2000 May Report of the Commissioner of the Environment and Sustainable Development
Chapter 3—Government Support for Energy Investments
3.8—Relationship Between Resource Allowance and Crown Royalties for Upstream Activities in the Oil and Gas Industry, 1983-1996
3.1 We undertook this study to give Parliament comprehensive information on the support provided by government for energy investments and to determine whether this support favours the non-renewable energy sector. We were particularly interested in support through the tax system because it is less transparent than direct support. We also wanted to explore reasons why energy from renewable sources, other than large-scale hydro-electric projects, makes up a small portion of Canada's energy mix. We sought to determine whether tax incentives are a major contributor to this situation.
3.2 Overall, we found that with a few exceptions, federal government support today for energy investments, including support through the tax system, does not particularly favour the non-renewable sector over the renewable sector. We also found that in the past, governments have intervened in energy markets for various reasons through direct spending, regulations and tax incentives. Most of the federal spending and tax incentives have been for non-renewable resources, the predominant source of energy in Canada.
3.3 All forms of energy are competing for investment dollars against many other investment opportunities. Investments with higher rates of return, established markets and good track records are the ones that attract investors. Most investors we surveyed find that many renewable energy investments do not currently have these features. As well, the payback period is often too long for investments in renewable energy and energy efficiency to make them the preferred choice.
3.4 The federal government stated in its 1996 Renewable Energy Strategy that it wants to increase investments in renewable energy. It has also said for many years that it wants Canadians to use energy more efficiently. Given the barriers we have identified, the federal government may wish to consider developing new strategies and approaches to accomplish its stated objectives for investments in renewable energy and energy efficiency.
Background and other observations
3.5 In December 1997, Canada and 160 other nations negotiated the Kyoto Protocol, an agreement on climate change to reduce emissions of six important greenhouse gases, including carbon dioxide. (The main source of human-induced greenhouse gas emissions in Canada is the production and consumption of fossil fuels, such as oil, natural gas and coal.) For its part, Canada committed to reducing its emissions to six percent below 1990 levels by 2008-2012. But Canada's emissions were already 13 percent above 1990 levels by 1997 and are expected to keep growing. Unless Canada takes new measures, Natural Resources Canada estimates that Canada will actually have to reduce emissions by at least 26 percent from their forecast levels to meet the Kyoto target.
3.6 For the purpose of this study, "non-renewable sources of energy" included oil, natural gas and coal (which are fossil fuels) and nuclear power. "Renewable sources of energy" included water (large-scale and small-scale hydro-electric projects), wind, the sun, the photovoltaic cell (energy produced by exposing to light two dissimilar materials), biomass (plant materials and animal waste), ethanol, geothermal power (heat energy produced in the earth), and waves or tides.
3.7 Governments have used the tax system to encourage exploration for and development of various sources of energy. Most of the federal tax provisions that exist today accelerate the write-off of an expense for tax purposes. This means that the taxpayer reduces current taxes but pays higher taxes later. Accelerated write-offs are a benefit mainly because of the "time value" of money. Investors who can reduce current taxes are able to achieve a higher rate of return on their investment and have more cash for other investments.
3.8 An adequate rate of return on investment was the factor most frequently mentioned by our survey respondents in assessing the potential of an investment project. As the International Energy Agency pointed out, many renewable energy projects do not yet provide an adequate rate of return to make them a desirable investment. Three reasons for this are markets are difficult to enter, renewable energy products generally cost more than non-renewable ones, and payback periods are often longer.
3.9 In December 1997, Canada and 160 other nations negotiated the Kyoto Protocol, an agreement on climate change to reduce emissions of six important greenhouse gases, including carbon dioxide. (The main source of human-induced greenhouse gas emissions in Canada is the production and consumption of fossil fuels, such as oil, natural gas and coal.) For its part, Canada committed to reducing its emissions to six percent below 1990 levels by 2008-2012. But Canada's emissions were already 13 percent above 1990 levels by 1997 and are expected to keep growing. Unless Canada takes new measures, Natural Resources Canada (NRCan) estimates that Canada will actually have to reduce emissions by at least 26 percent from their forecast levels to meet the Kyoto target.
3.10 The ministers of energy and the environment in the federal, provincial and territorial governments approved a process in April 1998 to develop a national implementation strategy to address climate change. Sixteen "issue tables" or working groups, involving about 450 people with many perspectives on climate change, were created to examine the impacts, costs and benefits of implementing the Kyoto Protocol. Each issue table is expected to develop a set of options for consideration by the ministers over a series of meetings in 2000-2001.
3.11 Two important ways to address climate change are using energy more efficiently and establishing a more sustainable mix of energy sources, which means a greater reliance on renewable sources. Using energy more efficiently is widely recognized as an effective way to reduce greenhouse gas emissions, particularly carbon dioxide. Renewable energy sources, such as water, biomass (plant materials and animal waste), wind and the sun, can provide Canada with a secure supply of energy over the long term in an environmentally friendly way.
3.12 For the purpose of this study, "non-renewable sources of energy" included oil, natural gas and coal (which are fossil fuels) and nuclear power. "Renewable sources of energy" included water (large-scale and small-scale hydro-electric projects), wind, the sun, the photovoltaic cell (energy produced by exposing to light two dissimilar materials), biomass, ethanol, geothermal power (heat energy produced in the earth), and waves or tides. "Other sources of energy" included methanol/methane and the hydrogen fuel cell. These sources can be renewable or non-renewable.
Overview of the energy sector
3.13 The economic development of modern societies depends on energy. Exhibit 3.1 shows the many sources of energy and their uses. According to NRCan, the Canadian consumption of energy in 1997 was 39 percent in the industrial sector, 27 percent in the transportation sector, 18 percent in the residential sector, 13 percent in the commercial sector, and 3 percent in the agricultural sector. In Canada, the consumption of energy varies by region because of population patterns, the climate and the mix of industrial activities.
3.14 In 1997, 24 percent of Canada's energy needs were met by electricity. To determine its environmental effects, it is important to understand how electricity is produced. Over half of Canada's electricity is generated from hydro-electric projects, mostly large-scale ones that can have negative impacts on the environment when flooding is required to create large reservoirs. The rest of the country's electricity is produced mostly by nuclear power reactors and the burning of fossil fuels. Some forms of renewable energy, such as wind, solar energy and biomass, also produce electricity, but the total amounts are small.
3.15 NRCan has projected Canada's growing energy requirement to 2020. As Exhibit 3.2 shows, non-renewable sources will be used to meet most of this requirement. However, extracting, producing and burning fossil fuels creates greenhouse gases, which have implications for climate change. Either domestic or foreign sources of energy can satisfy Canadian requirements. As long as Canadians and Canadian industry need more energy and are willing to pay for it, suppliers will provide it.
3.16 Domestic requirements for energy combined with export opportunities drive Canadian energy production. For some energy products such as electricity, there is a fairly close link between Canadian requirements and Canadian production. For others such as oil and gas, the link is not as close.
3.17 Non-renewable sources of energy tend to be traded on international markets, which set their prices. Changes in Canadian production will not necessarily affect the amount Canadians consume or the price they pay. However, international changes in the price or supply of these energy sources could well affect Canadian consumers. Canada has large reserves of oil, natural gas and coal and using them to meet Canadian energy requirements, thus, has some economic advantages.
3.18 Canada has a large and vibrant oil and gas industry. Net spending of the upstream sector of the industry (exploration and production) was about $28.4 billion in 1998. That year, companies produced over 2 million barrels of crude oil a day and about 16 billion cubic feet of natural gas a day and exported about half of this production. The upstream oil and gas sector employs over 70,000 people. From 1991 to 1997, the oil and gas industry recorded operating profit margins of 9.1 percent on average, compared with 6.6 percent for all industries. It recorded a return on capital of 5.5 percent on average, compared with 5.8 percent for all industries.
3.19 Renewable sources of energy tend to be produced, priced and consumed in a more local or regional market. These sources are competitive in their markets if they are available and if their cost is comparable with other energy options.
3.20 Both renewable and non-renewable sources of energy need capital to grow. However, they do not necessarily compete with each other for investment dollars. Rather, investors look for investments that meet their specific objectives, including a desired rate of return.
Energy policy, a shared responsibility
3.21 Jurisdiction over energy policy is shared between the federal and provincial governments. The provinces own energy resources and develop energy and taxation policies and regulations on the management of these resources. The federal government mainly deals with interprovincial and international movement of energy and energy-using equipment as well as projects that extend beyond a province's borders. It also regulates the nuclear industry in Canada. In addition, the federal government has broad taxation and spending powers. Both levels of government have responsibilities for protecting the environment.
3.22 Federal energy policy has evolved over the last three decades. During the mid-1970s and early 1980s, the government wanted to ensure that Canadians had a secure supply of energy at an affordable price. As world oil prices fell and supplies increased in the late 1980s and early 1990s, the focus shifted to developing Canadian energy resources and improving regional economies. Today's stated energy policy is market-based and increasingly shaped by Canada's domestic and international commitments, such as the North American Free Trade Agreement and the Kyoto Protocol. The planned national implementation strategy for dealing with climate change may have a significant effect on future energy policy.
3.23 In October 1996, NRCan released its Renewable Energy Strategy: Creating a New Momentum. Its objective is to bring Canadian renewable energy technologies into commercial use more quickly by enhancing investment conditions and promoting technology and market development initiatives. In April 1998, NRCan established the Office of Energy Efficiency with the mandate to renew, strengthen and expand Canada's commitment to energy efficiency.
Focus of the study
3.24 Governments have supported the exploration for and development of energy from non-renewable and renewable sources and encouraged energy efficiency over the years for various reasons. These include securing the supply of energy, especially during oil crises, developing regional economies and addressing environmental concerns. Some believe that the non-renewable sector has enjoyed and continues to enjoy more support than the renewable sector. Many have said that there are hidden subsidies in the tax system for investments in the non-renewable energy sector. Furthermore, some have argued that the renewable energy sector in Canada is not expanding as quickly as it should, largely because of government action, or inaction.
3.25 We undertook this study to give Parliament comprehensive information on the support provided by the federal government for energy investments and to determine whether this support favours the non-renewable energy sector. We were particularly interested in support through the tax system because it is less transparent than direct support. While our focus was on energy investments, we reviewed other significant federal government interventions in the energy sector. We also wanted to explore reasons why energy from renewable sources, other than large-scale hydro-electric projects, makes up a small portion of Canada's energy mix. We sought to determine whether tax incentives are a major contributor to this situation.
3.26 For more information on this study, see About the Study at the end of the chapter.
Government Spending and Regulation
3.27 Federal and provincial governments have intervened in energy markets almost since their beginning. Government policies have controlled or influenced particular activities through direct spending, regulation and tax incentives to provide Canadians with a secure supply of energy, to develop regional economies and to address environmental concerns. Appendix A presents highlights of federal government spending and regulation related to energy investments. In the past, much of this was focussed on non-renewable resources, the predominant source of energy in Canada. Sometimes the spending and regulation benefited mainly the producers of non-renewable resources; at other times consumers were the main beneficiaries.
3.28 We analyzed federal spending on energy reported in the Public Accounts of Canada and departmental reports on plans and priorities (formerly a portion of Part III of the Main Estimates) from 1970-71 to 1998-99. Exhibits 3.3 and 3.4 break down the spending over this period by energy source. We included payments to third parties and government programs that relate to investments in energy. We excluded general operating expenses of departments and regulatory expenses of agencies concerned with energy matters. We also excluded federal spending on energy to power, heat and cool facilities or run vehicles and other equipment.
3.29 For non-renewable resources, other than nuclear power, the federal government's greatest spending occurred between 1974 and 1986 during the days of oil import compensation payments (OICPs) and the National Energy Program (NEP).
3.30 The government introduced OICPs in 1974 so that consumers in Quebec and Atlantic Canada, who were then completely dependent on imported oil, would be protected against increases in world oil prices. The payments had totalled about $13.6 billion by the time they ended in 1985. A tax on crude oil exports helped to finance the payments.
3.31 The NEP was introduced in 1980 and, among other things, retained the government's objective of a single "made-in-Canada" oil price set below world levels. The NEP imposed a refinery levy, the petroleum compensation charge, to help achieve this objective. By the end of the regime following the signing of the Western Accord in 1985, the petroleum compensation charge had raised about $11.3 billion from refiners, of which $11.1 billion was paid out to the first users (usually other refiners) of high-cost petroleum. Under the NEP, the government encouraged exploration and sought to increase Canadian ownership in the oil and gas industry by paying some $7.7 billion in cash grants under the Petroleum Incentives Program.
3.32 In the late 1980s and early 1990s, the federal government supported energy megaprojects, such as the Hibernia Development Project and heavy oil upgraders. Since 1995, federal government spending on non-renewable energy resources has been reduced significantly.
3.33 The development of nuclear technology in Canada began in the 1940s. In 1944, the federal government started constructing a research facility at Chalk River, Ontario. Since 1946, the federal government has spent about $6 billion on nuclear technology, mostly through Atomic Energy of Canada Limited. As Exhibits 3.3 and 3.4 show, annual spending has declined in recent years.
3.34 The federal government has supported the development and use of renewable energy technologies for over 20 years, mainly through research and development programs and tax incentives. At first, this was because it wanted to be certain that Canada had a secure supply of energy. Now it is more concerned about the environmental impacts of using non-renewable resources to produce energy. The federal government is spending around $12 million annually to support renewable energy technologies.
3.35 The federal government has also promoted energy conservation and energy efficiency for many years. In the late 1970s, spending on energy efficiency programs grew significantly (see Exhibit 3.3). Grant programs, such as the Canadian Home Insulation Program, were used to convince energy users to become more energy-efficient. By the mid-1980s, spending on energy efficiency dropped substantially. In the early 1990s, the federal government re-emphasized energy efficiency and energy from alternative sources and began to regulate the energy efficiency of products that use energy. In recent years, it has spent about $64 million annually on energy efficiency activities.
Other federal support
3.36 The federal government has also supported the energy sector by investing in companies, granting loans, remitting certain taxes and export charges, and assuming certain potential losses (contingent liabilities). Since 1970, the federal government has written off $2.8 billion of its investments and loans for energy projects in the non-renewable sector; this is in addition to the amounts shown in Exhibits 3.3 and 3.4. Between 1975-76 and 1981-82, it remitted almost $2.4 billion of export and other charges on certain types of oil or oil products that companies exported "when an equal volume was returned to Canada."
3.37 The federal government's reported contingent liabilities related to energy had reached about $950 million on 31 March 1999. These liabilities concern the Hibernia Development Project, the NewGrade heavy oil upgrader, and installations governed by the Nuclear Liability Act. They do not include the cost of cleaning up high-level radioactive waste on federal property. Nor do they include the cost of cleaning up low-level radioactive waste, mainly in the Port Hope area of Ontario, and decommissioning sites of uranium tailings. (We estimated these costs to be $850 million in our May 1995 Report, Chapter 3, Federal Radioactive Waste Management.)
The Tax System and Energy Investments
Federal government revenue from energy
3.38 The federal government collects taxes from the production and consumption of energy (see Exhibits 3.5 and 3.6). The largest source of revenue is the excise tax that consumers pay on fuels to run their vehicles and equipment, which raised some $50 billion between 1970 and 1999. The federal government also collects goods and services tax (GST) on a number of energy products and services, but it is difficult to determine the exact amounts.
3.39 From 1973-74 to the late 1980s, the federal government collected about $7.8 billion in oil export taxes, $10.1 billion from the petroleum and gas revenue tax, and, as noted in paragraph 3.31, about $11.3 billion from the petroleum compensation charge. These levies were phased out after the Western Accord was signed in 1985 (see Appendix A).
3.40 The federal government also collects income taxes from producers of energy, except for provincially owned oil and gas companies and utilities. Exhibit 3.6 shows that between 1990 and 1997, the oil and gas and electricity industries paid over $12 billion in federal corporate income taxes.
Current tax incentives for energy investments
3.41 Governments have used the tax system to encourage exploration for and development of various sources of energy. Appendix B highlights some of the ways this support has been provided in the past. Appendix C describes the current income and excise tax provisions that relate specifically to energy investments. These provisions are complex and, when they are used, so is the way they interact with each other, with all the other provisions in the Income Tax Act and with provincial tax and royalty regimes.
3.42 Most of the current federal tax provisions accelerate the write-off of an expense for tax purposes. This means that the taxpayer reduces current taxes but pays higher taxes later (see Exhibit 3.7). Accelerated write-offs are a benefit mainly because of the "time value" of money. Investors who can reduce current taxes are able to achieve a higher rate of return on their investment and have more cash for other investments.
3.43 The incentive for companies is to keep spending and take advantage of the accelerated write-offs to reduce current taxes and put off the day when they have to pay increased taxes. This reaction is what the government had in mind when it designed these tax incentives to encourage investments in non-renewable and renewable resources.
3.44 Accelerated write-offs work best for companies that are making profits and are in a position to pay taxes. For companies that are not, the accelerated write-offs can be carried forward and deducted for tax purposes when the companies become profitable.
3.45 Flow-through shares allow companies to raise funds to carry out certain activities by flowing (or passing) some of their accelerated write-offs to shareholders. A company can issue flow-through shares for Canadian exploration expenses, Canadian development expenses and Canadian renewable and conservation expenses (see Appendix C for definitions). Investors receive equity in the company and can deduct the accelerated write-offs in calculating their taxes. The company cannot deduct the expenses that it has flowed to investors, and it may eventually pay higher taxes. In general, small companies that do not have taxable income are the ones that issue flow-through shares.
Royalties and the resource allowance
3.46 When companies calculate their federal income taxes, they cannot deduct royalties paid to provincial governments for oil, natural gas and minerals. (Normal income tax rules allow a deduction for most amounts that are paid to earn income.) The federal government imposed this restriction in 1974 in part to disentangle provincial royalty regimes from federal income taxes. To compensate for the restriction and to offer more incentives for exploration and development, the government introduced the resource allowance in 1976. In calculating income taxes, companies can deduct a resource allowance that is 25 percent of resource profits from mining and from producing oil and gas. In general terms, resource profits are defined as resource revenue minus associated overhead, operating costs and capital cost allowances (write-offs of capital assets, such as equipment and buildings).
3.47 In recent years, the benefits that the oil and gas industry received as a whole from the resource allowance deduction have roughly offset the increased tax cost arising from the non-deductibility of provincial royalty payments (see Exhibit 3.8). For the mining sector (including coal and uranium mines), the resource allowance generally exceeds royalties. However, the relationship between royalties and the resource allowance differs from one corporation to another. For example, a company with low resource profits would receive a small resource allowance that might not offset the non-deductibility of Crown royalties. But the rules give companies some discretion in calculating the resource allowance, and accelerated write-offs can reduce it significantly.
Estimating resource-related tax expenditures
3.49 Tax expenditures are usually thought of as tax measures, such as exemptions, deductions or tax credits, that the government uses to achieve specific economic and social policy objectives. They are often an alternative to direct spending. For example, incentives for research and development can be provided through government grants or through tax credits.
3.50 Current tax incentives for the energy sector are mainly accelerated write-offs that are designed to encourage investment. In these cases, a reasonable proxy for the tax expenditure would be the tax on the difference between the amount written off in the companies' books and the amount written off for taxes. When the tax write-off is greater than the book write-off there is a reduction in taxes and a positive tax expenditure (see Exhibit 3.7). When the tax write-off is less than the book write-off there is an increase in taxes and a negative tax expenditure.
3.51 Estimating total tax expenditures for accelerated write-offs is not an easy task. The provisions are complex, and gathering the appropriate data is difficult. Many of the deductions are discretionary, meaning that the taxpayer can determine how much of the eligible amount is actually claimed in a given year. Furthermore, because accelerated write-offs can result in positive or negative tax expenditures, an annual estimate may not provide an accurate picture of the real cost resulting from the write-offs.
3.52 The Department of Finance has tried to deal with these issues in its annual tax expenditure account by calculating the net present value of the tax benefit that an investor would realize from accelerated write-offs for a hypothetical investment of $100,000. According to the 1999 account, if $100,000 is spent on exploration for non-renewable resources, the net present value of the tax benefit from the accelerated write-off of the expense is $4,800. But this approach does not provide information on total tax expenditures.
3.53 Furthermore, no one is now collecting the data needed to estimate total tax expenditures related to accelerated write-offs. To get a sense of the size of the difference between the write-offs for book purposes and for tax purposes, we used rough data from Statistics Canada on the oil and gas industry. As Exhibit 3.9 shows, the tax write-off for physical assets is less than the book write-off, but for exploration and development expenses, the tax write-off is greater than the book write-off. However, it is not possible to estimate a tax expenditure using these data, mainly because the estimates must be calculated for each company to take account of its unique tax situation.
3.54 We encourage the Department of Finance to explore other ways to estimate the total cost of these tax incentives, to determine whether the incentives are meeting their objectives cost-effectively and to determine whether they are still needed.
Is the Current Tax Treatment Similar for Investments in Renewable and Non-Renewable Energy?
3.55 To answer this question asked by many interested stakeholders, NRCan and the Department of Finance published a study in 1996, The Level Playing Field: The Tax Treatment of Competing Energy Investments. The main objective of the study was to measure the degree to which the tax system does (or does not) provide comparable levels of support to investments in non-renewable and renewable energy and in energy efficiency.
3.56 The study concluded that while the playing field is not level, there are few variations in the tax treatment of energy projects, except for ethanol and certain energy efficiency projects. The level of tax support for investments in the supply of non-renewable and renewable energy varied between 5 percent and 20 percent of capital costs.
3.57 We reviewed the study and its underlying methodology to determine the accuracy of the findings. The study analyzed a number of projects and showed how much each project is taxed under the current system when compared with a neutral tax system (one that does not have any incentives). Then it determined which projects pay more taxes and which ones pay less.
3.58 We sought to check the results of the Level Playing Field study by using a different methodology, called marginal effective tax rates (METRs). This methodology looks at how the tax system treats marginal investments, that is investments that just meet the investor's acceptable rate of return. Once METRs are calculated for various investments, it is easy to see which ones the tax system does or does not favour.
3.59 We were unable to reach a firm conclusion using the METR methodology because some of the data that we needed to apply the methodology were not available. However, to the extent that we were able to complete the analysis, our results supported the conclusions of the Level Playing Field study.
3.60 We reviewed other evidence to determine whether the tax system favours non-renewable energy sources over renewable ones. We also examined the tax provisions for energy investments, including their evolution over time, and consulted people who invest in energy.
3.61 The Minister of Finance's Technical Committee on Business Taxation reported in 1997 on the METRs paid by companies in various industries. The Committee found that the average METR for all industries was 19 percent. Unfortunately, the Committee did not provide METRs for renewable energy.
3.62 For the upstream activities (exploration and development) of the oil and gas industry, the Committee calculated two METRs, depending on how royalties were treated. For purposes of comparing various energy investments, we believe that treating royalties paid to provincial governments as a tax is the preferred treatment. The METR for the upstream activities of the oil and gas industry was 18.2 percent, which was close to the average METR for all industries.
3.63 The downstream activities (refining and marketing) of the oil and gas industry are included in the manufacturing and retail trade industries. The METR was 16.5 percent for the manufacturing industry and 23.2 percent for retail trade. These METRs are reasonably similar to the average METR for all industries.
3.64 The Committee also calculated METRs for mining, including coal. When royalties paid to provincial governments are treated as a tax, the METR was 17.7 percent, which was close to the average METR for all industries.
3.65 It is important to note, however, that the approach used in the Level Playing Field study and the methodology for calculating METRs are theoretical. They assume that the tax provisions will be used in a particular manner. The way the provisions are actually applied determines the taxes that companies pay on specific energy investments. For example, most taxpayers can deduct interest on money borrowed for investments when calculating their taxes. Interest is a key component of many energy investments. If companies have the time and the resources to engage in complex tax-planning mechanisms that involve the deduction of interest, they can legally reduce the taxes they pay on particular energy investments.
3.66 We found that tax incentives for investing in non-renewable energy were more generous in the past than they are today. For example, the depletion allowances that allowed companies to deduct more than their actual expenses in the 1960s and 1970s are no longer available (see Appendix B). Changes were also made in the 1990s to tighten the income tax rules for calculating the resource allowance.
3.67 We also found that several amendments have been made in recent years that are intended to give similar tax treatment to all forms of energy investment. Investors told us that in most cases, the federal income tax treatment for renewable energy and non-renewable energy is similar but they desire further changes to ensure that all of the available provisions can be used.
3.68 At the same time, there are three important exceptions to this similar tax treatment. First, the tax system does not give any preferential treatment to certain investments that improve energy efficiency. For example, installing energy-efficient windows in a building is treated the same way for taxes as installing regular windows. Any encouragement to install energy-efficient windows has to come from other sources, such as reducing heating and cooling costs over time. Investors who want to have their investment repaid in a short period of time would likely choose regular windows if they were cheaper.
3.69 Second, investments in oil sands, like all mining investments including coal, receive a significant tax concession (see Appendix C). The rules allow companies to write off all capital costs for a project before they pay any federal income taxes on the profits earned from the project. These provisions recognize the risks involved in oil sands investments and the potential economic benefits, but they make the investments more attractive than they otherwise would be. The Department of Finance estimates that the benefit of this tax concession is between $5 million and $40 million for every $1 billion invested. As well, Alberta charges lower royalty rates during the early years of an oil sands project than it does for conventional oil and gas.
3.70 Third, alternative fuels, such as ethanol produced from renewable sources, propane, compressed natural gas and methanol, are exempted from the federal excise tax. For blended fuels, the tax exemption applies only to the proportion of the exempt fuel in the product.
3.71 Based on our review of the evidence, for current investments, the federal income tax treatment given to renewable and non-renewable energy investments is reasonably similar except for certain investments in energy efficiency, oil sands, coal mines and alternative fuels. Nevertheless, the interaction between the federal and provincial tax systems and the applicable provincial royalty regimes could result in dissimilarities in the overall treatment of energy investments.
Investing in Renewable Energy and Energy Efficiency
3.72 Renewable energy appears to be having difficulty getting established, despite its environmental benefits. The exception is large-scale hydro-electric projects, which are generally financed by provincial utilities and operate in a highly regulated market. We sought to determine some of the reasons for this difficulty, given that the current tax system does not significantly discriminate against renewable energy investments. We conducted a survey of a broad cross-section of individuals and small, medium-sized and large companies that invest in energy. We also reviewed some of the literature on energy investments.
3.73 In 1997, the International Energy Agency published Key Issues in Developing Renewables. It noted that most forms of renewable energy still had a long way to go before they could compete with fossil-fuel technologies, especially for generating electrical power. The Agency added that financiers and manufacturers were reluctant to invest the capital needed to reduce costs when consumer demand for renewable energy was low and uncertain. But demand stayed low because potential cost reductions cannot always be realized at low levels of production.
3.74 The Agency cited three major barriers that had to be overcome to increase the use of renewable energy in the market:
- Technical barriers. Many renewable energy technologies were still at an early stage of development. The Agency stated that renewable energy needed to build a substantial track record in order to convince consumers of its cost effectiveness and reliability.
- Economic barriers. Renewable energy generally could not compete with conventional fuels strictly on cost, except in niche markets. This was partly because the prices of energy products did not include the full costs of external factors such as environmental impacts.
- Institutional barriers. Key market players - policy makers, financial institutions, suppliers of utility equipment and consumers - were not aware of how far renewable energy technologies had developed.
3.75 We found similar issues. An adequate rate of return on investment was the factor most frequently mentioned by our survey respondents in assessing the potential of an investment project. As the Agency pointed out, many renewable energy projects do not yet provide an adequate rate of return to make them a desirable investment, for several reasons:
- markets are difficult to enter;
- renewable energy products generally cost more than non-renewable ones; and
- payback periods are often longer.
3.76 Provincial utility companies control the production of most electricity in Canada. They have little incentive to purchase or produce more costly "green power" (electricity generated with minimal environmental impact from renewable sources other than large-scale hydro-electric projects) when they can produce power more cheaply from existing sources. This means that independent "green power" producers have difficulty selling their product to the utility companies.
3.77 Furthermore, because the provinces have had highly regulated electricity markets, these independent producers generally have restricted access to the electrical grid, which also limits their ability to market their products. Some provinces are moving to deregulate their electricity markets and make them more open to competition.
3.78 The costs of many forms of "green power" have declined significantly in the last decade. However, they are still generally higher than the costs of generating power from existing and more traditional sources such as large-scale hydro-electric projects and fossil-fuel plants, except in niche markets. More research and development is likely to reduce the costs even further. Gaining access to larger markets would also help bring down costs as each unit is usually cheaper when goods are produced in larger quantities.
3.79 Proponents of renewable energy argue that the cost and ultimate market price of individual energy products do not include the environmental effects of producing and using them. So far, there is no general agreement on the value to be attached to these effects, known as externalities, particularly when broad geographic areas are involved. Therefore, a strategic role exists for governments to help markets take into account all of the benefits and effects of producing and consuming energy. If it were possible to include the value of the externalities in the price of individual energy products, the cost of fuels that create more environmental damage would be higher.
3.80 Investors told us that they generally look for the shortest possible time for their investment to be repaid (the payback period), given the risks of the investment and potential returns. The payback periods for renewable energy and energy efficiency investments are often too long to consider them desirable; thus, financing is hard to find. In the past, governments have in some cases provided a combination of direct support, regulations and tax incentives to help overcome such barriers.
3.81 Investors confirmed that the tax system can play a role in influencing their investment decisions. Tax incentives can sometimes improve the rate of return or reduce the payback period on an investment to make it more appealing. Tax incentives like accelerated write-offs are useful when a company has sufficient profits to claim the write-offs immediately. In other situations, tax incentives like refundable tax credits and flow-through shares are more valuable.
3.82 With the exception of large-scale hydro-electric projects, energy from renewable sources currently makes up a small portion of Canada's energy mix. Producers of renewable energy report that they face several barriers to financing and marketing their products. Some stakeholders have suggested that hidden tax subsidies for investments in energy from non-renewable sources are one important reason why this is happening.
3.83 We found that governments have intervened in energy markets in the past through direct spending, regulations and tax incentives. Sometimes this was to encourage investments in certain forms of energy and at other times it was to achieve specific policy objectives. Most of the federal spending and tax incentives have been for non-renewable resources, the predominant source of energy in Canada.
3.84 Overall, we found that with a few exceptions, federal government support today for energy investments, including support through the tax system, does not particularly favour the non-renewable sector over the renewable sector. The exceptions are investments in oil sands and coal mines, which receive a significant tax concession; nuclear technology investments, which receive substantial direct support; investments in alternative fuels, which receive more favourable excise tax treatment; and provincially owned energy companies, which pay no federal income tax. We also found that the income tax system does not give any preferential treatment to certain energy efficiency investments.
3.85 All forms of energy are competing for investment dollars against many other investment opportunities, such as high technology. Investments with higher rates of return, established markets and good track records are the ones that attract investors. Non-renewable energy investments often have these features. However, most investors we surveyed find that many renewable energy investments do not currently have these features. They also revealed that the payback period is often too long for investments in renewable energy and energy efficiency to make them the preferred choice.
3.86 Two important ways to address climate change are using energy more efficiently and establishing a more sustainable mix of energy sources, which means a greater reliance on renewable sources. The federal government stated in its 1996 Renewable Energy Strategy that it wants to increase investments in renewable energy. It has also said for many years that it wants Canadians to use energy more efficiently, and the Office of Energy Efficiency is currently promoting this goal.
3.87 Given the barriers we have identified, the federal government may wish to consider developing new strategies and approaches to accomplish its stated objectives for investments in renewable energy and energy efficiency. It will also need to work in close co-operation with other levels of government because in Canada jurisdiction over energy policy is shared.
Natural Resources Canada's comments: The chapter's historical record of federal energy expenditures and revenues offers the public considerable insight into how federal fiscal policies may have influenced the evolution and growth of the Canadian energy sector over the eventful period covered in the analysis.
As the report acknowledges, jurisdiction over energy policy is shared between the federal and provincial governments. Both levels of government have a responsibility to foster an attractive investment climate. One important objective of current policy is to use energy more efficiently and to increase market acceptance of renewable energy. Natural Resources Canada is committed to reducing greenhouse gas emissions resulting from energy production and consumption and is working closely with the provinces and stakeholders to address the issue of climate change.
Department of Finance's comments: In reference to paragraph 3.48, the Department acknowledges the importance of monitoring the resource allowance to ensure that it is an appropriate compensation for the non-deductibility of provincial royalty payments. An extensive review of the resource allowance was undertaken in 1995-96 and, as a result of this review, a number of changes were proposed in the March 6, 1996 budget. The Department continues to monitor the effectiveness of the resource allowance and other resource tax provisions.
In reference to paragraph 3.54, the Department is continuing to improve its estimates of tax expenditures related to accelerated write-offs for both renewable and non-renewable projects including oil sands investments.
About the Study
The objectives of our study were to give Parliament comprehensive information on the support provided by the federal government for energy investments and to determine whether this support favours the non-renewable energy sector. We were particularly interested in support through the tax system because it is less transparent than direct support. While our focus was on energy investments, we reviewed other significant federal government interventions in the energy sector. We also wanted to explore reasons why energy from renewable sources, other than large-scale hydro-electric projects, makes up a small portion of Canada's energy mix. We sought to determine whether tax incentives are a major contributor to this situation.
Scope and Approach
We focussed mainly on Natural Resources Canada (NRCan), the Department of Finance and the Canada Customs and Revenue Agency (the successor to Revenue Canada). We also obtained information about other federal organizations that dealt with or had an impact on energy matters, such as Atomic Energy of Canada Limited, the Atomic Energy Control Board, the Cape Breton Development Corporation and the National Energy Board.
We reviewed direct federal spending and regulatory regimes as well as federal revenues collected from the energy sector between 1970-71 and 1998-99 to provide historical information and analyze trends. Due to some data limitations, we looked at corporate income tax revenue only for the calendar years 1990 to 1997.
We analyzed the financial information contained in the Public Accounts of Canada and departmental reports on plans and priorities (formerly a portion of Part III of the Main Estimates) and obtained more information from NRCan, the Department of Finance and Statistics Canada. We included payments to third parties and government programs that relate to investments in energy. We excluded general operating expenses of departments and regulatory expenses of agencies concerned with energy matters. We also excluded federal spending on energy to power, heat and cool facilities or run vehicles and other equipment. For regulatory matters, we reviewed documentation on historical developments and information from federal organizations.
We examined past and current means by which the federal government has used the tax system to encourage exploration for and development of various sources of energy. We reviewed and analyzed how the system treats marginal investments, that is investments that just meet the investor's acceptable rate of return.
We conducted a telephone survey of 45 investors to explore reasons why energy from renewable sources, other than large-scale hydro-electric projects, makes up a small portion of Canada's energy mix and to determine whether tax incentives are a major contributor to this situation. These investors, comprising a broad cross-section of individuals and small, medium-sized and large companies, explained the factors they consider in making their decisions on energy investments.
Assistant Auditor General: Shahid Minto
Principal: Jamie Hood
Director: Robert Pelland
For information, please contact Jamie Hood.