This article was published by Policy Options on April 6, 2023.
Budget 2023 presented a “made-in-Canada” clean economy plan to compete with the U.S. Inflation Reduction Act (IRA) and accelerate investment in Canada to achieve climate-change goals. It provides around $18 billion over five years for a range of new and expanded investment tax credits and spending as part of a larger package of around $83 billion over the next decade.
Is it enough? The total envelope of funding may be, but further clarity is needed on big initiatives like the $15-billion Canada Growth Fund and “carbon contracts for difference” (which guarantee a certain carbon or product price for companies). If that clarity doesn’t come fast enough, Canada will continue to lose investment, and Canadian companies, to the United States.
Investment tax credits vs. production tax credits
The federal government went all-in on investment tax credits, which allow businesses to deduct a certain percentage of eligible capital costs from their taxes. There are investment tax credits for clean electricity (15 per cent), clean hydrogen (15 to 40 per cent), clean technology adoption (30 per cent), clean technology manufacturing (30 per cent) and carbon capture and storage (dependent on project details).
These tax credits are a major step forward in offering an attractive investment environment. However, investment tax credits – even if they are more generous than those in the U.S. – may not be as attractive to investors as the production tax credits used in the IRA. These production tax credits offer a payment-per-unit produced, which can help offset the market uncertainty associated with early-stage technologies and allow enough time for them to reach a return on investment. This is particularly true in areas such as hydrogen, clean fuels and sustainable aviation fuels, but it may also affect certain manufacturing and critical-minerals projects.
If the U.S. draws investment away from Canada, it will limit Canada’s ability to leverage the private-sector investment needed to establish a foothold in markets that will be important drivers of economic growth in the coming decades.
The scale of investment
The U.S. IRA is estimated to cost $US392 billion over 10 years, with $US121 billion in direct spending and $US271 billion in tax credits. However, a recent Brookings paper suggested the cost of tax credits could be much higher, reaching $US780 billion by 2031.
At the lower amount, Canada’s $83 billion (roughly $US59 billion) is competitive. At the higher end, Canada falls short, given the relative size of our economy compared to the United States.
The scale of direct spending also matters, since unbalanced investment draws Canadian companies away to the United States. For example, Li-Cycle, a Canadian-based electric-vehicle battery recycling company, received a conditional $US375-million loan from the U.S. Department of Energy’s Loan Programs Office to help finance the construction of a lithium-ion battery resource recovery facility in New York state.
Both the Canada Growth Fund and the newly promised “broad-based approach to contracts for difference” could close the gap.
The Canada Growth Fund
The Canada Growth Fund was first announced in the 2022 budget, with further elaboration in the Fall Economic Statement. In this year’s budget, it was announced that the fund will be managed by the Public Sector Pension Investment Board (PSP Investments).
Choosing PSP makes sense in terms of moving quickly. A well-established investment team can hit the ground running, with the promise that investment will begin in the first half of 2023.
However, pension funds are not known for their ability to support the type of risky, new technologies where a competitive edge is needed. They tend to invest in safe, large-scale, proven projects and companies with clear long-run returns.
If the Canada Growth Fund is to close the gap with the U.S., PSP Investments may need to bring in some additional expertise with knowledge of earlier-stage clean energy and technology. The funding will have the greatest long-term impact if it operates in the space where investment and technology risk is too high for private debt and equity. That line will shift over time, so PSP investments will need to stay on top of rapidly evolving markets. Potential models to learn from include the U.S. Department of Energy’s Loan Programs Office, Australia’s Clean Energy Finance Corporation and Quebec’s Investissement Quebec.
Contracts for difference
Contracts for difference also have the potential to capitalize on a big advantage Canada has relative to the U.S. – carbon pricing. Canada’s carbon price is scheduled to rise to $170/tonne by 2030. The carbon price acts as a signal to the market, generating value for investments in low-carbon energy, technologies and products. However, if a future government rolls back Canada’s carbon price, the market value of low-carbon energy and products could plummet. The risk of policy reversal can deter investors.
Contracts for difference, where the government guarantees a certain carbon price into the future, can help unlock private investment. The Canada Growth Fund will have the ability to sign contracts for difference, but this year’s budget also announced that it will consult on a broad-based approach to carbon contracts for difference.
In theory, contracts for difference are a low-cost approach to accelerate private investment. If the carbon-price trajectory remains in place, the government will not have to pay anything. The potential liability for the government in the event of a reduction in carbon price would be substantial, however.
A future government – potentially led by Pierre Poilievre – would face a difficult choice if broad-based contracts for difference were in place: Roll back carbon pricing and pay out billions of taxpayer dollars to companies or keep the carbon-price trajectory intact (at least for relevant sectors). And while the idea is that the contracts could tie the hands of a Poilievre government, it is important to note that the Conservative government in Ontario scrapped renewable energy contracts despite the financial cost.
Federal contracts for difference that guarantee a certain carbon price get complicated in provinces and territories that have their own carbon pricing policies. It doesn’t make sense for the federal government to guarantee a price that a provincial or territorial government could change. Provincial and territorial governments with their own carbon pricing systems will need to develop their own contract for difference programs.
Contracts for difference are also be more challenging for Quebec, where there is a cap-and-trade program linked to California. With a cap-and-trade system, prices rise and fall depending on the demand and supply of allowances in the market. To date, carbon prices are below those in other provinces. A project in Quebec would be disadvantaged compared with a project in another province or territory where a proponent secures a contract for difference based on the higher federal carbon-price trajectory.
Governments at all levels, and entities such as PSP Investments, could also use contracts for difference to guarantee product prices, such as hydrogen prices, or input prices such as electricity rates. Those contracts carry a higher risk of payout since they depend on market fluctuations.
To limit costs, reverse auctions could be used, where a fixed amount of money is set aside, and companies submit bids for the guaranteed price they need for their project to move forward. Government entities select the cheapest bids (that meet certain quality criteria) and structure the contracts accordingly. The U.K. uses reverse auctions for its renewable contracts for difference.
Contracts are also often designed to require companies to pay the government when product prices are higher than the guaranteed price. The Alberta government made over $100 million from its renewable support agreements between 2016 and October 2022. This allows a government entity to have a balanced, lower-risk portfolio across a number of different markets, like hydrogen and biofuels.
Figuring it out ASAP
Despite complexity, the federal government – and partners such as PSP Investments – should aim to provide clarity as soon as possible on eligibility, investment instruments, criteria, terms and timelines. If Canada is going to be a player in the global race for market share in the future clean economy, it needs to find a way to catch up with those who were first out of the starting gates.
About the author
Rachel Samson is the vice president of research at the Institute for Research on Public Policy. Previous to her current role, she was clean growth research director at the Canadian Climate Institute. Rachel also spent 15 years as an economist and executive with the federal government, and five years as an independent consultant. Twitter @rachel_e_samson