9. Path Forward: Potential Instruments to Reduce Sulphur in Canadian Fuel Oils

• 9.1 Overview
• 9.2 Economic Instruments
  • 9.2.1 Tradable Permits
  • 9.2.2 Example 1 - US Sulphur Dioxide Trading Program
  • 9.2.3 Sulphur Taxes
  • 9.2.4 Example 2 - Tax Differential in Italy
  • 9.2.5 Example 3 - Sulphur Content Tax in Sweden
  • 9.2.6 Example 4 - Sulphur Content or Product Tax in Denmark
• 9.3 Potential Combination or Hybrid Instruments
• 9.4 Fuel Quality Regulations

In the Government of Canada's Notice of Intent for cleaner vehicles, engines and fuels, Environment Canada proposed "to develop measures to reduce the level of sulphur in both light and heavy fuel oils used in stationary facilities... with the view to matching the requirements set by the European Union for sulphur in fuel oils which will be fully implemented by 2008." The NOI noted that "Complementary measures to regulations, such as economic instruments, will be examined to accelerate the introduction of low-sulphur fuel oils."

Environment Canada is now moving forward on this initiative, with a target of reducing sulphur levels in HFO to 1.0% wt. and in LFO to 0.1% wt. Through this discussion document, Environment Canada is initiating public consultation on the basic approach to and timing of this initiative.

The following section provides an overview of instruments that can be used to reduce sulphur in fuel oils.

Economic instruments are policy tools that use market-based incentives to influence behaviour and achieve environmental objectives. Economic instruments include tradable permits, user charges and pricing, taxes, deposit-refund schemes, liability or insurance schemes, and subsidies.

Reasons that support the use of a market-based approach to environmental policy are:

• Economic instruments can be less costly to industry and consumers than command-and-control regulations because they provide firms and consumers the flexibility to choose among various mitigation options. For instance, emissions trading used under the US Acid Rain program has been estimated to have resulted in cost savings of about 50 per cent compared to command-and-control regulations.
• Economic instruments provide a continuing economic incentive for firms to reduce pollution, thereby stimulating innovation., and
• Economic instruments can result in lower administrative costs for government.

International organizations, such as the OECD, the United Nations' Environment Program and the World Bank, have supported the use of economic instruments for many years, in the name of achieving national environmental goals in the most environmentally effective and economically efficient ways possible. The Policy Report prepared by the OECD's Sustainable Development Task Force urges that "Governments should make greater use of environment-related taxes, and use the revenues to reduce other distortionary taxes, thereby maintaining revenue neutrality".

The OECD has also made specific recommendations for Canada on this respect. For example, the 2001 Economic Review of Canada and the 1995 Environmental Performance Review of Canada urged this country to "ensure that economic signals are right ... [by] moving forward with the wider use of economic instruments to prevent pollution and conserve natural resources".

Economic instruments have not yet been widely used in Canada, particularly at the federal level. There are several reasons for this.

First, both government and the public have more experience with traditional, command-and-control regulations. Secondly, the federal government has only recently acquired the legal authority (under the Canadian Environmental Protection Act, 1999) to implement tradable permit systems and deposit-refund schemes. Finally, although the federal government has long had the authority to implement environmental taxes, there has been some reluctance to adopt these measures because of the public's aversion to new taxes.

As noted in the Review of International Initiatives to Accelerate the Reduction of Sulphur in Light and Heavy Fuel Oils (March 2001) report, there is evidence from other countries that economic instruments can be cost-effective tools to reduce SO₂ emissions from LFO and HFO. The following sections examine examples of economic instruments that have been successfully used in other OECD countries for this purpose.

Two economic instruments have been used by jurisdictions to reduce SO₂ emissions from LFO and HFO, namely: tradable permits and taxation.

Under tradable permit systems, the government sets a limit on emissions or on total sales of particular substance used. There are two design options for a tradable permit program:

1. Emission trading can be used to control emissions of a substance. Generally, tradable permits schemes consist of three elements: first, the government would set a cap or limit on emissions. Second, the government would allocate permits allowing each designated emitter to release a specified amount of the pollutant, up to the total allowable limit. Finally, the firms are allowed to trade their allocated permits. Thus, firms with higher abatement costs may purchase permits from firms with lower abatement costs, resulting in lower abatement costs overall.
   
2. Product trading. A trading system can also be designed to control total product sales. For example, a tradable allowances system has been put in place to phase out the use of methyl bromide in Canada.

The main advantages of using tradable emissions permits are that:

• The desired SO₂ emissions target would be achieved; and
• Targets would be achieved at lower cost than command and control instruments, both to industry and government, mainly due to a high level of flexibility for industry and a relatively low level of information needs for governments.

Some of the main concerns around trading schemes are that:

• The cap may not be set at an optimal level of pollution from a social welfare point of view.
• Trading can lead to emission reductions in less-polluted (seller) regions and to an increase in heavily-polluted (buyer) regions, where local problems may be exacerbated. Correction factors can be considered to address these concerns.

The following example illustrates how emission trading has been applied to reduce SO₂ emissions in the US. It is also possible to conceive of a tradable allowance system for sulphur in fuels, whereby a cap would be set on total sulphur content, but there are no examples of this type of system. Further analysis would be required to determine the applicability of tradable permits systems to control emissions from HFO or LFO in Canada.

Under the U.S. Acid Rain Program, emissions trading is used to reduce SO₂ emissions from electric power utilities. The US government set a goal of reducing annual SO₂ emissions by 10 million tons below 1980 levels.

Phase I began in 1995 and affected mostly coal-burning electric utility plants. Emissions data indicate that, in that year, SO₂ emissions at these units were reduced nationwide by almost 40% below their required level. Phase II, which began in 2000, tightened the annual emissions limits imposed on these large, higher emitting plants. Restrictions were also placed on smaller, cleaner plants fired by coal, oil, and gas. The program now affects existing utility units serving generators with an output capacity of greater than 25 megawatts and all new utility units.

The trading system consists of three elements. First, the U.S. government set a ceiling (or cap) on emissions. This cap firmly restricts emissions and ensures that environmental benefits will be achieved and maintained. During Phase II of the sulphur trading program, the Act set a permanent ceiling of 8.95 million tons.

Secondly, when Phase II was introduced in 2000, the government allocated emissions permits allowing each designated emitter to release a specified amount of the pollutant, up to the total allowable limit. Allowance allocation calculations were made for various types of units, such as coal- and gas-fired units with low and high emissions rates or low fuel consumption.⁴⁵

Finally, the utilities are allowed to trade their allocated permits. Thus, utilities that require permits in excess of those allowed must buy them from utilities willing to sell their unused credits. To facilitate trading, the U.S. Environmental Protection Agency (EPA) holds an allowance auction annually. The auctions help to send the market an allowance price signal, as well as furnish utilities with an additional avenue for purchasing needed allowances.

The U.S. SO₂ trading program is considered to be a highly successful example of the use of economic instruments and continues to meet its goals. The volume of transactions among firms has more than doubled annually since 1994, SO₂ emissions have fallen faster than required by law, and the cost of reducing emissions has been substantially lower than predicted (1/5th to 1/7th of pre-program estimates).

According to the EPA, the General Accounting Office recently confirmed the benefits of this approach, projecting that the allowance trading system could save as much as $3 billion per year - over 50% - compared with a command and control approach typical of previous environmental protection programs.

Sulphur taxation is another type of economic instrument that has been used as an effective means of achieving government targets in managing the risks from SO₂ emissions. There are three design options for a sulphur tax:

• Tax differential: to levy a higher charge on those fuel oils that have the higher sulphur content, thus encouraging consumers to purchase more of the cleaner fuel.
• Product tax: to levy a tax on the sulphur content of the fuel. The higher the sulphur content, the more tax the user would pay.
• Sulphur dioxide emission tax: the tax would be levied not on the sulphur content per se, but rather on how much SO₂ is emitted.

Economic theory suggests that an emission tax represents a preferred tool to reduce a pollutant since it addresses the environmental goal or target more directly than other taxes. However, other factors such as transaction and compliance costs, e.g. for mobile sources, may well make a differential tax or a product tax the optimal instrument.

The advantages of using tax instruments are:

• Depending on its design, a tax may provide more flexibility and thus be less costly to producers and consumers;
• A tax provides a continuing incentive to reduce emissions; and
• A tax may be less costly to government to administer than a command-and-control regulation.

The main disadvantages of using a tax are that:

• It is not certain that the environmental target would be achieved; and
• A tax may be less politically acceptable than a traditional regulation.

The examples below illustrate how taxes have been applied in European countries to control SO₂ emissions from LFO and HFO. Further analysis would be required to determine the applicability of tax instruments to the Canadian context. Some of the issues that would have to be thoroughly examined as part of a successful tax design, include: the application of the tax, market behaviour, government revenue stream, distributional impacts, competitiveness concerns from industry, and effectiveness of the tax in achieving the environmental objective.

In January 1988, the Italian government introduced two sulphur taxes: 45 Lira (CA$0.034) per kilogram for HFO with a sulphur content below 1% wt. and 90 Lira (CA$0.068) per kilogram for HFO with sulphur content above 1% wt. Each year, the amount of the tax is confirmed or revised, but the tax for high sulphur HFO is always twice that of low sulphur HFO.

The key sectors targeted by the tax are the industrial and heating sectors. Refineries are exempted from the tax in respect of fuels that are self-produced and used internally. Electricity generators, the largest consumers of high sulphur HFO, are not obliged to pay the tax.

The differential sulphur tax is credited with reducing the sulphur content in HFO from an average sulphur content of 3.3% wt. in 1988 to 1.9% wt. in 2001.

In 1991, Sweden introduced a sulphur tax for all fuels, including LFO, HFO, peat and coal. The sulphur tax for liquid fuels is at the rate of 27 SEK (or CA$3.96) per cubic metre for each 0.1% wt. sulphur. The tax was aimed at encouraging the use of cleaner fuels (to reduce acid rain) and increase desulphurization technology in the combustion process with the goal of reduced sulphur emissions.

The tax rate was based on the estimated emission abatement costs. Large-scale consumers who restrict their sulphur emissions through desulphurization technologies are eligible for a refund of the sulphur tax. In 1997, approximately one quarter of the 240 taxpayers had implemented such emission control measures, thereby reducing their assessed taxes by 70%.

The sulphur tax is credited with reducing average sulphur content in LFO from 0.2% wt. in 1990 to 0.076% wt. in 1995, and with reducing average sulphur content in HFO from 0.7% wt. to 0.35% wt. over the same time period. According to the Swedish Environmental Protection Agency, sulphur emissions from combustion of LFO and HFO have decreased by approximately 8.5 tonnes owing to the sulphur tax.

The actual revenues from the sulphur tax have been considerably lower than expected because emissions have declined more rapidly than projected. The Swedish Environmental Protection Agency also reports that residual oil with a high sulphur content, which is a by-product from the manufacture of low-sulphur HFO, is often exported to countries with lower environmental standards than Sweden.

As part of ecological tax reform, energy products in Denmark are subject to an energy tax, a carbon dioxide tax and a sulphur tax. Since 1996, Denmark has levied a sulphur tax with choice provided to larger fuel consumers for application either as a product tax or an emission tax. When levied as a product tax, the rate on sulphur content in fuel is DKK 20/kg (CA$3.90/kg) of sulphur in the fuel. When charged as an emissions tax, the rate is DKK 10/kg (CA$1.95/kg) of SO₂. These two rates are equivalent based on sulphur content. The tax applies to fuels with sulphur content of greater than 0.05% wt.

Larger HFO and LFO consumers who have invested in desulphurization technology have an option to register as a sulphur taxpayer, which exempts them from the sulphur tax on fuel. Instead, they must measure and pay the tax on the basis of their SO₂ emissions. A further option is available to register to pay the sulphur product tax on the fuel, but to generate a tax refund based on the measured sulphur content in the ashes as a result of the combustion process.

According to the Danish Government, the total SO₂ emissions decreased by approximately 24% between 1995 and 1997, and they estimate that total reduction of sulphur emissions will reach 34 000 tonnes by 2005 as a result of the sulphur tax on all fuels. The sulphur tax is credited with dramatically reducing the sulphur content of fuel oils and reducing emissions from combustion plants. Only fuel oils with a sulphur content of less than 0.05% wt. are now sold.

Although a single economic instrument may very well achieve the environmental objective, there are many examples worldwide that show that a combination of different policy tools may sometimes achieve this objective more effectively.

Considering the OECD experience, fiscal incentives have seldom been stand-alone measures. They are often introduced as one component in a package of measures. The policy context as well as efficiency considerations greatly influence the decision of using an economic instrument in tandem with other policy tools.

For example, Switzerland pools the revenues from both of the taxes on LFO and volatile organic compounds to redistribute it to Swiss citizens. Many OECD countries have regulations in place, both those of the European Union and their own national standards, in addition to the economic instruments.

Below are three combination or hybrid instruments that may be worthy of examination, in the context of reducing sulphur in fuel oils; and within each of these, different design and structure can give different results.

1. Fuel quality regulations and a tax: This approach has been adopted by many European countries. Regulations have been used in combination with a tax for various reasons. First, the tax can be used as a means to accelerate the response to a planned regulation. Secondly, a tax can be used to complement a regulation as it can both accelerate implementation as well as provide continuing incentives for firms and consumers to lower sulphur emissions below levels required by regulations. Thirdly, the regulation can be seen to be a complement to the tax in that it can support the intent of the tax, and back it up in case the desired results are not attained.
   
2. Fuel quality regulations and emission trading: Emission trading systems are normally implemented by regulation. There are cases however, where a command-and-control regulation is appropriate for a certain sector of the industry, whereas trading may be best suited for another. For example, trading may involve high transaction costs for smaller users, such as the transportation sector, whereas it may represent a cost-efficient policy for larger users, such as the electric power generation sector.
   
3. Tax and emission trading: Similarly, this approach may be appropriate when different sectors have very different economic structures, and different transaction costs for emissions trading.

The list of combinations above is by no means a comprehensive one, it merely illustrates the fact that the optimal outcome may be achieved through the use of economic instruments in combination with other policy tools.

A regulatory approach could be used to prescribe the maximum sulphur limits in fuel oils. This has been the traditional method of implementing environmental requirements for fuels in Canada. A regulation could include some flexibility to allow for the use of higher sulphur fuels in facilities that are equipped with emission control technologies. A sample regulation is provided in Appendix 6.

⁴⁵ U.S. EPA allocated allowances to each unit at an emission rate of 1.2 pounds of SO₂/mmBtu of heat input, multiplied by the unit's baseline.