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2.0 THE BASIS OF THE NRTEE?S CARBON PRICING POLICY ANALYSIS

In this chapter, the policy and analytical foundations upon which this project is based are presented.

2.1 The Policy Basis of the NRTEE's Advice

Two main considerations influenced the NRTEE?s new work on carbon pricing policy, both in this document and in the Advisory Note: (1) building on Getting to 2050; and (2) recognizing short-term uncertainties, but planning for the long-term. These considerations provide important context for this report, and are intended to ensure that the NRTEE?s research will remain credible and relevant to policy makers for years to come.

2.1.1 Building on Getting to 2050

Getting to 2050 established the need for carbon emissions pricing policy in Canada to meet the government?s targets of reducing emissions relative to 2006 levels by 20% by 2020 and 65% by 2050. Getting to 2050 also identified the policy stringency, or the strength of the policy, required to meet the targets as the fast and deep emissions pathway. Under this pathway, the economy-wide price of carbon would start at $15 per tonne of CO₂e (CO₂ equivalent) and gradually rise to a long-term price of $300/tonne, as illustrated in Figure 1.²

2.1.2 Recognizing Short-term uncertainties, but Planning for the Long-term

While uncertainty underscores any forecasts of the future, 2008 provides a sharp reminder of just how rapidly events change and how inaccurate forecasts can be. In 2008 there were significant shifts in virtually all major drivers that influence climate policy and emissions growth: record high oil prices dropping to less than a third of their high-point value; major swings in economic growth forecasts; and large revisions to Canada?s national GHG inventory.

These short-term shifts highlight the uncertainty in any long-term analysis. However, if an attempt were made to fully reflect these events in this long-term advice, a highly reactive and myopic focus on the short-term would be the result. Instead, this report focuses on the need to influence long-term investment and behavioural decisions in the pursuit of the Government of Canada?s long-term targets. Getting to 2050 highlighted the need for a long-term transition, necessitating a long-term view of climate policy. Some factors that influenced this report, and how the issues were addressed, are discussed in detail below.

Changing Carbon Policies

The political landscape for carbon pricing policy in Canada has changed since the publication of Getting to 2050:

• In recent statements, it would appear the Government of Canada is re-assessing its original focus in the Regulatory Framework on Air Emissions, moving from intensity-based targets to ?hard caps?;

• Canada?s largest trading partner, the United States, has signalled its intention to establish a cap-and-trade system to reduce emissions;

• The province of British Columbia has introduced a carbon tax;

• The provinces of British Columbia, Manitoba, Quebec and Ontario have joined the Western Climate Initiative; and,

• Carbon taxes played a prominent role in the 2008 federal election campaign.

These events have implications for the short-term political appeal of alternative carbon pricing policies, and longer term implications for carbon pricing in North America. The NRTEE has taken these changing political conditions into account in its consideration of long-term carbon pricing policy for Canada, and believes that the case for carbon pricing in Canada is stronger now than it was when Getting to 2050 was published. Specifically, thought needs to be given to how these emerging carbon policies will interact and possibly integrate.

Changing Economic Conditions

The global economic outlook has also changed since the publication of Getting to 2050. The global economic slow-down will likely lead to short-term emission reductions, as output and economic activity contracts. However, the short-term downturn does not reduce the urgency of carbon pricing. Business continues to make investment decisions, and these should be guided by an expectation of a long-term price on carbon if they are to reflect society?s need to reduce emissions.

The modelling work underpinning the NRTEE?s policy uses long-term forecasts of economic growth to 2050. In doing so, it assumes that periodic downturns will take place, as well as periodic booms. As a result, the conclusions of this work are robust in the face of short-term economic uncertainty.

Similarly, when oil prices are high, some people feel that efforts to price carbon are unnecessary, because fuels like gasoline are already expensive and further price rises will do nothing to change behaviour and investment decisions. However, experience shows that high oil prices are not enough to drive emission reductions. There are three main reasons for this:

• First is that high oil prices are not always expected to last, and it is expectations about future prices that drive investment decisions now. 2008 saw record high oil prices; it also saw a significant price crash. This price volatility means that while prices are high, investors and consumers cannot be sure that they will remain high, and that investments in energy efficient capital stock, vehicles and so on will pay back. Volatility weakens the impacts of high oil prices on emissions;

• Second, high oil prices do not provide an incentive for emission reductions across all emissions in the economy. High oil prices provide an incentive to use less oil-based fuels like gasoline, but they do not provide an incentive on all fuels. For example, high oil and natural gas prices encourage increased use of coal for industry and electricity generation.⁴ Only carbon pricing provides economically efficient incentives in this way, because it puts the same price on carbon emissions regardless of where they arise;

• Third, high oil prices provide greater incentive for oil extraction, which is becoming a major component of Canada?s overall GHG emissions. Forecasted expansion of the oil sands, for example, is sensitive to the price of oil, with less expansion expected under lower oil prices.⁵

Nevertheless, oil prices do have an impact on investment decisions and consumer behaviour. In order to take account of revised long-term oil price expectations since the publication of Getting to 2050, the analysis in this report used the US Energy Information Administration?s forecast world oil price of $68/barrel (compared with $50/barrel used in Getting to 2050).⁶

Evolving climate science

The science of climate change is robust: there is a high degree of scientific confidence that climate change is occurring, and anthropogenic emissions are a major cause of that change. It is this strong level of confidence in climate science that makes the case for the reductions in greenhouse gas emissions to which Canada is committed. However, there is uncertainty in the rate of climate change, and the potential mechanisms that will slow or accelerate warming.

In 2007, the Intergovernmental Panel on Climate Change (IPCC) provided a major synthesis of scientific knowledge about climate change in its Fourth Assessment Report (AR4).⁷ In this report, it provided ranges of likelihood for various climate change outcomes, and noted the potential for feedback mechanisms that could lead to more rapid warming. Since the publication of the AR4, further scientific evidence has emerged that suggests more rapid warming is possible, and that as a result deeper emission reductions may be necessary. Lenton et al (2007) have identified a number of possible ?tipping points?, at which warming would lead to major changes in natural systems.⁸ Examples include:

• Methane release from permafrost (recent reports highlight unexpectedly rapid methane release in the Arctic)⁹

• Dieback of boreal and/or Amazon forests

• Melting of the Greenland ice-sheet

New evidence on all or any of these could substantively change society?s assessment of the risks of climate change, and may mean that deeper targets are necessary. It is also possible that climate change may occur more slowly than current scientific knowledge suggests, and that Canada and the world can decrease efforts to reduce emissions.¹⁰Carbon pricing policy must be adaptive to such changes, while maintaining the short-term certainty that is essential if low carbon investments are to be made. Importantly, while the NRTEE?s recommendations for carbon pricing policy design were developed to meet the Government of Canada?s current targets, the design recommendations remain relevant for more or less stringent levels of mitigation targets.

2.2 The Analytical Basis of the Research

Extensive quantitative and qualitative analysis was commissioned or carried out by the NRTEE under the auspices of the Carbon Emissions Pricing Policy Project. This combination of both qualitative and quantitative research provides a strong evidence base and reference for carbon pricing policy design in Canada. Three core methods were followed in developing the research for this report:

• A common set of policy evaluation criteria were used across all commissioned and internal work;
• Quantitative modelling and analysis was undertaken; and,
• Qualitative assessments were used to supplement the quantitative analysis.

Each of these is discussed below.

2.2.1 Policy Evaluation Criteria

A common thread throughout all the work was the use of a standard set of policy evaluation criteria. These criteria form the basis for assessing and ultimately selecting the elements of the policy. The five evaluation criteria common throughout this report are consistent with those used by Finance Canada, and have been used by the NRTEE in a number of climate change and energy-related projects including Getting to 2050:

• Environmental Effectiveness is a measure of how a design choice affects whether a policy will achieve the emission reduction targets;

• Economic Efficiency is a measure of how a choice affects the cost-effectiveness of a policy; efficiency means meeting emission reductions at least cost;

• Distributional Effects is a measure of impact on equity and the extent to which some stakeholders are affected more adversely than others;

• Political Acceptability is a measure of likely support politicians would find to implement a policy option; and,

• Administrative Feasibility is a measure of the burden of implementing and reporting, monitoring, and enforcing a policy over time.

By employing a standard set of policy evaluation criteria across all of the research undertaken for this project, the NRTEE arrived at a better understanding of the implications of alternative policy design options as revealed by the diverse research initiatives.

2.2.2 Quantitative Analysis and Economic modelling Tools

Quantitative analysis in this report relies on three different economic models: CIMS, D-GEEM, and TIM. Results from these analyses corroborate each other. Given the inherent uncertainty associated with economic modelling, consistency between models provides credibility for the overall analysis. Further, different models have different strengths; for example, CIMS provides a good representation of technology and investment in technology, while D-GEEM and TIM can provide better projections of macroeconomic costs and trade impacts. Short summaries of the three models follow:

• The CIMS model provides a good representation of technology change and how it might respond to carbon emissions pricing policy. It simulates the evolution of technology stocks (such as buildings, vehicles, and equipment) and the resulting effect on costs, energy use and emissions. Technology in use is tracked in terms of energy service provided (e.g., m² of lighting or space heating) or units of a physical product (tonnes of market pulp or steel). Forecasted market shares of technologies competing to meet new stock demands are determined by financial factors as well as consumer and business technology preferences.¹¹

• D-GEEM is a computable general equilibrium model of the Canadian economy.¹² It aggregates Statistics Canada data into eight energy producing and using sectors, namely crude oil production and extraction, gas extraction and transmission, refined petroleum product manufacturing, coal extraction, electricity generation, energy intensive manufacturing, other manufacturing, and the rest of the economy. As a dynamic general equilibrium model, D-GEEM provides a better representation of macroeconomic feedbacks and of consumer behaviour than technology models such as CIMS. Alone, however, it does not provide a good representation of technological responses to carbon policy.

• TIM is also a macroeconomic model and thus useful for modelling likely trade and macroeconomic impacts of policy to the Canadian economy as whole. In TIM, approximately 70 categories of foreign trade are identified (separately for exports and imports) in 285 industries. Among other factors, changes in the cost of operating an industry due to policy will be reflected in both exports and imports.¹³ Changes to the shipments of any industry impacts all other industries indirectly. Changes to real incomes of households and businesses will induce further changes to spending (consumption and business investment) to provide a full ?multiplier? impact on overall, and industry-specific, impacts.

The models informed different elements of the report. CIMS modelling was used to inform the assessment of distributional impacts, to develop the technology forecast scenario, and to assess options for complementary regulations. CIMS outputs were also linked to the TIM and D-GEEM models which were used to assess macroeconomic implications for pricing policy and to empirically assess competitiveness and leakage issues. D-GEEM was also used to evaluate policy options for revenue recycling, border adjustments, and international purchases.

Limitations of Economic Modelling

Economic models can be very useful tools for understanding complex systems like the Canadian energy-economy system and the likely impacts of policy. In the analyses in this report, the best modelling available has been used. Combining models with different strengths and weaknesses has allowed the NRTEE to generate more improved forecasts than those resulting from one model or another. Comparing forecasts from different models leads to greater confidence in the conclusions drawn from modelling. Finally, using stakeholder and expert elicitation processes to test the results of modelling improves the credibility of the results.

It is important to remember that all model forecasts are inherently uncertain. They should not be considered as exact predictions of what will occur. These complex models depend on assumptions about technology, consumers, trade, and the economy. Uncertainty in the forecasts, however, does not preclude the usefulness of the models. Forecasts can provide a directional indication of the likely impacts of policy and can be very useful in comparing relative impacts of different policy options. In an effort to be as transparent as possible, throughout this report the assumptions and different combinations of models underlying each of the different modelling analyses are described.

2.2.3 Qualitative Analysis

The NRTEE undertook and commissioned substantial qualitative analysis and research to inform and test its conclusions. This qualitative research included:

• Qualitative analysis of carbon pricing instruments. In addition to the rigorous economic modelling of carbon pricing options, consultants provided qualitative analysis of carbon pricing policy instruments. This analysis assessed the administrative feasibility and political acceptability of carbon pricing design options, and supported the economic evidence on their cost-effectiveness.¹⁴
• Analysis of technology policies and innovation frameworks. Two consultant reports were commissioned to assess barriers to the deployment of carbon abatement technologies, and the technology policies that may be required within the context of a broader carbon pricing policy framework. Consultants also conducted an expert stakeholder review and ?ground-truthing? of the technology scenario projected by the NRTEE?s quantitative modelling.¹⁵
• Consultations with expert stakeholder groups concerning the interests and needs of regions and sectors.¹⁶ Consultations and meetings with stakeholders took place throughout the project. This included consultations with industry and business interests, environmental experts and groups, academics, public sector experts, economic modelling experts and financial interests. Regional outreach sessions were held in Montreal, Ottawa, Toronto, Calgary and Vancouver, and three expert advisory meetings took place in Ottawa. Consultants were also commissioned to assess stakeholder views of various carbon pricing policy options.¹⁷
• Analysis of international policy developments. In-house research reviewed developments in jurisdictions implementing or moving towards carbon pricing and in Canada?s major trading partners, particularly Europe, the US and Australia.
• Analysis of governance frameworks and institutions to implement carbon pricing policy. In-house analysis was supplemented with an expert workshop on carbon pricing and governance issues.

The next chapter discusses the main elements of the carbon pricing policy, starting with its goals.