if the international carbon dioxide

pr ice is $10. But little dom estic emission red uction w ould occur in th is case,

reflecting the fact that there are relatively few low-cost emissions abatement

options in Canad a compared to other countries.

Only by seeing more d etails will we be able to determine w hether p articular

Kyoto Op tions can be implemen ted at anything like the m odest social costspotentially achievable, or whether through excessive reliance on an ill-conceived

range of targeted m easures the costs will end up being dram atically higher.

As it stands the Discussion Paper d oes not provide an adequ ate basis for

making a d ecision on Kyoto. The an alysis offered thu s far does n ot provide

sufficient information to un derstand the economic consequences and risks of

accepting the Kyoto target as legally binding. Given the macro-economic scale of

this policy commitment and the potentially far-reaching economic effects, without

a more thorou gh u nd erstanding of the economic impact a d ecision to ratify on the

basis of what has been determ ined thu s far wou ld indeed be precipitous.


26 C D Howe Institute Commentary


28/41


Appendix 1: Specific Targeted Measuresincluded in Options1 and 3

BuildingsOption 1 Option 3

National Standards Program Equipment & AppliancesMinimum efficiency standards introduced in 2004 for HVAC equipment majorappliances; domestic water heaters; lighting; windows and doors etc.Penetration Rate: 44% Penetration Rate: 100%

Energy Performance Labelling ProgramPenetration Rate: 44% Penetration Rate: 100%

Public Building Initiativealong the lines of Federal Buildings InitiativePenetration Rate: 34% Penetration Rate: 100%

Commercial Building Retrofit ProgramEnhancement and expansion of a private sector building programPenetration Rate: 30% Penetration Rate: 100%

Multi-Residential Retrofit ProgramEnhancement and expansion of a private sector building programPenetration Rate: 8% Penetration Rate: 100%

Provinces Ado pt a More Stringent Model N ational Building Code for Houses(MNECH).Penetration Rate: 50% Penetration Rate: 50%

Strengthe ned R2000 Program:more marketing, access to preferred mortgage rates,expanded builder training and certification, etc.Penetration Rate: 20% Penetration Rate: 100%

EnerGuide for Houses:households would receive a home energy audit.Penetration Rate: 150% Penetration Rate: 200%

Residential Retrofit Guideline s and Installation StandardAdherence would be encouraged or required in these Measures.Penetration Rate: 50%

Same level of effort, but combined to theNational Energy Efficient Hou singRenov ation & Retrofit Program.

R-2000 for Existing D wel lings Renovation Program:Including demonstrationof new design approaches; demonstration ofmarket-ready technology.Penetration Rate: 25% Same level of effort

Increase the provincial minimumenergy efficiency regulations fornew buildings

to 15 % above MNECB.Penetration Rate: 100%

National Energy Efficient Hous ingRenov ation & Retrofit ProgramTax breaks such as removal of GST, PST,HST, and/or accelerated depreciation ofcosts in rental housing; new financing;h dit d l b lli

C D Howe Institute Commentary 27


29/41


Transportation

Option 1 Option 3

Enhancements to the Pedestrian and Bicycle EnvironmentTo be implemented by municipal governments: increased spending on sidewalks,signalized intersections, street lighting, bicycle paths, bicycle racks, lockers,connecting transit, winter maintenance, policing.Penetration Rate: 33% Same as in Option 1

Synchronized Traffic Signalsa wide range of programs and projects to reduce delays, and manage incidents.Penetration Rate: 33% Same as in Option 1

TelecommutingAggressive education and outreach program and mandatory telecommuting programs(as appropriate) for offices with more than 50 employees. Implemented by employersand enforced by provincial government, would take until 2005 to be effective in

bringing companies on-board.Penetration Rate: 17% Same as in Option 1

CarS haringCo-operative ownership and sharing of automobiles, implemented by the privatesector.

Penetration Rate: 33% Same as in Option 1

Transit Service ImprovementsExpansions and enhancements by municipal and provincial governments.Improvements implemented by 2010: 10 minute reduction in in-vehicle travel times,10 minute reductions in headways etc.Penetration Rate: 20% Penetration Rate: 100%

Short-Term Aviation Me asuresTo be taken by the aviation industry in Canada between 2000 and 2010. Enhancedair traffic management; oceanic reduced vertical and horizontal minima; preferredaircraft trajectories, polar routes; optimization of noise abatement procedures;decreased congestion at airport.Penetration Rate: 100% Same as in Option 1

Rigid Pavements (Cement)Primarily be the responsibility of the provincial highway agencies. A total of6,500 km of the National Highway system is involved.Penetration Rate: 61% Same as in Option 1

Truck Driver TrainingTrucking fleets would implement driver training programs addressing fuel efficiencyand GHG emission reduction. 250,000 commercial drivers trained on an annual basis,

from 2000 till 2020 through a combination of one-on-one and classroom training.Penetration Rate: 100% Same as in Option 1

Advance Vehicle Control SystemOn-board sensing and processing technologies to facilitate collision avoidance.E.g., adaptive cruise control, night vision sensors, heads up displays, and obstacledetection; reducing incident congestion in urban areas. Primarily the responsibilityof the private sector automobile industry, funded by private individuals

28 C D Howe Institute Commentary


30/41


Transportation (contd)

Option 1 Option 3

Trucking Load MatchingAll van and flatbed trailers operating in Canada on trips over 300 kilometersare assumed to reduce their empty travel by one percent as a result of newInternet-based services.Penetration Rate: 100% Same as in Option 1

Truck LubricantsAll trucks shift to synthetic or partially synthetic engine oils starting inthe year 2000.Penetration Rate: 33% Same as in Option 1

Marine Code of Practice I and IIPenetration Rate: 100% Same as in Option 1

Fleet Average Fuel Consumption Target HarmonizedVehicle manufacturers would reduce the average fuel consumption of thenew light-duty vehicle fleet by 25% by 2010 over a baseline of 1998.Consumer education /awareness component is assumed to be includedin the policy.Penetration Rate: 100% Same as in Option 1

Alternative Fuel InfrastructureCanadian Government could provide incentives for provinces and / ormetropolitan areas to develop alternative fuel infrastructure within their areas.Government will supply enough subsidy to place the fuel option on at leastan equivalency with gasoline or diesel; other incentives could be employedto help market penetrationPenetration Rate: 100% Same as in Option 1

Comme rcial Vehi cle Electronic ClearanceElectronic clearance at border crossings andinspection stationsPenetration Rate: 100%

Enforcement of Current Speed Limits for both autoand truck travel. Existing posted speeds would beobserved; there would be no reductions in postedspeeds. (reductions in posted speeds are considered asa separate measure). Provincial enforcement agencieswould be responsible.Penetration Rate: 100%

Alternate Fuel Vehicl e (AFV) PurchaseAssume fleet and government purchase commitments

of 10,000 AFVs per year, increasing to 20,000 in 2010and beyond; spread evenly across electric, CNG, LPG,and ethanol vehicles in the near term and will addfuel cell vehicules and cellulosic ethanol as they

becomes available after 2005.Penetration Rate: 100%

Heavy Duty Truck Efficiency Improvements



31/41

y

Transportation (contd)

Option 1 Option 3

50%Ethanol Mandate the renewable fuel content ofgasoline. Provinces would agree to adopt these;commercialization of converting biomass residuessuch as wood waste and straw into fuel .Penetration Rate: 100%

Biodiesel from Waste Greases, Stressed CanolaIn partnership with Canadian industry, the provincesand municipalities. Industrial production of 500million litres per year by 2010 of renewable fuels

made from restaurant cooking oils, tallow and wastestream soybeans and canola.Penetration Rate: 100%

Trucking Drive r Idling TrainingTrucking fleets would reduce the amount of totalengine idling time through training.Penetration Rate: 100%

Diesel Incentive for New VehiclesIncrease in the gasoline excise tax. Federalnegotiation/suasion with light duty vehicle

manufacturers to preferentially market diesel enginesin Canada. Assumes that 20% of new light dutyvehicles will be diesel powered by 2010, and thatupstream emissions would be reduced based onNRCans Genius fuel cycle GHG model.Penetration Rate: 100%

Freight Intermodal System ImprovementsFund improved road access to intermodal terminalsPenetration Rate: 100%

Agriculture

Improved N utrient Management Provide the appropriate amount andconcentration of nitrogen and reducing fall application of N fertilizerPenetration Rate: 100% Same as in Option 1

Increase No-Till Increasing the sequestration of carbon in agricultural soils.Penetration Rate:

100% Same as in Option 1

De crease Summe rfallowPenetration Rate: 100% Same as in Option 1

Increase Permanent Cover ProgramConverting marginal (economic and/or environmental) land from annual crop production to permanent coverPenetration Rate: 100% Same as in Option 1



32/41

y

Municipalities

Option 1 Option 3

Green Municipal Enabling Fund (GMEF) Five-year, $50-million fund providesgrants (up to 50% of eligible costs) to support feasibility studies to increasemunicipal expertise and knowledge of leading-edge environmentaltechnologies.Penetration Rate: 100% Same as in Option 1

Regulate Ne w/Existing Landfill SitesRequire capture and flaring of landfill gas at new and expanded sites withwaste capacity greater than 2.5 million tonnes.Penetration Rate: 5% Same as in Option 1

Green Mun icipal Investment Fund (GMIF)Low cost loans for up to 25% of eligible costs plus grant funding supportup to 50% for investment in innovative technologies.Penetration Rate: 70% Same as in Option 1

Market Value for Emission Reduction (PERRL)Subsidies for emission reductions achieved over period 2002-2007, supportinglandfill gas capture, flaring and utilization systems (and other areas)Penetration Rate: 25% Same as in Option 1

Landfill G as Utilization Go vernment ProcurementLow cost loan and grant funding from GMIF supplemented with expandedeligibility for Federal Producer Incentive for renewable electricity.Penetration Rate: 100% Same as in Option 1

Green Fund Incentives for Waste DiversionExpanded low cost loan and grant funding from GMIF in support of municipalgovernment efforts to establish programs for increased diversion of wastefrom landfill sitesPenetration Rate: 90% Same as in Option 1

Establish a Revolving Fund CES ProjectsExpanded low cost loan and grant funding from GMIF in support ofinstallation of community energy systems.Penetration Rate: 75% Same as in Option 1

Revolving Fund Energy Efficiency RetrofitsMunicipal Operations Measures Expanded low cost loan and grant fundingfrom GMIF for wastewater facility retrofits.Penetration Rate: 75% Same as in Option 1

Water ConservationExpanded low cost loan and grant funding from GMIF to assist municipal

governments in developing and implementing Water Conservation measures.Penetration Rate: 75% Same as in Option 1



33/41

Industry

Option 1 Option 3

Expand CIPEC beyond to include all of industry. CIPEC promotes theestablishment, implementation, tracking and reporting of energy efficiencyimprovement targets. Will entail inviting participation from the upstreamoil and gas, forestry, construction and electrical generation sectors and

broadening the reach of existing task forces (e.g., SMEs).Same as in Option 1

Tracking Better align existing survey instruments administered by StatisticsCanada and by increasing their scope and the timeliness of results.

Same as in Option 1

Awareness New tools will be developed and delivered to employees of industrialcompanies to increase their awareness about the opportunities to become moreenergy efficient and to reduce GHG emissions. Include customized workshops,technical support, guidebooks and videos. Companies are expected to introducemore new practices and technologies that lead to reduced energy consumptionand GHG emissions.

Same as in Option 1

Benchmarking consultants will work with companies to record data on businessesas a whole, including profitability, investment, financial management, productivity

and innovation with special emphasis placed on energy efficiency and GHGperformance. Benchmarking reports expected to have the impact of auditsdue to their non-prescriptive nature, however by targeting substantial membersof large industrial energy users the reduction potential increases significantly.

Same as in Option 1

Audits Financial assistance and guidance will be given to companies to haveon-site industrial energy/ emissions audits conducted. Engineers will performaudits at 350 to 500 industrial establishments and outline energy savingopportunities and their associated GHG emission reduction potential and costs.Companies will be responsible for at least 50% of the audit cost. The auditsrepresent a new Industrial Energy Innovator service offered by NRCan.

Increased level of effort focused on thesmall and medium enterprises. Combinedto a Facilitation Fund.

Supply Chain To explore and develop the potential for supply chain managementto increase awareness of climate change implications and to encourage small andmedium firmsto achieve meaningful reductions in GHG emissions.

Same as in Option 1

Industrial Buildings Incentive Program Financial, technical and trainingassistance to the design of efficient industrial buildings.

Same as in Option 1

REDI for Industry Similar to REDI, but customized for the industrial sector.

Designed to stimulate market demand for commercially reliable, cost-effectiverenewable energy systems for space and water heating and cooling.Same as in Option 1

CHP Study on barrier and potentialSame as in Option 1

Industry EnerGuide Encourage energy managers procurement and financial



34/41

Industry (contd)

Option 1 Option 3

Concrete Fly Ash Promote the use of concrete in the construction of roads.Same as in Option 1

Steel and Aluminum Recycling Establish a national recycling council annetwork, to bring common understanding and national standards for

processing and use of recycled materials and the resulting products.Same as in Option

Electricity Government ProcurementFederal government to purchase450 GWh of non-emitting electricity from new sources products. Providesubsidy to electricity retailers to stimulate production and sale of electricityfrom emerging renewable sources.

Same as in Option 1

Windpower Government of Canada will subsidize installation of 1000MWof new wind energy capacity in Canada over the next 5 years. Selected windenergy producers will receive a maximum financial incentive of $0.012 forenergy kilowatt-hour produced during the first 10 years of activity oftheir new wind farms.

Same as in Option 1

Facilitation Fund Increased audit activities for SME(up to price of carbon) and a facilitation fund to offsetto incremental capital cost requirements to realizerecommended EE activities from the Audit Program.


35/41



36/41

Effective Income Tax Rates:

Federal

Source: Informetrica Ltd.

Effective Income Tax Rates:

Provincial

Option 3 $50

Option 3 $10

Base

Option 1 $10

Option 1 $50

9.0

8.5

8.0

7.5

7.0

6.5

6.0

5 5

2000 20202004 2006 2008 20162002 2010 2012 2014 2018

Option 3 $50

Option 3 $10

Base

Option 1 $10

Option 1 $50

12.0

11.5

11.0

10.5

10.0

9.5

9.0

8.5

8.0



37/41

References

Analysis and Mod eling Grou p. 2002. A Guid e to the Assum ptions and Method ology Underlying the

AMG Results.Ottaw a: mimeo.Beausjou r, Louis, Gordon Lenjosek and Michael Sma rt. 1992. An Env ironm ental CGE Mod el of

Canad a and the United States.Ottawa: Dept. of Finance Working Pap er 92-04.

Boven berg, A. Lans an d Law rence H. Gou lder. 1996. Op timal Environ men tal Taxation in th e

Presence of Other Taxes: General-Equilibrium Analyses.American Economic Review 86(4)

9851000.

Field, Barry and Nancy Olewiler. 2002.Environmental Economics: 2nd Canadian Edition. Toron to:

McGraw-Hill Ryerson.

Flaring Project Team. 1998. Managem ent of Routine Solution Gas Flaring in Alberta.Ed monton:mimeo.

Governm ent of Canad a. 2002. A Discussion Pap er on Can adas Contribution to Add ressing Climate

Change.Ottawa.

Governm ent of Alberta . 2002. Clean Air Strateg ic Alliance: Gas Flaring and Venting in Alberta.

Edmonton: mimeo.

Governm ent of Can ada. 2000. Action Plan 2000 on Climate Chan ge.Ottawa.

Harr is, Richard G. 1986. Summ ary of a Project on the General Equ ilibrium Evaluation of Can adian

Trad e Policy.Cha pter 8 in Whalley, (ed.), Canada-United States Free Trade. Toronto: University of

Toronto Press.

Intergovernm ental Panel on Climate Chan ge. 2001. Climate Change 2001: Synthesis Report. Cambridge

University Press: Cambr idge.

Jacques, A.P. 1990. Na tional Inventor y of Sources and Em issions of Carbon Dioxide.Env ironm ent

Canada Report EPS 5/ AP/ 2. Ottawa.

Kenned y, Peter W. 2001. Op timal Early Action on Green hou se Gas Emissions. Canadian Journal of

Economics 35(1): 16 01535.

Lschel, Andreas an d Zhon gXiang Zh ang. 2002. The Economic and Environmental Implications of

the US Repu diation of the Kyoto Protocol and the Subsequent Deals in Bonn and Marrakech.

Fondazione Eni Enrico Mattei Discussion Pap er 23.

McKitrick, Ross R. 1996. The Econom ic Consequ ences of Taxing Ca rbon Emissions in Cana da.

Report 5-55896 to Environm ent Can ada.

. 1997. Dou ble-Dividend Environ ment al Taxation and Can ad ian Carbon Emissions Con trol,

Canadian Public Policy, pp. 417434.

Oliviera-Mart ins, Joaqu im, Jean-Mar c Bur niau x and John P. Martin. Trad e and the Effectiveness of

Unilateral CO2-Abatement Policies: Evidence from GREEN.OECD Economic Studies 19, pp.

123140.

Parry, Ian, Roberton C. Williams III and Lawren ce H. Gould er. 1999. When Can Ca rbon Abatem ent

Policies Increase Welfare? The Fundamental Role of Distorted Factor Markets. Journal of

Environmental Economics and Management37: 5284.



38/41

Victor, David. 2001. The Collapse of the Kyoto Protocol and the Struggle to Slow Global Warming . Princeton:

Princeton University Press.

Weitzman, Mart in (1974). Prices vs. Q ua ntities. Review of Economic Studies XLI, pp. 477491.

kyoto canada case

Documents