As Canadians wrestle with the financial and fiscal impli- cations of the current surge in energy prices, it is instructive to harken back to the range of implications triggered by the first energy price cycle, defined for present pur- poses as the period from 1972 to the mid-1980s. Toward this end, the accompanying graph presents the trends in world ener- gy prices from the early 1970s to the present. The ”œUS$” line is the per-barrel price for Brent Sea crude in US dollars. The ”œC$” line is this US dollar price expressed in Canadian dollars. From a level of about $2 per barrel in 1972, world prices soared to US$36 (C$45) in the early 1980s before falling back to under $20 in both Canadian and US dollars by 1988.
The ongoing oil price increase from US$14 in 1998 to US$66 in August 2005 (or C$22 to C$82) is larger in absolute value, but cannot compare in relative terms with the 20-fold increase over the 1972-82 period.
The final line is the real (inflation adjusted, in 2004 dollars) Canadian dollar price. Note that the 2005 real Canadian dollar price is considerably lower than it was in 1980. But because Canadian domestic energy prices were less than half of world prices in 1980, real domestic prices are higher in 2005 than they were in 1980. In other words, the cost of gas at the pumps is now at an all-time high.
Turning to the equalization program, although it was intro- duced in 1957 it was the 1967 revision that made the program comprehensive, one aspect of which was that 100 percent of all energy revenues was equalized to the national average standard (NAS). As an aside, 1967 to 1973 would turn out to be the only period to date where energy revenues were fully equalized.
Faced with the 1973-74 price spike, during which OPEC effectively tripled the price of oil to $9 a barrel, Ottawa’s immediate response was to keep the domestic prices from rising apace with world prices. As part of the overall strategy to bring this about, the federal gov- ernment imposed an export tax on oil equal to the difference between the domestic and world price. A key part of the rationale for this export price was to generate revenues sufficient to enable Ottawa to subsidize oil imports into eastern Canada, thereby maintaining a uniform domestic price across the country.
In roughly the same time frame, the producing provinces substantially increased their royalty rates for oil and natural gas. Ottawa responded by dis- allowing the deduction of these provincial royalty payments for pur- poses of federal corporate income tax calculations. If the domestic price of energy were allowed to rise and the producing provinces were allowed to pocket the increased royalties, the result would be a very substantial rise in equalization payments. And if, in addition, royalties paid to the provinces were deductible for federal corporate income tax purposes, Ottawa would surely find itself in a serious fiscal bind ”” its equalization responsibilities arising from energy revenues would be substantially increased while its own revenues from these same energy sources would not have so increased. In particular, Ottawa would not be able to extract much revenue from the very provinces that were benefiting from energy rev- enues and triggering the increase in equalization payments.
This equalization dilemma can be rephrased as follows. If Canada had gone to world oil prices in 1974, total equalization payments would have tripled, and in the process Ontario would have become a ”œhave- not” province. Indeed, with Ontario as a have-not province, three-quar- ters of Canadians would then reside in provinces that receive equalization payments. In turn, this would have implied that each additional dollar of energy revenues would generate 75 cents in equalization. Not surprising- ly, therefore, in the fall of 1974 Ottawa abruptly and without provin- cial consultation amended the equal- ization formula. Henceforth, Ottawa would distinguish between ”œbasic” energy revenues and ”œadditional” energy revenues. Basic revenues were defined as existing revenues in 1974 (indexed for production increases) and would be equalized in full. Additional revenues would equal actu- al revenues for the current year minus basic revenues, i.e., they would reflect the energy price increase since 1973-74. Only one-third of these additional revenues would enter the equalization formula.
An important caveat is in order here. This differen- tiation between basic and additional equalization rep- resented the abandonment of the concept of ”œfull equalization” embraced in the 1967 fiscal arrange- ments. However, by contin- uing to subsidize imports for the eastern provinces (i.e., Quebec and the four Atlantic Provinces) in order to maintain a uni- form domestic price below the world price, Ottawa could be viewed as pro- viding an alternative form of equaliza- tion for the residents of these provinces, all of which fell into the ”œhave-not” category. In other words, by maintaining a domestic price below the world price, Ottawa was diverting potential energy revenues from the energy-rich provinces and essentially transferring them directly to Canadi- ans in terms of subsidized energy prices. In this sense, the energy-rich provinces, and Alberta in particular, were making an enormous financial contribution to the fiscal basis of the federation. By way of an anticipatory comment, this is quite different from the current environment where domestic energy prices are moving apace with world prices and, therefore, all of the increased revenues from energy price increases are finding their way into provincial coffers.
While the 1977 reworking of the fiscal arrangements are best remem- bered for the block funding of the Established Programs Financing (EPF), our interest here relates to the two provisions relating to the equalization treatment of resource revenues. The first was the estab- lishment of a ”œresource ceiling” or a ”œresource cap” that stipulated that the pro- portion of equalization that could arise from natural resources (renewable as well as non-renewable) could not exceed one-third. The second was that the distinction between ”œbasic” and ”œaddi- tional” energy revenues was jettisoned: henceforth 50 percent of all non-renewable resource revenues would be eligible for equalization.
This latter provision was unfathomable, given that the immediate result was to increase equalization to the degree where Ontario became a ”œhave-not” province for each and every year over the 1977-78 to 1981-82 period. Ottawa’s bounceback was three-fold. First, it excluded Ontario’s equalization entitlements from resource revenue categories for purposes of calculating the so-called resource ceiling. Second, Ottawa retroactively removed the admittedly volatile energy category ”œsale of crown leases” from the formula. Third, and far and away the most important, the federal government retroactively excluded Ontario from receiving equalization payments by legislating the ”œpersonal income over- ride,” the thrust of which was that no province could receive equalization payments if its per capita income exceeded the national average.
In the more general political- economy context, the more than doubling of energy prices in 1979-80 rendered Canada’s existing energy policies obsolete. Accordingly, in the fall of 1980 the federal government introduced the NEP, a policy whose ramifications transcended the energy patch and the West to profoundly influence Canada’s political, consti- tutional and federal evolution as well as to serve a catalytic role in the introduction of the Canada-US FTA. On the pricing front, the 1980 well- head price of C$16.75 (less than 40 percent of the 1980 Canadian dollar equivalent of the world price) would, under the provisions of the NEP, increase to about C$40 by 1986, with similar increases for natural gas. On the taxation front, Ottawa intro- duced three energy taxes (the Natur- al Gas and Gas Liquid Tax, the Petroleum and Gas Revenue Tax, and the Petroleum Compensation Charge), as well as a Canadian Own- ership Charge, designed to increase public ownership of the energy sec- tor. Relatedly, depletion allowances were to be phased out and replaced by the Petroleum Incentive Program (PIP), which established preferential rates for Canadian-owned companies and for activity on the Canada Lands (as distinct from provincial or pri- vate lands). Finally, the NEP includ- ed two ”œnationalization” provisions: the federal government reserved for itself (or a federal crown corpora- tion) a 25 percent interest in all existing and future petroleum rights on Canada Lands (i.e., the controversial ”œback-in provision”), and it also signalled its intention to purchase several large for- eign-owned oil and gas firms.
Not surprisingly, the reac- tion from the provinces and the energy patch ranged from negative to outright hostile, but this was ameliorated somewhat by the September 1981 Canada- Alberta Energy Pricing and Taxation Agreement (EPTA). Among its major provisions was a commitment to a near- C$60 price for oil in 1986 com- pared with the NEP’s projection of roughly C$40. In the 1984 federal election, the victorious Mulroney Tories made the effective dismantling of the NEP one of their key selling points in the west. Admittedly, delivering on this electoral promise was made much easier by the collapse in world energy prices: the near-C$60 EPTA price for 1986 contrasts with the then-world price of roughly C$20. Intriguingly, Canadian prices ”œfell” to world levels, and they remain at world levels.
However, the NEP and federal energy policy generally had fur- ther implications. Ottawa’s subsi- dized oil prices, its initial export tax, its later taxation and exploration measures under the NEP, as well as the Supreme Court’s decision in the CIGOL case, all combined to lead the energy-producing provinces to demand and receive a confirmation of provincial powers over resources as part of the Constitution Act, 1982. The result was section 92A, which granted the provinces exclusive authority over the development, conservation and management of natural resources. On the taxation front, sec- tion 4 of 92A gave new powers to the provinces, namely the right to ”œmake laws in relation to the raising of money by any mode or system of tax- ation” in respect of non-renewable natural resources, forestry resources and the generation of electrical ener- gy. In an important related develop- ment, while the federal government refused to negotiate constitutional amendments that would cede off-shore resources to the relevant provinces during the 1980-82 negoti- ations, a compromise was reached in 1982 that granted these provinces a revenue stream from these resources without relinquishing federal con- trol. Arguably this paved the way for mid-1980s offshore energy accords with Newfoundland and Labrador and Nova Scotia and the subsequent 2005 bilaterals with Ottawa that eliminated any equalization claw- backs on offshore energy royalties.
Then came the 1982 renegotia- tions of the fiscal arrangements. With world energy prices near C$40 and projected under the EPTA to rise to C$60, and with domestic prices slated to move rapidly to world levels, there were two overarching (and related) issues that had to be addressed. The first was to find a way to lessen the impact of energy rev- enues on the equalization formula, and the second was to find a formula- driven way (other than the ”œpersonal income override”) to ensure that Ontario would not become a recipient province. Ottawa’s initial and obvious proposal in the fall of 1981 was to adopt an ”œOntario standard,” which, by definition, would preclude Ontario from ever becoming a have-not province and would simultaneously minimize the impact of energy rev- enues, because the energy-revenue- receiving provinces and their energy tax bases were excluded from the standard. In 1982, Ottawa took the advice of the provinces to broaden the standard somewhat beyond Ontario, the result of which is the so- called ”œfive-province standard” (FPS). At the high fiscal capacity end the FPS excluded Alberta and at the low fiscal capacity end it excluded the four Atlantic provinces. As a result, the FPS sharply reduces the impact of energy revenues on the formula, thereby ensuring that Ontario will not qualify for equalization. One often-forgotten feature of the FPS is that it still employs a ten-province tax rate, which further reduces equalization (compared to a five-province tax rate) because it incorporates Alberta’s low tax rates.
At one level, the adoption of the FPS in 1982 can be viewed as a stroke of policy genius, especially since it remains in place to this day. Howev- er, it created its own set of problems, which are becoming more acute as world energy prices again spiral upward. For example, the potential for high clawback rates on offshore energy revenues arguably led to the Newfoundland and Nova Scotia Accords, to the 70 percent ”œgeneric solution”, and finally to the offshore revenue bilaterals between Prime Minister Martin and premiers Williams and Hamm. The result is that these provinces have zero clawbacks on their energy revenues whereas Saskatchewan still reels under very high equalization taxbacks. More- over, at current energy prices, with zero clawbacks on its energy revenues, Newfoundland and Labrador’s per capita revenues will be substantially higher than those of Ontario.
By way of summary then, the first energy shock clearly had a dra- matic impact on the political econo- my of Canada, running the gamut from the Constitutional dossier, to the politics of federalism, to Canada- US relations and western support for the FTA and, of course, to equalization payments and fiscal federalism more generally. Beyond this, the first energy-price shock began the process, continuing in the current time frame, of shifting economic power within Canada westward. It is difficult to think of another political or econom- ic event whose implications have been so direct and pervasive.
Will the on-going energy price explosion hold the same potential for altering the political economy of the federation? From Ottawa’s own perspective and inter- ests the answer would seem to be ”œno.” Consider, first, the most sensi- tive issue for the energy-producing provinces, namely a replication of NEP-type interventionist initiatives. The 2005 environment is very differ- ent from that of 25 years ago. Instead of running large deficits as in the NEP era, Ottawa is basking in its near- decade-long string of surpluses.
Indeed, Ottawa probably already has too much in the way of fiscal capaci- ty, since all three of its policy priori- ties (children, cities and medicare) are largely or wholly in provincial juris- diction. Moreover, with domestic prices moving in tandem with world prices, there is no pressing need for revenues at the federal level as there was in the earlier energy price cycle when Ottawa held down the domestic energy price.
Another key difference is that energy price surges cannot send equalization payments soaring as they did the earlier period. This is so because under the provisions of the October 2004 First Ministers’ Frame- work Agreement, the amount of overall equalization will be increased to $10.9 billion for fiscal year 2005- 06 and thereafter escalated by 3.5 percent annually. (Note that the new framework was agreed upon because under the FPS approach equalization payments had actually been falling of late.) Thus the new role for any for- mula will only be to allocate this pre- determined envelope across the recipient provinces. And because the equalization formula, per se, no longer determines the overall amount of transfer payments under equalization, the methodology for allocating the fixed equalization pool could well be hived off to a ded- icated arm’s-length institution like Australia’s Commonwealth Grants Commission.
For all of these reasons it is diffi- cult to envision a central govern- ment rationale for taking action with respect to rising energy rev- enues in the resource-rich provinces. However, there may well be an inter- provincial rationale. Specifically, the pressure on the equalization princi- ple and on horizontal fiscal balance, as distinct from the level of equal- ization payments, may become acute, since a doubling of energy prices has the potential for more than doubling provincial energy rev- enues (since the increase in prices should correspond to economic rents, all of which could find their way into royalties). And unlike the first energy shock, Canada’s domes- tic energy prices will move in lock- step with world prices, so that the earlier diversion of royalties away from the producing provinces will not happen this time around. As a result, several provinces may find themselves unable to keep up with some of the energy-rich provinces in providing reasonably comparable levels of public services at reason- ably comparable tax rates. The potential for this to become a reality will be heightened if the energy-rich provinces utilize their resource rev- enues to substantially ramp up their public services or reduce their tax rates well beyond the average else- where, and will be diminished to the extent that these provinces shelter their energy revenues in savings funds or invest them outside the country, following Norwegian prac- tice. Note that how to spend or oth- erwise allocate energy royalties also poses challenges for the energy- producing provinces, and Alberta among others is beginning to address this allocation issue.
Hence, while Ottawa may not have a rationale of its own for rework- ing aspects of the fiscal framwork, this may not be the case for concerns pressed upon it in the name of restor- ing horizontal fiscal balance.
It is in light of this concern that I have proposed a two-tier approach to equalization: 1) allocate the $10.9 billion fixed equalization pool (for 2005-06) in accordance with fiscal capacity disparities relat- ing to non-resource revenues, and 2) create a modest interprovincial rev- enue-sharing pool for resource rev- enues that would have to be agreed to and operated by the provinces (presumably by the Council of the Federation). For instance, an 8 per- cent contribution of provincial resource revenues to the second-tier pool would be sufficient to equalize 20 percent of resource revenues. This second tier would have to be volun- tary, since the Constitution pre- cludes Ottawa from confiscating provincial revenues. A variant of this proposal would be for the $10.9 billion to be the sum of the two tiers, with the resulting federal sav- ings returned to the provinces in the form of an equivalent tax-point transfer. A roughly similar option proposed in 1980 was rejected by the federal government, by the recipient provinces and, not surprisingly, by the donor provinces. A similar fate appears to await the current version. However, in its defence, let me make two points. The first is that I do not accept the criticism that this propos- al smacks of another NEP. Indeed it is actually the reverse of the NEP: apart from the fact that the second tier bypasses Ottawa entirely, it is a creative and strategic initiative orchestrated by the provinces to allow all of them to increase their room to manoeuvre in the federa- tion. The second is to recognize that saying ”œno” to this or similar pro- posals will not remove the underly- ing issue of satisfying the constitutional commitment that Canadians everywhere have access to comparable public services. Fail- ure to come to grips with this socie- tal value could mean that this current energy-price surge might also have dramatic ramifications for the evolution of the federation.
Finally, another difference this time around is that the current energy-price surge appears to be converting the Canadian dollar into a version of a ”œpetro-cur- rency,” rising and falling apace with energy prices. While this serves to decrease the Canadian- dollar value of world oil prices (and the revenues of the energy-rich provinces), the prevailing concern relates to the potential for falling prey to the ”œDutch disease,” namely, that the resulting appreciation (spurred on by foreign investment in the energy sector) will undermine our manufacturing com- petitiveness and further complicate Canada’s economic geography.
In concluding, it is wise to cast a further glance at the accompanying chart to note just how fast the first energy price shock unwound in the mid-1980s. The same could easily happen this time around. But assum- ing that $US60+ oil is in our future for the medium term, the above analysis would suggest that the potential fault lines will relate more to horizontal (or interprovincial fis- cal) imbalance than to vertical (or federal-provincial) imbalance. Assum- ing that the provinces are willing to bear a degree of collective responsibil- ity commensurate with their taxing and spending powers, this suggests that the Council of the Federation may be the institution that should take policy centre-stage.