January 31, 2020

Economic diversification: what it is and just how diversified is Alberta’s economy?

For more than half a century the energy sector has been the engine of the Alberta economy. It has attracted both investment and people here. It is directly responsible for our relatively high incomes and low tax burden. Along with those benefits, has also come economic volatility. For better or worse, Albertans have grown accustomed to the soaring highs and gut-wrenching lows that come with being one of the world’s largest energy producers.  A variety of factors that we have varying ability to influence – international markets, geopolitical risk, business competitiveness, domestic policy – all affect these cycles.

Whenever the oil and gas industry struggles – as it has for the past several years – it invariably leads to discussions about the need for economic diversification in Alberta. While silent when the industry is thriving, observers frequently criticize the province during downtimes for its failure to diversify away from oil and gas. 

[bctt tweet=”Talk of economic diversification in Alberta begs the question: just how diversified IS Alberta today? BCA Chief Economist @MHoldenAB dives deeper into Alberta’s economic mix and what that means for our long-term prosperity.”]

What is Economic Diversification?

What does “diversification” mean? In a basic sense, it is about how broadly economic activity is distributed across a range of sectors. People usually think of it like an investment portfolio: instead of putting all your bets on one company, you buy a wide range of stocks, bonds and/or mutual funds. In that way, you insulate yourself against the risk that any one of those assets might fall dramatically in value.

The problem with this analogy, of course, is that economies are not investment portfolios. The structure of any given economy is based on resource endowments, geography, the impact of historical policy decisions, comparative advantages in trade, and a host of other factors – including, often, serendipity. You cannot simply “buy” a new industry for your economy in the same way as you buy a new stock for your portfolio.

In that sense, economies are more like public infrastructure. Roads and cities can be redesigned, but only either very gradually or at terrible cost. 

How Diversified is Alberta’s Economy?

Nevertheless, talk of economic diversification in Alberta begs the question: just how diversified IS Alberta today? How does it compare to other provinces? And have we made any progress in diversifying over the last 20 years?

To answer these questions, we first need a way to measure diversification. One common approach is to use a calculation called the Herfindahl Index (H-score for short), the math behind which is explained here. H-scores can be placed on a scale of 0 to 1.

  • 0 represents a perfectly diversified economy – every industry or sector is the exact same size
  • 1 represents a perfectly undiversified economy – a single industry accounts for 100% of economic activity

Figure 1 shows the H-scores for the 10 provinces in 2018 using real GDP (H-scores can also be calculated using employment, income or exports). According to this measure, Newfoundland and Labrador is by far the least diversified province in Canada, while Alberta is in the third position, at about the same level as Nova Scotia and PEI. At the other end of the spectrum, Manitoba is Canada’s most diversified province.  However, what stands out is how little separation there is between the provinces. Considering that the H-score is on a scale of 0 to 1, all provinces save Newfoundland and Labrador are within a relatively narrow band.

Figure 1: Economic Diversification Across Canada

That said, one of the challenges with evaluating diversification in Alberta is the impact that the oil and gas industry has on other parts of the economy. The most obvious example is manufacturing: Alberta is home to Canada’s third-largest manufacturing sector, most of which is either directly tied to supplying materials to the energy sector or to making value-added goods (like gasoline or plastics) out of the raw resource. These businesses would likely not exist in the absence of the energy sector. Do they contribute to diversification? Or do they compound the impact of oil and gas?

It is also unclear whether Alberta is becoming more or less diversified over time. Alberta’s H-score has fluctuated dramatically over the last 20 years, closely following the boom/bust cycle of the energy sector. Figure 2 compares the H-score in Alberta and Manitoba over the last 20 years. In 1998, when oil prices were less than $12/barrel, the Alberta economy was nearly as diversified as Manitoba. Ten years later, oil prices were averaging close to $100/barrel and the province was booming. At that point, there was a wide gap between Alberta and Manitoba – not because other sectors of the Alberta economy were doing poorly, but because one specific sector was doing so well. Finally, in 2018, after four years of struggle in the energy sector, Alberta was once again almost as diversified as Manitoba.

Figure 2: Economic Diversification Over Time

What does this mean?

The lesson here is that Alberta’s lack of economic diversification is not because we put all our eggs into a single basket, it’s because that one basket ended up becoming so large. History shows that the quickest way to “diversify” the Alberta economy is for the energy sector to crash.

Obviously, thousands of lost jobs and billions of dollars of lost investment opportunities are not in anyone’s best interests. There is only one way that diversification benefits the Alberta economy: when we have a healthy and growing energy sector; and other industries within the province are growing even faster. Anything short of that is a recipe for a less prosperous Alberta, and a lower quality of life for Albertan people.

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