How Fossil Fuels Drive Inflation and Make Life Less Affordable for Canadians

Consumers can benefit from lower fossil fuel prices during periods of decline, but abrupt price drops can also disrupt the economy, leading to uncertainty and affecting businesses, employment, and productivity. When prices rebound, consumers are often left unprotected, exacerbating difficulties for businesses and households that are unable to hedge against fluctuating energy prices. Another challenge with volatility is that ongoing and repeated fossil fuel price shocks can trigger self-perpetuating price increases. Increasing energy prices causes inflation in other sectors of Canada’s economy that are sensitive to energy inputs, such as food and homeownership costs, where prices are slower to fall once elevated.

The ripple effect of high energy prices should not be underestimated. With ongoing energy price fluctuations and persistent higher prices amongst other key goods and services, central banks look to strategies to counter inflation, typically through interest rate hikes. Higher interest rates, in turn, put a further squeeze on affordability as mortgage and rental costs increase. This highlights the disproportionate and escalating effect that energy price hikes can have on consumers.

The economic impact of Canada’s reliance on fossil fuels was particularly evident during the post-pandemic recovery phase. As COVID-19 restrictions lifted in 2021 and economies started recovering, energy demand grew rapidly. However, supply-side challenges arose due to sluggish oil production in key OPEC-plus countries, unexpected outages in LNG supply, and Russia’s invasion of Ukraine, exacerbating already tight oil and gas markets. This combination of demand-side and supply-side pressures led to skyrocketing international oil and gas prices. Global energy consumption expenditures were 20% higher in 2022 than the average from the previous 5 years. By June 2022, Canadians were paying on average CAD 2.07 per litre for gasoline, up 55% from a year prior—while diesel fuel prices soared more than 80% in certain regions over the same period. It is worth noting that although carbon prices in Canada also rose during this period, with a CAD 0.73 year over year increase on gasoline prices, only CAD 0.03/litre was attributed to the increase of the carbon tax.  The remaining CAD 0.70/litre impact was driven by international pricing dynamics (Figure 4). 

Figure 4. Year over year price increase of regular unleaded gasoline (Canadian average retail price)

Canadian inflation analysis has determined the majority of Canada’s high inflation during the pandemic recovery period stemmed from three specific items: energy, food, and shelter costs (Figure 5). These items contributed more than 60% of Canada’s overall inflation in June 2022 and played an even more substantial role in the acceleration observed in the previous year. From February 2021 to June 2022, energy prices alone accounted for a third (33%) of Canada’s overall inflation. And when energy costs spike, a wide range of other items are impacted.

Items that are energy intensive contributed nearly three full percentage points to Canada’s overall inflation in Q3 2022. The costs of these items rise and fall with oil and gas prices.  Up to 25% of non-energy items within the consumer price index are sensitive to oil prices (including most food categories and various durable goods), accounting for nearly 60% of Canada’s non-energy inflation in July 2022 and over 85% of the increase since February 2020. These spillover effects accelerate inflation across the board and become difficult to reverse once they have taken hold. 

Figure 5. Key drivers of consumer price inflation in Canada

Recognizing the systemic importance that energy plays in maintaining price stability, it is imperative to consider and monitor its price volatility and factor it into monetary policy considerations. To combat inflation, interest rate hikes have been the preferred policy of central banks. This approach is meant to curb consumer cash flows in demand-driven inflation scenarios (i.e., excess consumer spending). But when supply-side inflation mounts (i.e., rapidly rising energy prices), interest rate changes have little immediate effect on inflation, and raise loan and mortgage payments for consumers already facing higher prices for energy, goods, and services. In this way, the consequences of combined higher energy prices and higher interest rates are quite costly for consumers. Higher interest rates can also increase the upfront costs of clean energy projects in a feedback loop that slows the energy transition.

In order to provide some immediate energy price relief for consumers, Ontario, Alberta, and Manitoba have provided gasoline tax “holidays” from their provincial fuel taxation programs, temporarily lowering gasoline costs by  CAD 0.057/litre, CAD 0.13/litre, and CAD 0.14/litre respectively (Government of Alberta, 2024; Government of Manitoba, 2024; Government of Ontario, 2024). Carbon price “carveouts” for specific consumers have also been attempted, with questionable results, including higher emissions and lower rebates.  This ad hoc price relief is temporary by design, doing little to reduce energy costs in the long term and depriving federal and provincial governments of important tax revenue. These blanket responses are easily deployed but are ultimately expensive and inefficient ways to protect the consumers who are most in need. Subsidizing fuel costs keeps prices artificially low, reducing incentives for energy efficiency and fuel switching, and keeps consumers stuck on the fuel price rollercoaster.

While only 18% of Canada’s electricity generation is from fossil fuels, there is considerable variation across the country. Provinces with the highest amounts of fossil fuel-generated electricity are Nunavut (99%), Alberta (81%), Saskatchewan (79%), Nova Scotia (59%), Yukon (32%), and New Brunswick (30%). Although coal use has dropped, natural gas use for electricity generation has increased significantly from 3% of total generation in 1996 to 16% in 2022.

Expanding natural gas generation increases the entire system’s exposure to volatile energy sources and risks higher costs for producers and higher prices for consumers. For example, between 2020 and 2022, the amount of natural gas used for electricity generation in Canada increased by 5%, generating 16% more electricity (due to more efficient technology), but the cost ballooned by 151%, from CAD 1.9 billion in 2020 to CAD 4.7 billion in 2022. These higher operating costs are ultimately covered through electricity rates. When looking at the long-range operating costs of gas-powered electricity, the picture is even more grim. A 2021 study of electricity generation facilities in the EU, United Kingdom, and United States found that due to the volatility of fuel prices and other factors, the economics of gas-fired power generation are growing more fragile. Roughly 31% of U.S. and 22% of European gas-fired power generation facilities are already estimated to be unprofitable, while others are facing increasing risk of becoming stranded assets.  

Conversely, the cost of renewables has dropped dramatically in the last decade (as shown in Figure 6), making it the lowest-cost form of electricity production in most jurisdictions. The levelized cost of electricity (LCOE) dropped 89% for solar and 69% for onshore wind, falling below the fossil fuel cost floor. The cost of these renewables is projected to continue trending downward and will fall nearly 60% below the cost of natural gas production by 2030. In 2023, more than 95% of new utility-scale solar installations and new onshore wind capacity had generation costs lower than new coal and natural gas plants.

Figure 6. Global LCOE from newly commissioned utility-scale renewable energy

Power generation from renewables, specifically wind and solar, can lower and stabilize electricity prices. This is in part because wind and solar electricity does not rely on input fuel to operate. Once built and connected to the grid, renewable energy costs do not fluctuate based on fuel prices. Long-term price stability can be locked in through power purchase agreements that guarantee a price for renewables decades into the future. As a result, integrating renewables can lower electricity prices for consumers. Modelling in Alberta, New Brunswick, and Nova Scotia shows that clean energy portfolios can provide the same electricity services as natural gas generation but at a lower cost.  

Concerns about the variability of renewable sources can be managed—through storage as well as demand-side and grid-side measures—to ensure capacity is there when needed. Modelling has shown that Canada’s electricity capacity can grow to the required levels through additional wind, solar, energy storage, and interprovincial transmission without compromising reliability.  

Nevertheless, Canada will require 2.6 to 2.9 times its current electricity capacity to meet increased demand by 2050. A build-out of this scale will require significant upfront investments. Roughly double the rate of current capital expenditure is required, but the savings to Canadian households of transitioning to a net-zero grid by 2050 is estimated at CAD 15 billion annually and roughly CAD 1,500 annually per household. Investments in transmission infrastructure and interconnectors, flexible generation, and specialized forecasting and planning tools, as well as ensuring access to regional electricity markets, are critical (Eriksen, 2018). Fortunately, Canada is well-placed to perform in all four categories including a high percentage of legacy hydroelectric power that can provide firm, dispatchable power to complement variable generation from wind and solar.  

Canada’s energy system is diverse, and jurisdictional authority over electricity systems and pricing is largely a provincial matter. Provinces and territories with a large share of fossil fuel generation will face the highest costs in the energy transition. These costs may, to an extent, be passed on to consumer ratepayers, and, in some cases, higher prices will result for some, despite longer-term trends that favour affordability and price stability. Policies and incentives can and should be designed to address these regional challenges, including supports for consumers directly through measures on energy efficiency as well as initiatives such as inter-jurisdictional cooperation on transmission interties. Detailed analysis of who will be impacted by the clean energy transition both positively and negatively should also be a priority to understand the nature of the issue and develop regionally focused responses.  With this said, delaying the clean energy transition will only lead to higher production costs and price volatility down the road as fossil fuel-based energy systems become less attractive compared to renewable energy technologies.    

Regional challenges have been acknowledged to an extent through the federal government’s announced financial supports for provinces to grow their clean electricity grids. The supports were designed so that provinces with emissions-intensive grids would receive the most support relative to the scale of their existing grid, roughly 33% more than hydro-rich provinces. Through these financial incentives, along with its Clean Electricity Regulations, the federal government is aiming to achieve a net-zero electricity grid by 2035. In addition, policies that provide a level playing field for renewable energy technology and investment will ensure that clean energy industries can remain competitive against fossil fuel incumbency.

Household energy consumption in Canada is largely reliant on fossil fuels (Figure 7), primarily for heating, exposing consumers to fossil fuel price volatility. Switching away from fossil fuels will lead to more household electricity use in Canada, but an overall reduction in average energy costs of 12% is expected between now and 2050. Additional analysis predicts households could save as much as CAD 1,500 annually. One of the most direct ways to improve affordability for Canadians is by lowering household energy costs through fuel switching, efficiency upgrades, and electrification. 

Figure 7. Household energy consumption by type (excluding transportation), 2021

Electric air-source heat pumps offer better efficiency and significant cost savings as compared to gas furnaces. Research by the Canadian Climate Institute found that, on average, the lifetime costs of a standard heat pump with electric backup are 13% less than a gas furnace with air conditioning and can cut approximately CAD 55 off the monthly bill of a detached family home in Ontario. Clean Energy Canada has concluded that air-source heat pumps “are the cheapest option for many Canadian households, even when the costs of installation are included.” Furthermore, an average of  CAD 328 could also be saved per year by eliminating a home’s natural gas hook-up.  

Federal and provincial initiatives exist to help consumers offset the upfront cost of home energy retrofits through rebates as well as low-interest or no-interest financing. The Government of Canada’s Greener Homes Grants Program, which was launched in 2021, provided homeowners with up to CAD 5,000 for energy efficiency retrofits (e.g., insulation, windows and doors, heat pumps, and solar panels) and up to CAD 600 to help with the cost of home energy evaluations. The CAD 2.6-billion program was slated to run until 2027, or until funds were depleted, but in spring 2024, the program was paused, citing high demand (especially for heat pumps) and signalling a program redesign. With Natural Resources Canada reporting more than half a million applications over 3 years, it is clear that there is high demand and anticipation for the program to continue.   

Reducing fossil fuel reliance through targeted home energy retrofit programs improves energy efficiency and can protect consumers from price volatility. Consumer demand for these programs is strong, and the retrofit industry has generated jobs across the country. The Pembina Institute has modelled that up to 200,000 long-lasting, well-paid jobs would be created over 20 years should Canada choose to invest in addressing carbon emissions from homes and buildings through deep energy retrofits. Energy savings, job growth, and lower emissions mean a win for both the climate and affordability.

Personal transportation is another area where fossil fuel-free alternatives provide improved affordability for consumers. Transportation costs accounted for 15% of household spending in Canada in 2021, second only to food (15.4%) and shelter (31.4%). According to a recent report, Canadian car owners spend an average of  CAD 200 per month on gasoline, whereas a comparable electric vehicle (EV) would cost CAD 23–54 per month to power. Clean Energy Canada compared the lifetime costs (10 years of ownership, 20,000 km per year) between various categories of EVs and comparable internal combustion engine vehicles, and found that EVs cost less in all scenarios across Canada, even without a provincial rebate. The Honda Civic, for example, cost an additional CAD 36,000 over its lifetime than a comparable EV (Nissan Leaf S Plus) (Figure 8). Similar savings were found for hatchback, SUV, and crossover car models as well (based on the average retail gasoline price in 2022—CAD 1.73/litre).

Figure 8. Ownership and fuelling costs for comparable EV and gas-powered vehicle (sedan model)

A 2022 study calculated how much it would cost to charge an EV from zero to full in every province in Canada. The cost of charging the Chevy Bolt ranged from CAD 5.46 in Quebec to CAD 12.61 in P.E.I., but in all cases, was significantly cheaper per kilometre than gasoline. That adds up to significant savings over a vehicle’s lifetime. As the manufacturing costs of EVs come down over time, retail prices will fall, making the switch to electric even more attractive. 

Access to EV options is limited to those who can pay the upfront costs, making them still out of reach for many. Innovation and scaling up of manufacturing will lower retail costs over time. Meanwhile, rebates and incentives can make EV purchases more affordable, and governments can further support EV adoption through the development of charging infrastructure. The federal government’s CAD 5,000 rebate on EVs, as well as rebates available from provincial governments in the Yukon, British Columbia, Manitoba, Quebec, and all the Atlantic provinces, have been helping consumers make the switch. More consumers can be reached by ensuring used EVs are eligible for rebates, as they are in many provinces.  

While infrastructure investments are necessary, they require sufficient demand to make the investments worthwhile. EV market momentum can be built by better supporting low- and middle-income households through a progressive rebate program that is income-tested, ensuring higher-income households are not the primary beneficiaries. Making clean transportation accessible is essential to help lower costs for everyone, not just those who can afford to buy an EV. Supporting clean, reliable, and affordable public transportation also increases low-cost options for Canadians while simultaneously reducing transportation-related emissions.