One of the key issues missing in the very passionate debate currently taking place in British Columbia on Kinder Morgan is the strategic importance of this project in the context of an increasingly unreliable trading relationship with the United States.

It is not just the mindless protectionist rhetoric coming from the Trump White House; it is the very real and mindful tariffs the United States has imposed on lumber, newsprint and other goods in its mercantalist efforts to protect politically favoured industries. Canadian politicians of all stripes say that the American tariffs and threats are unacceptable; we must stand up for Canadian workers and industries. But the fact is we only control what we can do – in the end the Americans, Democrats as well as Republicans, will do what they perceive to be in their political interest. They are all “America ‘Firsters” – just some (like Trump) more obnoxious about it than others.

Diverting sales of what the United States wants most from us – abundant, low-cost natural resources – is one of the things we can and should do. And the Kinder Morgan project could play an important role in that regard. It would provide expanded Canadian access to Asia-Pacific markets that would enable oil producers to divert some $5 to $10 billion of crude oil sales per year away from the United States to other markets. Whether in the context of Trump’s “zero-sum game” trade policy, or simply through resulting exchange-rate effects, diverting significant amounts of crude oil (and the same applies to natural gas and other natural resource sales) would make more room for U.S.-bound exports of manufactured goods.

Critics will rightly point out that Kinder Morgan does not guarantee that crude oil exports will be diverted to Asian markets. Deliveries through Kinder Morgan may simply enable more sales to the U.S. Pacific Northwest and California. The point, however, is that it provides the potential to do so, and that potential in itself would not only enhance the value of our crude oil exports but also reduce our dependence and vulnerability to protectionist (in effect classic colonial power) politics in the United States. In short, in addition to the higher prices and transportation cost savings the Kinder Morgan project is expected to generate, there is the strategic diversification / reduced U.S. dependence value that is very important to recognize in this difficult pipeline debate.

Of course, whatever the benefits of Kinder Morgan, there are the very real concerns the project raises. There is the concern that pipeline expansion will contribute to growing oil sands production and greenhouse gas emissions. There is the low-probability but high-consequence risk of major oil spills. And there are adverse environmental effects, most notably, in the National Energy Board final report, with respect to the impact of increased tanker traffic on the population of endangered resident southern killer whales. These are undeniable and unavoidable tradeoffs which people will very legitimately value and weight differently. For some these concerns are of overwhelming significance and no matter what the government does they will remain opposed to the project. For many others, however, there are much stronger steps the government could take to lessen the risks and costs – to make the tradeoffs more acceptable.

With respect to concerns about growth of oil sands production and related emissions, the federal government could pull back from what appears to be support for all new pipeline projects. If the key benefit is reducing dependence on the U.S. market, the government could make clear while it supports Kinder Morgan, it does not support the development of Keystone XL or other increased access to the U.S. market. Diversification, not expansion of export capacity, should be the primary goal.

With respect to oil spill risk, the government has already announced measures that would improve tanker safety and oil spill response. Indeed, the NEB concluded that these improvements may offer the coast a benefit relative to the current situation. But this is an area where British Columbians and indeed all Canadians must be satisfied that the residual risks truly are minimized, the oil spill response in fact ready and effective, and issues around marine spill liability fully addressed.

And with respect to the impact of marine operations on the resident killer whale population, the issue here is the total amount of tanker traffic, not just the increment from Kinder Morgan. A comprehensive tanker traffic plan is required, not an arbitrary restriction on one source of shipment. If limitations on the total number of tanker transits are required, the restrictions should be imposed on the least valuable or desirable products. It is hard to imagine, for example, that shipments of strategic importance to the Canadian oil industry should be restricted before the phaseout of thermal coal export–related tanker traffic. Nor should Canadians willingly accept neighbouring U.S. calls for restrictions on Canadian oil tanker traffic without regard for the number and impact of U.S. oil-laden and other tankers destined for Puget Sound.

Continue reading “What to Do with the Elephant”

The Peace River is located in the northeast corner of British Columbia. It has long been recognized that the river has significant potential to generate electricity and, by 1980, two of three productive sites had been exploited (see map). Since July 2015, BC Hydro, the provincially owned power utility, has been constructing a dam at the third site. This third dam, the Site C project, has become a subject of intense controversy.

Site C Map

In the provincial election held in the spring of 2017, the then-governing Liberals defended their decision to launch the $9 billion project, while the NDP and Green Party opposed completion – the Greens more adamantly than the NDP. The election outcome was 43 Liberal MLAs and 41 NDP, with three Green MLAs holding the balance of power. The province is now governed by the NDP under Premier John Horgan with support from the Greens. One of the new government’s initiatives was to order a quick review of the Site C project. The BC Utilities Commission (BCUC) was given a deadline of November 1. At the time of writing in early November, its final report has been released and the government is reviewing the findings. A decision is expected before the end of the year.

Over the past 35 years there had been two major reviews of BC Hydro’s proposed Site C project. The first was in the early 1980s when the BCUC held hearings on BC Hydro’s application for an Energy Project Certificate – the regulatory requirement at that time. The second and more recent review was that of the Joint Review Panel, which held hearings and in May 2014 provided its report and recommendations to the governments of British Columbia and Canada on the social and environmental impacts of the project.

Despite the passage of time and differing focus and regulatory context of their investigations, what is most striking about these two previous reviews is the similarity of their conclusions and recommendations. Neither review rejected the project on environmental or other grounds. They both set out mitigation and compensation strategies to address land use and environmental impacts. And they both recognized that the project could provide significant benefits. The Joint Review Panel was particularly clear on the benefits:

Despite high initial costs and some uncertainty about when the power would be needed, the Project would provide a large and long-term increment of firm energy and capacity at a price that would benefit future generations … and provide a foundation for the integration of other renewable low carbon sources as the need arises.1

Notwithstanding the benefits the project could provide, both reviews recommended further study and public hearings before authorizing the project to proceed.

In its 1983 report, the BC Utilities Commission recommended that the issuance of an Energy Project Certificate be deferred until BC Hydro could confirm the need for and cost-effectiveness of Site C. It recommended that BC Hydro improve its forecasting procedures, including the use of econometric methods and better treatment of conservation, and investigate other alternatives including planning agreements with Alberta that could increase the firm supply capability of existing resources. It also recommended that the government clarify its industrial development strategy, in particular the role that BC Hydro should play in facilitating the development of new electric-intensive industry.

In its 2014 report, the Joint Review Panel concluded that BC Hydro had not fully demonstrated the need for the project in the timetable it set forth. Like the review three decades earlier, the panel called for improvements in forecasting, further consideration of alternatives and greater clarity on the need for BC Hydro to develop resources in anticipation of major liquefied natural gas (LNG) loads. In its concluding remarks, the Joint Review Panel set out the difficult tradeoff the Site C project entailed:

Site C, after an initial burst of expenditure, would lock in low rates for many decades and would produce fewer greenhouse emissions per unit of energy than any alternative source, save nuclear. These advantages must be set against permanent damages to nature, the interests of First Nations and to the specific local interests described in this report.2

A clear case would be required to justify Site C, and both reviews called for further investigation and follow-up hearings for that case to be made.

Unfortunately, Christy Clark’s B.C. government did not heed the Joint Review Panel’s advice. Despite outstanding questions about need and alternatives, and the vociferous opposition of environmental groups, First Nations and local interests, the government directed BC Hydro to start construction immediately with a target in-service date of 2024.

It is not entirely clear why the government decided to start Site C construction in 2015, before the case for the project could be independently reviewed and confirmed. Unless major LNG projects with large electricity loads were undertaken – an unlikely prospect with the post-2014 decline in oil and gas prices – there was no urgent need for new supply. And there were First Nation and other court challenges to be heard. If the object was simply to get past the inevitable opposition to large projects of this kind, proceeding without a clear, independently confirmed business case only served to inflame those opposed.

Project construction is now well underway; BC Hydro has hired thousands of workers and already spent more than $2 billion of the nearly $9 billion it expects the project to cost. It is in this context that the NDP government established the latest review. It specifically called on the Commission to advise on whether the project is on time and on budget, what the costs to ratepayers of suspending or terminating the project would be, and whether there are alternative portfolios of projects and measures that could provide similar benefits at similar or lower cost.

The Commission advised that there will likely be a one-year delay in the in-service date and the total cost for Site C will likely escalate to $10 billion or more. It estimated that the cost to terminate the project and remediate the site would approach $2 billion. It concluded that suspending the project would be the least desirable option. The choice for the government, it advised, was completion or termination. Based on an assumed $10 billion total cost for Site C and a set of Commission assumptions about export prices, and the cost and relative energy value of alternative resources, it concluded that there was only a small difference (in favour of completion) between the present value cost of completing Site C and the present value cost of terminating the project and pursuing alternative resources as required (in particular, wind, geothermal and demand-side management measures).

This latest review was a seriously constrained process. What normally would take a year or more to do – assess matters of major consequence to the future development of BC Hydro – had to be done within a 12-week period. As the Commission stated, its analysis was only intended to be illustrative in nature. There was no time to examine in any detail the evidence BC Hydro, other parties and the Commission itself put forward on the consequences of completing, terminating or suspending the project. Complicating the process and colouring much of the evidence is the fact that, for many opponents, the issue is that Site C should never have been started in the first place – a valid argument in many respects but irrelevant to the question of what to do now.

Should the project be stopped now that it has been started?

The question the government must address is: What is the best way to proceed given the $2 billion that has already been spent and the additional close to $2 billion, according to the Commission, that would be required to terminate the project and remediate the site to its original condition?

Opponents argue that Site C power is not needed, and if and when it is needed there are lower-cost demand- and supply-side alternatives that could be pursued. As with other megaprojects of this kind, they maintain that costs will likely escalate far above what BC Hydro has estimated. Notwithstanding the close to $4 billion in sunk and termination costs, opponents say it will be better for ratepayers, let alone environmental and First Nation interests, to stop the project. Though that is not what the BCUC concluded, many see the BCUC report as a vindication of their arguments that termination is the better option.

Site C

There is widespread agreement that BC Hydro will not need the energy Site C will produce in 2024. Site C power will be largely or totally surplus to provincial requirements for a number of years after the project is scheduled to come into service. And BC Hydro itself has belatedly acknowledged that construction costs will escalate above the estimates it has provided and stood by since the start of construction.

However, the validity of the opponents’ claim that lower-cost alternatives can be developed when needed is much less clear. There may be alternatives that would have been competitive with Site C before the project started, but there is no credible evidence to suggest that is the case given the over $2 billion BC Hydro has already spent on the project and the additional near $2 billion that would have to be spent to terminate the project and remediate the site.

The Commission’s self-described illustrative analysis of a portfolio of wind, geothermal and demand-side management measures suggests that completion and termination would be roughly equal in present value cost. However, the assumptions underlying the Commission’s analysis were manifestly unbalanced – very conservative in its evaluation of the completion option and very favourable and in important respects incomplete in its assessment of its alternative portfolio.

A key issue in the comparison of completion versus termination is the valuation of surplus energy and peak capacity. Site C will be largely or fully surplus to BC requirements for many years – the value BC Hydro can capture from surplus sales is critically important in determining the net costs of the completion option. The Commission rejected BC Hydro’s forecast of spot market prices and the even higher forecast of its own consultants. It argued a more conservative forecast should be used, much lower than those provided by power trade experts and its own technical consultants.

The Commission recognized that peak generating capacity has value, but decided to give no value to the surplus capacity Site C would provide. It wasn’t satisfied that BC Hydro could capture that value in export trades, even though that is precisely what BC Hydro’s trading subsidiary is designed to do.

The Commission further assumed that there would be no premium for the daily and seasonal shaping and the dispatchability Site C offers, even though that is a major comparative advantage of hydro generation with storage as compared to alternative resources – an advantage that trading experts see as increasingly important the more wind and solar are developed in neighbouring jurisdictions.

And the Commission did not consider or account for any value that surplus sales would have in displacing greenhouse gases (GHGs). Oddly, the Commission’s only comment on GHGs was that its alternative portfolio would have lower emissions in the short term, which in itself is misleading because over the longer term the Joint Review Panel concluded Site C would have lower GHG emissions than any other source save nuclear. More importantly it ignores the very significant GHG benefit that surplus from Site C would have in displacing thermal power generation. Depending on unfolding carbon policy, that could add to surplus sales prices; at a minimum it is a very important social benefit to take into account.

All of this served to greatly understate the value of Site C surplus and therefore overstate the net cost of Site C for ratepayers when required to meet domestic loads. At the same time the Commission made a number of assumptions serving to understate the costs of its alternative portfolio. With respect to the demand-side management measures, it only included costs BC Hydro would incur to provide incentives or programs designed to encourage less consumption or to shift consumption off peak. It didn’t include any of the costs customers would incur and, in the case of industrial load curtailments, the costs that workers would bear. It included geothermal resources even though it acknowledged the resource may not be available at the assumed cost. With respect to wind projects, it assumed they would be financed at BC Hydro’s borrowing rate, even though they would more likely be developed by independent power producers with the significantly higher costs of capital they would incur. And it assumed a minimal integration (instantaneous backup) cost for wind – one fifth of what Hydro estimated.

While there are reasons to question some of BC Hydro’s assumptions underlying its assessment that termination at this time would be $7.5 billion in present value more expensive for ratepayers than completing the project, BC Hydro’s general conclusion – it is more cost-effective to complete Site C than to abandon the project – is most likely right.

A simple model of the value of the energy and peak generating capacity Site C will provide suggests the present value of completing Site C in 2024, even if the power is fully surplus for five to ten years and is valued at an arguably conservative set of assumptions,3 would be in the order of $9 to $10 billion. This is $1 to $2 billion more than the BCUC’s estimate of the remaining costs to complete Site C. This plus the avoided termination and remediation cost would suggest ratepayers would be $3 to $4 billion in present value better off completing than terminating the project.

One could, of course, calculate different net benefits or even a net cost with a different set of assumptions. In an unabashed reversal from the conclusion the Joint Review Panel reached in its 2014 report about the long-term benefit from Site C, the former chair of the panel, Harry Swain, has argued that the value of completing Site C would be only $2 billion – far less than the costs BC Hydro would have to incur to complete the project. But to get that result he assumed that Site C would be fully surplus to domestic requirements for 20 years after coming into service, with an export value of $30 per megawatt-hour over that entire period. He didn’t assign any value to Site C’s peak generating capacity and completely ignored the value of Site C after 20 years of operation. It was not a serious or credible analysis.

There are reasons the value of Site C’s output could be lower than $9 to $10 billion (less growth in demand for electricity; falling costs of alternative supply). But there are also many reasons why the value of Site C’s output could be higher, including more demand for electricity from electrification trends than currently forecast, greater value from peak generating capacity, and higher surplus sales prices as a result of a more aggressive carbon tax or other such policies. It would take a one-sided set of pessimistic assumptions to suggest with any degree of confidence that BC Hydro and ratepayers would be better off abandoning the project at this time..

Build Site C – with a stronger intertie and a Peace River Trust

Peace River Valley

All eyes are now on the government, which faces an extraordinarily difficult decision. If the government proceeds with Site C, it will face the anger of many of its own supporters who are unequivocally opposed to the project. It will run the risk of alienating Green Party MLAs whose support it needs to maintain a majority in the Legislature. And it will be greatly disappointing to those First Nations who are opposed to the project, who will see this as a betrayal of the government’s commitment to reconciliation.

On the other hand, cancelling the project will have immediate adverse impacts on rates, with BC Hydro having to write off close to $4 billion in sunk and termination costs. The Commission was curiously silent on the time period over which these costs would be recovered in the termination case, but there clearly would be no justification to defer cost recovery into the distant future – in effect almost doubling BC Hydro’s deferral accounts that are already widely considered unfair to future customers. Termination would potentially have significant adverse long-term impacts as well, with BC Hydro being forced to develop or acquire what BC Hydro submits would be lower-value, higher-cost alternative sources of supply.

There is no middle ground here, but perhaps there is a strategy that the government could pursue that would not risk billions of dollars for BC Hydro ratepayers and could mitigate some of the environmental and First Nation opposition to the project. That would entail proceeding to complete the project, but taking steps to maximize the economic and environmental benefit it can provide and meaningfully recognize the adverse impacts this project and previous ones have had on First Nations and other communities in the Peace region.

An obvious step to take to enhance the economic and environmental benefit Site C can provide would be to strengthen the intertie with Alberta to enable more trade and coordination with that province. If Alberta and B.C. were a single province, there would be no issue about the need for Site C. Its development, combined with increased intertie capacity, would serve as an important component of the Alberta government’s commitment to phase out coal-fired thermal power production and thereby dramatically reduce GHG emissions in the electric sector.

In the short term, 5,100 gigawatt-hours of surplus energy from Site C could displace coal- and natural gas–fired generation, reducing GHG emissions by some 2.5 to 4.5 million tonnes of carbon dioxide equivalent per year. Assuming a social cost of carbon emissions of just $50 per tonne (and there are those who argue the social cost is much higher), the benefits of those emission reductions would be $125 to $225 million per year. Over the longer term, the storage, energy shaping and peak generating capacity provided by Site C and the rest of the BC Hydro system could provide the backup that wind projects in Alberta will need to ensure reliable supply and mitigate the volatility of Alberta electricity market prices that could otherwise occur as a result of variations in wind conditions. It would reduce the need for Alberta to develop gas-fired thermal backup for wind, enhancing the long-term GHG benefits greater coordination with Alberta can provide.

The federal government is currently investigating opportunities for strategic investments in interprovincial intertie capacity. A serious engagement in that process could add market value to Site C in the short and long term, and contribute significantly to the achievement of Canada’s GHG reduction goals.

The other key step would be to fully recognize and address the unavoidable adverse effects of Site C development, as well as the cumulative impacts of previous hydro development on the Peace River. B.C. could commit to something similar to the Columbia Basin Trust. This provincially funded and locally governed trust was created in recognition of the very significant cumulative impacts of hydro development on the Columbia River.

Instead of cancelling Site C with the very significant costs that would in all likelihood entail for BC Hydro and its customers, the government could direct significant resources to First Nation and other communities to support major investments in education, housing, family and community wellness and infrastructure, with priorities and programs established by the First Nations and local communities themselves.

The goal of a Peace River Trust would be to enable investments in the region that yield long-term benefits as important as what is lost with the dam’s development. A generously funded trust wouldn’t satisfy implacable opponents, but it would offset in meaningful ways the unavoidable adverse impacts of hydro development on the Peace.

Continue reading “John Horgan’s Site C Problem”

Nicholas Stern,
The Global Deal: Climate Change and the Creation of a New Era of Progress and Prosperity.
London: The Bodley Head; New York: PublicAffairs, 2009. 248 pages, includes references and index.

Lord Nicholas Stern has enjoyed an illustrious career as an economics professor, as Chief Economist of the World Bank and as an adviser to Gordon Brown, now British Prime Minister. He headed the British government team that in 2006 produced the 700-page “Stern Review” on the economics of climate change, and a very “stern” review it is. The report concludes that the costs of inaction are dire. Somewhat in the imperial tradition of William Gladstone, the moralizing 19th-century British Prime Minister, Stern has now supplemented the review with a book telling the world what is to be done.

“I am not a campaigner,” writes Nicholas Stern, but his passionate arguments and seemingly angry response to his critics speak otherwise. This is not follow-up analysis, nor simply logical argument. It is a call and guide for global action, and a curt dismissal of those who would argue against his position.

On the basis of his background in development economics and more recent work on climate change, Stern sees poverty in developing countries and climate change as the two greatest – and inextricably linked – challenges of our time. These are not alternative issues that must compete for global attention and resources: a central theme of Stern’s book is that they can and must be addressed together. Development assistance will not succeed if climate change is not mitigated. It is the developing countries that are most vulnerable to the effects of climate change and least able to cope with them. And efforts to curtail greenhouse emissions will be fruitless without the cooperation and participation of the developing world. These countries will be more willing and able to make significant contributions if their limited historic responsibilities are recognized and their future development aspirations are not undermined.

There is, in Stern’s view, no justification for failing to act. The scientific and moral imperatives are very clear. “Business as usual” will lead to concentrations of greenhouse gases in the atmosphere that significantly risk an increase in average world temperatures of more than 5 degrees Celsius – a level that would radically change the physical and human geography of the world. Failure to act, Stern warns, will result in severe dislocation; the consequent migration of billions of people “would plunge the world into massive and extended conflict.”

Carefully planned and concerted action, on the other hand, can reduce those risks at what Stern describes as relatively modest cost. His recommended target is to limit concentrations of greenhouse gases to 500 parts per million.That would still result in significant global warming, but would greatly reduce the probability of the more catastrophic temperature increases. To achieve this target, annual greenhouse gas emissions must be reduced by about 30 billion tonnes of carbon dioxide equivalent (more than 50 per cent of current levels) by 2050. Based on an estimated supply curve of greenhouse gas abatement opportunities, Stern calculates that the cost of achieving those reductions would be less than €30 (about C$48 at the time of writing) per tonne, in total less than 1 per cent of world GDP. Even if reductions costing up to €50 (C$79) per tonne were required, the total cost would still be less than 2 per cent of world GDP, a price “well worth paying” for the avoided risks.

Stern has no patience for those who do not accept what in his view is the overwhelmingly compelling logic of such greenhouse gas reductions. He calls those who argue for investment in adaptation as opposed to emission reduction “ignorant and reckless.” He dismisses as mistaken and confused those fellow economists who argue that he has overstated climate change costs by not applying a reasonable discount rate in summing distant future, uncertain events; in his view they are “making one logical mistake after another.”

This aspect of Stern’s book is greatly disappointing, the style as much as the substance. Few quarrel with the need for greenhouse gas reductions and an ultimate shift to a low-carbon economy. Fewer still oppose the aggressive pursuit of low-cost opportunities to abate emissions and reduce whatever risks there may be from increasing concentrations of greenhouse gases in the atmosphere. However, there are questions about the rate and extent of reductions Stern calls for, and legitimate concerns that they may not be achievable at anywhere close to the costs Stern suggests. It isn’t measured, efficient reduction in greenhouse gas emissions that is so worrying. It is the evangelical fervour that some advocates bring to this issue, demanding emission reductions at virtually any cost.

Stern’s estimated cost of 2 per cent of world GDP to meet his recommended target (which assumes unit costs remain below €50 per tonne) is not an insignificant amount. By 2050 that would equal some $2 trillion annually, an amount that exceeds Canada’s entire 2008 gross domestic product. The opportunity costs of that magnitude of investment should not be ignored. There are alternative investments in education, public health, infrastructure, governance and security – other moral imperatives – that also need to be addressed to improve social, environmental and economic conditions throughout the world and may yield greater social returns. And not all of those investments necessarily depend on greenhouse gas reductions to succeed.

Resources are scarce and need to be efficiently allocated. There is a risk that the absolute supremacy Stern and others assign to the greenhouse gas issue, and the disdain they exhibit toward those who might question their position, will preclude the dispassionate assessments needed for efficient allocations to take place.

Stern’s discussion of discounting, the economic practice of giving less weight to a benefit or cost the farther in the future it is expected to occur, is particularly sharp and unhelpful. There are good reasons for discounting. People generally do give more weight to more immediate than to more distant consequences, especially highly uncertain ones. Like Arthur Pigou and other classical British economists, Stern uses a near-zero discount rate in summing future costs and benefits. He considers discounting of the future at higher rates to be immoral, but in democracies people’s views matter and should not be summarily dismissed.

Furthermore, if the world economy continues to grow, as by most accounts it is expected to, especially in developing countries, a dollar of benefit or cost in the future will be less significant than a dollar today. Diverting resources from the present to the future may be tantamount to a diversion from the relatively poor to the relatively rich. Discounting, as Stern himself seems to grudgingly recognize, is needed to reflect that. Most importantly, discounting is needed to ensure that investments are not made without taking the social return into account. It is a way of recognizing the opportunity cost of displacing other possible investments.

Stern is right, and his critics would agree, when he states that an immediate program to reduce greenhouse gas emissions will have the benefit of enhancing our flexibility to respond effectively and efficiently to emerging information on the pace and consequences of global warming. The discounted present value of what we currently expect future climate damages to be is not the central issue; we need insurance against the more catastrophic outcomes that may arise. But the questions still remain: how much insurance do we need, and what is the best way of achieving it? It may well be that the slow-ramp approach of William Nordhaus and other critics, combined with aggressive, targeted research into abatement technologies, would be more cost-effective and achievable than the aggressive reductions Stern proposes.

The second half of Stern’s book addresses how his targets are to be met. The key criteria, he writes, are that the measures taken must be effective in meeting the emission targets he calls for, efficient in doing so at lowest cost, and equitable in the allocation of responsibilities and costs.

He argues that the full suite of policy measures – carbon taxes, cap-and-trade quota systems and regulations – will likely all be required, along with research and development support for renewable energy and other new technologies. Carbon taxes are a way to “internalize” the greenhouse gas externality – that is, to make those responsible for greenhouse gas emissions bear the cost – but are limited by the uncertainty over exactly what the magnitude of that externality is (what the marginal damage costs are), and by the uncertainty over the amount of emission reductions they will induce. Quota systems provide greater certainty over emission reductions, and are needed to create the global carbon markets that are central to Stern’s proposed global deal. However, quota systems can create uncertainty over the quota price, thus inhibiting long-term investment, and are more costly to implement. Regulations are generally not as desirable as market mechanisms, but can play an important and cost-effective role in setting industry-wide emission and energy-related standards. The mix of measures will vary from country to country.

Of course, exactly what is done and to what extent will depend on the global allocation of emission reduction responsibilities. Like the leaders of many developing countries, Stern insists that the developed countries must assume financial responsibility for realizing most of the needed reductions. He says this not as a practical matter – that the rich countries have the resources to take this on – but rather as a moral issue. It is the developed world that is historically responsible for the problem we face, and is currently contributing most to the increased concentration of greenhouse gases in the atmosphere. Therefore it is the developed world that must take the lead in addressing the problem.

Stern calculates that with a world population of some 9 billion in 2050, emissions will have to fall to about 2 tonnes per person, as compared to an average 8 tonnes today, and more than 20 in some developed countries like Canada and the United States. The question of how to allocate these emissions is central to Stern’s global deal. Limiting emissions to 2 tonnes per person in all countries would in itself require reductions in the developed world many times greater than in the developing world. However, Stern goes further: he says there are moral arguments that the per capita allocation of emissions to developed countries should be less than the world average, possibly even negative given their responsibility for the problems we now face.

The greater the required reductions in the developed world, the greater will be the transfer of resources to the developing world through investment in offset projects or purchase of quotas. And that serves well Stern’s interest in economic development as well as emission reductions. However, all this is very much Stern’s global plan as opposed to a viable global deal.

There is little reason to believe that the developed world will agree to emission caps that are proportional to population – let alone less than proportional. Stern’s arguments may play well in Delhi and Jakarta, but leaders in Washington, Paris and Ottawa will not be receptive to the suggestion that their citizens must bear a markedly disproportionate share of the costs to mitigate future problems. Will the citizens of the developed world agree to Stern’s plan because a British economist and developing world leaders say they must – regardless of how rich or poor they may be and regardless of how recently they may have migrated to the developed world? Not likely.

A global deal won’t be done by dividing the world into good guys and bad guys. It won’t be done if inequities perceived by the developing world are replaced by attempts to impose inequities on the developed world. A much different, more practical approach is required – one that recognizes the global interest in action and global ability to respond.

Stern likes to conduct thought experiments. He would have done well to consider how one would fashion a global deal if we were all one global country. The best way would be to seek out the globally least costly ways to reduce emissions wherever they may occur, and to impose global industry and energy pricing standards. The cost of emission reductions would fall most on wealthier residents, not by region but on individuals wherever they lived. And as for development, the efforts to eliminate poverty would have to be continued, in rich as well as poor regions of the globe, and be reinforced not because of climate change, but rather despite it.

 

There is little doubt, among economists at least, that market mechanisms are required to achieve significant reductions of greenhouse gas emissions in a cost-effective way. Exhortations will not suffice, and regulatory measures typically do not recognize the different circumstances of different households and firms. By providing financial incentives to reduce greenhouse gases, market mechanisms let individual decision-makers determine the optimum manner and extent of their response.

There is less agreement, however, about the type of market mechanism to apply. Should greenhouse gas emission quotas be instituted, like the cap-and-trade system successfully used to reduce sulfur dioxide and other air contaminant emissions from industrial processes? Or should a carbon tax be imposed on goods and services that generate greenhouse gases?

The economic logic of a carbon tax is that it internalizes the external cost of greenhouse gas emissions – the incremental damage costs that the release of greenhouse gases imposes on all others now and in the future. In so doing, the tax will raise the direct cost people and businesses incur when they consume goods and services that generate greenhouse gases, and provide industry with an incentive to develop substitute products and processes that generate less greenhouse gases. That in turn will promote a more appropriate benefit-cost test in the decisions people and businesses make. They will have to determine whether the benefit they derive from any greenhouse gas–generating behaviour exceeds the costs they face – costs that include the internalized cost of the greenhouse gases emitted. The higher the tax, the more likely they will choose alternatives that generate less greenhouse gases.

The political argument in support of carbon taxes is that, like sin taxes, they are a charge on behaviour we want to discourage. Most importantly, proponents of carbon taxes argue, the revenues a carbon tax raises can be used to reduce taxes on income and sales – charges on effort and economic activity that we do not want to discourage. Indeed, a major selling feature of the carbon tax recently instituted in British Columbia is that it will be revenue neutral – in effect, substituting for more odious, inefficient forms of taxation.

The economic logic and supporting political argument for a carbon tax are compelling. However, they are not entirely valid. The economic logic underlying a carbon tax presumes there is a well-defined external cost to internalize. The problem is that the incremental damage costs associated with incremental greenhouse gas emissions in any given jurisdiction are very unclear.

Whatever consensus there may be on the meteorological implications of increasing releases and concentrations of greenhouse gases in the atmosphere, there is no consensus on the damage caused by an incremental tonne of emissions. The incremental damage of a tonne of emissions generated in any given jurisdiction at any point in time will depend first and foremost on the amount of emissions being generated elsewhere – in other words, what any tonne of emissions in any given jurisdiction at any point in time is incremental to. In particular it will depend on where we are in relation to key thresholds.

Also, the estimated economic consequences of the emissions will depend on what measures are assumed to be taken to adapt to climate change and what technological innovations in adaptive and offset measures take place. Further, the present value of the damage or adaptation costs, as the recent Nordhaus-Stern debate shows, depends critically on the discount rate we apply to future effects –
especially very distant future ones.

If there is any emerging consensus among economists, it is that the fundamental concern is not so much the expected damage from each incremental tonne of emissions, which is highly uncertain and may be relatively small in present value terms at any significant discount rate. The major cost of greenhouse gas emissions above what scientists are telling us is a tolerable maximum threshold has to do with the risk of future catastrophic, irreversible consequences that ever-increasing greenhouse gas emissions may cause. Such a catastrophe may be a low-probability “tail event,” but nonetheless it is a risk that people in wealthier societies do not want to take and poorer societies do not want imposed on them by the cumulative historical and current actions of others.

This suggests that the market failure our greenhouse gas market mechanism must address is not the need to internalize a well-defined external cost. Rather it is the need to live within a cap on the total amount of greenhouse gases we emit – a cap that in any given jurisdiction is consistent with the global cap and global allocation of emission rights we expect will ultimately be agreed on.

Carbon taxes could be designed to achieve a target cap on emissions. However, the level of tax required is highly uncertain, dependent not only on the price elasticity of demand on all emission-generating goods and services but also on all other factors governing the price of those goods and services, like the cost of crude oil. The tax needed at a $50 per barrel price of crude is markedly different from that required at $150 per barrel. The likelihood of significantly undershooting or overshooting the target is considerable.

The more direct and certain way to achieve an overall emission target is to impose a cap-and-trade system. If a carbon tax is chosen, it is only as a practical “second best” alternative where a cap-and-trade system is difficult or expensive to implement and enforce.1

And what about the political argument in favour of a carbon tax – that it constitutes a more efficient and desirable form of taxation than income or sales taxes? That argument presumes the greenhouse gas–generating behaviour giving rise to the payment of carbon taxes is costless. However, if we take seriously the rationale for imposing the tax in the first place – as a way, even a “second best” way, to achieve a specified emission target – and if we recognize that even under the most optimistic elasticity and price assumptions the taxes currently introduced in British Columbia and elsewhere will not achieve that target, the funds that are raised are not free. They cannot be dedicated to reducing other taxes unless the emission target is abandoned. In other words, the carbon tax revenues are needed for additional measures, such as international offset purchases and spending on green infrastructure, that will be required to supplement the effect of the tax alone.

To say that a carbon tax can be revenue neutral, with the funds used entirely to reduce income and other taxation, would be like saying the same for road tolls. Perhaps road toll revenues could be used entirely to reduce income and other taxation, but only if the tolls were sufficiently high to eliminate the need for investments in additional road and bridge capacity. Otherwise, at least some of the road toll revenues are needed to pay for the investments needed to accommodate the increase in traffic that occurs despite the tolls. One could say that the road tolls offset the increase in income and property taxes that would otherwise be needed to make the required road and bridge investments, but that is quite disingenuous. It means other taxes may not go up as a result of the introduction of road tolls, but it certainly does not mean other taxes can go down.

So, by all means we should support carbon taxes if the alternative is no market mechanism at all. But it is important to recognize that cap-and-trade is a preferable market mechanism and carbon taxes should be limited to those sectors where cap-and-trade is impractical to implement and enforce. And let us not pretend that carbon taxes are revenue neutral, at least if our emission targets are to be met.

Continue reading “The Case for Cap and Trade”