Aldyen Donnelly: Getting the carbon market right

(Dec. 15, 2010)  Aldyen Donnelly talks about the best way to reduce carbon emissions in Canada.

I oppose carbon taxes because, not only are they regressive, but they shift the tax burden from corporations to the public sector and feed-in tariffs, which, in implementation, require civil servants to set prices and pick technologies, inhibiting both competition and innovation rates.  The current form of carbon tax proposed by most advocates at this time—including but not limited to the Council of Chief Executives—taxes Canadian consumption of made-in-Canada energy while effectively exempting GHGs arising from the export of Canadian raw resources.

Any of the proposed carbon tax measures call on Canadian taxpayers to indirectly provide new subsidies for raw resource exports at a time when government policy should be incenting investors to develop value-adding capacity within Canada’s boundaries.

I do favour legally-binding Renewable Energy Standards (RES), as long as the definition of “renewable” in the standard includes conservation/demand side management (“negawatt-hours” in my lingo) in the definition of “renewable supply”.  Japan first introduced its RES in the early 1970s, as a defence against oil shocks. Every European nation has an RES (Spain’s goes back to 1985), as do 36 US states.

A significant share of the academics who write about these things conflate the RES and FIT, typically attribute energy efficiency and green energy supply gains to the FIT without either:

  • distinguishing between the RES and the FIT, or
  • determining what portion of the efficiency and/or renewable energy supply benefits are rightly attached to the RES, as opposed to the FIT.

Every nation/state that has cost-effectively developed a significant renewable energy sector through policy has done so with an RES—best US examples: Texas, Connecticut, Massachusetts, Minnesota.  But not all RESs are equal or equally cost-effective—worst US RES examples: California, New York.

Except for Ontario and Germany, every nation/state that currently has an FIT in place had first operated an RES-regulated energy market for a number of years before introducing the FIT. Spain’s RES became law in 1985.  Spain’s FIT was introduced in 2002 and subject to major modification in 2006. Spain and Germany both effectively gutted their FITs in 2009/10.

Perhaps this is the point at which I should also note that the government of Canada likely can introduce a federal RES with the expanded sectoral scope as a regulation without risk that the regulation will be subjected to a constitutional challenge.  I recognize that the feds can introduce a carbon tax without constitutional challenge, but such a regressive tax measure is ill-advised.

By comparison, any federally-proposed cap and trade regime—which is simply a quota-based supply management regime—will likely be defeated by a provinces-led constitutional challenge. The federal government may not impose a quota regime on provinces without their prior consent and full approval.

There are two reasons the RES is the more effective and efficient measure and should never be confused with or conflated with an FIT.  First, an RES dictates increases in the renewable shares of total electricity or energy sales.  BC’s current renewable electricity policy is deficient because it defines the target as a % of domestic electricity generation, not as a % of total electricity sales, so the policy is failing to displace low cost coal-fired power imports and is in fact, perversely, contributing to increases in those high GHG imports.

A policy is also deficient—in comparison to a regulated standard—because well-capitalized renewable energy developers do not invest in response to a policy, they need a law.  That BC’s lawmakers continue to decline to convert the policy into a law and continue to use domestic production as the baseline, instead of total—domestic and export—electricity sales, sends a clear signal to well-capitalized investors that BC’s government is not yet truly serious about reducing GHGs.

Because well-capitalized investors are, therefore, avoiding BC, renewable energy development in BC will always be more expensive than elsewhere, because the utility-guaranteed price for new renewables in the province has to finance both (1) the capital works and (2) the under-financed balance sheets of the project proponents.

Second, the RES leaves it to the market to compete on a price basis to offer the target new supply.  When governments set prices through an FIT, they inhibit competition and innovation.

Most existing RESs do not recognize the permanent reduction of demand for energy (conservation, demand side management) as equivalent to the introduction of new zero-emission supply.  That is a mistake.

If/when Canadian legislators settle down and consider legislating RESs instead of the less efficient carbon taxes and FITs, they should be careful to introduce conservation as “renewable supply”, thus putting efficiency investments on a level playing field with new renewable supply.  In this context, I would classify district/community heating—the substitution of distributed steam or hot water for gas-fired or electric space and water heaters—as conservation that should be rated “renewable” in an RES.

In the longer-term, Canadian fossil fuel exporters should be in a position to ship fossil carbon-based products along with Canadian RECs, putting a verifiable low carbon rating on all of our carbon-based exports (energy, building products and food).

In Canada, I would hope to go farther than Europe and the 36 US states have gone in RES scope.  For the mostpart, their RES’s dictate an increase in renewable’s share of electricity sales only.  Canada’s final RES should treat all major energy suppliers equally.

Let’s say we promulgate an RES that dictates the development of 10,000 MW-equivalents of new renewable supply—where permanent demand reductions are deemed to be included in the definition of “new renewable supply”.  The process is that new renewable supply and conservation projects are registered, and every time they report (ex-poste) the sale of one MWh of power (or prove, ex-poste, a one MWh-equivalent reduction in power demand), the registered projects receive one Renewable Energy Credit (REC).  The suppliers of electricity are required to surrender, annually, a volume of RECs to cover the government-estimate MWh sales-equivalent of the new renewable electricity supply target.

That is where most EU and US RESs stop.

Canada’s RES should require every distributor of natural gas and petroleum products to report total sales and exports, annually, in both petajoules (Pjs) and MWh-equivalents (where one Pj = 277.778 MWhs).  These other energy suppliers/distributors should have the same obligation to surrender RECs—where the obligation is defined as % of total MWh-e sales t that is assigned, by law, to the electricity distributors.  This approach covers 85% of the national GHG inventory with the renewable mandate and increases demand for RECs.

This increase in demand breaks monopoly electricity distributors ability to set prices in the REC market.  It also makes, for the first time, investment in renewable energy supply and conservation a core business programme for fossil fuel distribution companies.

Investments in carbon stock increases in forests and through geological sequestration can also receive RECs—as opposed to issuing RECs to biomass combustion…a bad idea in the long term.  The verifiable increase in carbon stocks can be converted to Pj-equivalents which, in turn, can be converted to MWh-equivalents for purposes of determining how many RECs can be issued to new and sustained increased in biological and geological carbon stock increases.

It is much simpler to track and audit carbon stock, renewable energy capacity and energy efficiency project claims than to track and verify full fuel cycle GHG factors.  Focusing on the RES/REC market opportunity involves much reduced government market intervention and administration than regulations that are based on GHG factors.  That is not to suggest that Canada will be able to totally abandon GHG regulation.  But our GHG regulations should be limited to emission reporting, large stationary source emission permitting and critical product standards.

The primary objective of GHG regulations should be to reduce the rate at which domestic GHG levels increase.  The RES/REC measures should be the primary driver of reduction in demand for GHG-intensive products.  Since the RES/REC regulations create market demand for low GHG products, they are the pre-requisite compliments to the GHG-based product standards.

Think of the ultra low sulphur diesel regulation as an analogy.  In that regulation, Canada stipulates that (1) only low sulphur diesel can be sold in Canada (the product standard), and (2) Canadian refineries can manufacturer only low sulphur diesel (the production standard) and (3) there are limits to the amount of SO2 that Canadian refineries can release to the atmosphere (the permit- based point-of-production emission limit). Our regulators could only contemplate regulating (2) and (3) because they were first regulating (1).  The very large mistake we witness playing out in the carbon markets is that regulators and their advisors are trying to figure out how to impose (3) and to a lesser extent (2) without first defining (1).

The RES/REC rule is one (certainly not the only, but my recommended) way to define (1).  This has to be in place before Canada can contemplate any variation on (2) or (3).

Please note that throughout the EU and under current US legislation, as soon as a substance is regulated or a new investment is incented under any type-(1), (2), or (3) regulation, any capital investments that result in the measurement, control or reduction of the targeted discharge can be “expenses in the same year” (in US tax language, which is the same as saying that 1-year depreciation for tax purposes applies in Canadian tax language).

Of course, even the best Canadian RES/REC regulation will fail to draw sufficient capital into the Canadian economy if we remain the only developed OECD nation that does not offer one-year ACCA for capital investments that will be register-able and earn RECs.  Of course, the ACCA regulation administration costs are very low if, by definition, the standard for qualifying for the ACCA is that a project is federally registered as “renewable” and receiving RECs.

I should note that every “tax expenditure” (including ACCA) benefit that exists in US law must, under law, receive a discrete budget allocation just as if it was a cash expenditure.

This procedure caps the federal treasury’s exposure to tax credit/exemption-based incentives.  It also required legislators to agree on a method for rationing tax credits if/when demand exceeds supply.

For example, the legislated tax “credit” for US ethanol producers is US$0.51/US gallon.  In law, this is actually a maximum tax credit.  In 2009, ethanol supply exceeded the budget forecast, so the average tax credit realized by the large ethanol producers was US$0.40/US gallon.  For this credit, the US regulations stipulate that the tax credit received from the budget will be pro-rated to the producer’s share of total US output.

For other tax measures, a first-in/first-paid principal applies.  I like the first-in/first paid principal for one time tax credits and when there is a good reason to create competition for the tax credit.  I like the pro-rating procedure when private costs of producing the favoured good or service should go down as market penetration goes up.

Either way, I think that the governments of Canada should seriously consider: (1) 1-year depreciation for capital investment in potentially REC-earning projects (as long as they are REC-earning), along with (2) the discipline of US-style capping of budgets for direct or indirect energy tax credits that are authorized in Schedule II (ACCA regulations) of the Canada Income Tax Act and (2) a pro-rating approach to rationing these ACCA credits if/when demand exceeds budgeted supply.

Back to Denmark’s national GHG reductions…

In fact, 3 factors account for 100% of Denmark’s achievement of their Kyoto target:

1. Offshoring most manufacturing. By the end of 2008, Denmark hosted 3,547,000 jobs in the manufacturing sector. This is down 41% from 1990 and down 23% from 2000 manufacturing job levels. You could argue, however, that this dissemination of the Danish manufacturing sector is at least in part due to the high price of electricity. You could also argue that the Danish jobs-lost-per-TCO2e-of-GHGs-reduced ratio is one of the highest in the world. If we are looking for good policies, shouldn’t we favour ones that deliver goods producing sector job gains per TCO2e reduced?

2, District Heat. In 1989, Denmark passed a law making it illegal to install a furnace or water heater (of any efficiency) in a new home, or to replace one in an existing home in most districts in the nation. That meant that families had no choice but to hook up their homes to district heating systems to heat space and water. This displaced building sector demand for natural gas. (Danish natural gas production levels have increased, and all of the gas that is no longer consumed in Denmark is now exported.) 80% of the hot water in the Danish district heating system is generated at old coal-fired power generation stations. I, personally, am a big fan of DH and mourn the fact that we are not even talking about it, at any volume, in Canada. Having said that, I don’t think I can support the very Draconian regulation (no more furnaces in homes) that Denmark promulgated in 1989.

3. Shifting the single passenger vehicle fleet from gasoline to diesel fuel. This produces a 25% reduction in passenger vehicle tailpipe GHGs. I remain astounded that moving gasoline out and substituting very low sulphur (less than 10 parts per million) diesel in Canada’s passenger vehicle fleet is not the #1 ranking energy efficiency and GHG reduction strategy in Canadian provinces’ policy packages.  While producing gasoline from Alberta oilsands feedstocks in refineries designed to achieve a 45+% gasoline fraction results in a relatively high full fuel cycle GHG footprint, producing diesel in refineries designed to max out the diesel/distillate fraction (Shell’s existing Scotford plant in Alberta, for example, or the proposed new NWU upgrading and refining facility) from oilsands feedstocks can have a lower wellhead-to-refinery gate GHG footprint than diesel or gasoline refined from conventional crude in those refineries designed to max out the gasoline fraction.

So one of the cheapest, best proved ways to reduce Canadian GHGs while protecting the asset base that is Canada’s oilsands is to shift the Canadian passenger vehicle fleet from gasoline to diesel, where the diesel originates in refineries designed to max out the diesel/distillate fraction.  Of course, I would hope that over time this diesel would include biodiesel.  From an environmental standpoint, biodiesel can be sustainably produced, where ethanol—a gasoline additive—probably cannot.

Of course, none of these measures that have led to reductions in Denmark’s GHG inventory has anything to do with wind power generation capacity, carbon taxes or feed-in tariffs.

Aldyen Donnelly, December 15, 2010

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2 Responses to Aldyen Donnelly: Getting the carbon market right

  1. Scott says:

    You note Ontario and Germany as two countries that jumped to FITs without stopping a “RES-regulated energy market.”
    Germany didn’t seem to revise all the kinks out of their FIT programs in the past couple of years. Solar, particularly, seems to be a large problem due to the success of the FITs, with the reduction of FIT amounts only spurring more rapid expansion in solar output. Here’s one more example of the problems associated with the FITs:

    • Aldyen says:


      You are very right. While I probably should not generalize, it seems to me that nations that started with RESs had the opportunity to get the kinks out in that regulatory context, with less damage to the overall economy, if they did not get the RES right in the first place. That is not to say that every nation that started with an inefficient RES elected to get the kinks out (the UK comes to mind), but many did.

      I just don’t see any examples of nations that got it anywhere close to right if/when they started with the FIT, in the absence of the foundation of and prior experience with an RES.

      Germany’s green energy market problems are legion. Most of the new “green energy jobs” that did appear in Germany were short-lived, and imported from places like Denmark. As quickly as these jobs left Denmark to set up in Germany, they left Germany to set up in Portugal and Spain, and are now transitioning from Portugal and Spain to China.

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