The Low Costs of a Zero-Carbon Economy
The challenge in moving to a fully "green" economy now concerns harder-to-abate sectors such as trucking, shipping and aviation, steel, cement, and chemicals. To make the same rapid progress there that has been made in renewable-energy technologies requires the same type of forward-looking policies.
LONDON – When you buy your next automobile, would you pay $100 extra to ensure that the steel in it was made without producing carbon dioxide emissions?
My guess is that most readers will say yes. Most people in most countries, including the United States, accept the overwhelming scientific evidence that human-induced greenhouse-gas emissions are causing potentially harmful climate change. Most people with decent incomes are willing to pay some price to achieve the zero-carbon economy needed to reduce the risks posed by climate change. And there is growing evidence that the total costs of that transition will be far less than the 1-2% of GDP suggested by Nicholas Stern in his seminal 2006 report The Economics of Climate Change. But, despite low costs, change will not happen fast enough without forceful new policies.
Renewable electricity costs have fallen faster than all but the most extreme optimists believed possible only a few years ago. In favorable sunny locations, such as northern Chile, electricity auctions are being won by solar power at prices that have plummeted 90% in ten years. Even in less sunny Germany, reductions of 80% have been achieved. Wind costs have fallen some 70%, and battery costs around 80%, since 2010.
As the Energy Transition Commission set out in its April 2017 report Better Energy-Greater Prosperity, power systems that are 85-90% dependent on intermittent renewables will be able by the 2030s to produce power at an all-in cost – including storage and any flexible back-up required – below that of fossil fuels. For power supply, Stern’s estimate that the cost of going green will be very small has proved too pessimistic – the cost will actually be negative.
These dramatic cost reductions did not happen in a vacuum. They are the result of deliberate and initially expensive public policy. Public expenditures over several decades supported basic research into photovoltaic technology, and large subsidies for initial deployment, particularly in Germany, enabled the solar industry to reach sufficient size for learning-curve and economy-of-scale effects to kick in.
Contrary to simplistic economic models, the pace of innovation and cost reduction is not an exogenous given; it is strongly determined by governments’ long-term objectives. On the cost curves economists use to rank carbon-reduction technologies, solar PV was, a mere ten years ago, one of the most expensive options. On the latest cost curves, however, it shows up as one of the cheapest. Strong policy support drove it there.
At the higher end of most published cost curves, we now find actions to decarbonize economic sectors where electrification seems impossible, difficult, or expensive. Emissions from the chemical reaction of cement production would remain even if the heat input were electrified: and installing carbon capture and storage (CCS) will add significant additional cost. Battery-powered flight may be possible over short distances, but for many decades – and perhaps forever – international aviation will require the energy density of a liquid hydrocarbon, and delivering that density with biofuels or by synthesizing hydrogen and air-captured CO2 will probably always be more expensive than deriving it from oil.
Likewise, steel production can be decarbonized by applying CCS or using hydrogen produced by electrolysis as the reduction agent, rather than coking coal. But unless low-carbon electricity costs fall much further, the hydrogen route will remain more expensive than today’s technology. And, by definition, adding CCS at the back of the process adds cost.
But not that much more cost. Estimates suggest that with already achievable renewable electricity costs, steel produced via hydrogen-based direct reduction might cost an additional $100 per ton – in turn adding $100 to the cost of a one-ton car. And these costs could fall significantly if, as is likely, hydrogen emerges as a major route to decarbonization across many sectors – including aviation (via synfuels), shipping (by using ammonia derived from green hydrogen instead of heavy fuel oil), and long-distance trucking (where hydrogen fuel cells may play a significant role).
Large-scale development of a hydrogen economy could drive the cost of electrolyzers onto a downward path similar to that observed with solar panels and batteries. And the cost of CCS could also fall significantly if government policies supported large-scale deployment.
The challenge is to replicate the stunning success we have seen in renewable power and batteries in the “harder to abate” sectors such as trucking, shipping and aviation, steel, cement, and chemicals. That will require a mix of carbon pricing, regulation, and government support for research and initial deployment.
Some of the policies require international coordination, but some could be pursued by countries acting alone. A requirement that all cars sold in either Europe or China had to meet a certified “green steel” standard, with the share of steel sourced from zero-carbon production increasing gradually toward 100% over the next few decades, would provide a strong stimulus toward steel decarbonization. If several major countries could agree on such a standard, or on the imposition of a significant carbon price, progress would occur even faster.
The technologies to decarbonize even the harder-to-abate sectors are now available, and the estimated costs are not daunting. If strong policies were introduced, the technological innovations and learning-curve effects unleashed would probably, as with renewable energy, prove the initial cost estimates to be pessimistic. If you are willing to pay $100 extra for your green car today, within a few decades the cost will probably be lower, but only if public policy forces the pace.
Why Markets Can’t Cool the Planet
Among the most discussed climate-change remedies are those that would use market forces to make fossil fuels more expensive. But while free markets may have steered much of the world toward a wealthier, healthier future, placing our faith in Smith’s “invisible hand” to win the fight against climate change would be a tragic mistake.
MILWAUKEE – With global temperatures rising at an alarming rate, the race is on to lower the world’s consumption of fossil fuels and accelerate the adoption of greener forms of energy. Among the most discussed remedies are those that would use market forces to make traditional fuels more expensive; ideas include putting a price on carbon and protecting natural resources that remove carbon dioxide from the atmosphere.
At first glance, market-based strategies might seem appealing. After all, as Adam Smith noted in The Wealth of Nations, “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” In other words, the best way to convince emitters like Chevron or General Motors to help save the planet must be to appeal to their profit motive, right?
Not necessarily. While free markets may have steered much of the world toward a wealthier, healthier future, placing our faith in Smith’s “invisible hand” to win the fight against climate change would be a tragic mistake.
In a capitalist economy, our relationship with the future is guided by economic forces that are notoriously fickle. Commodities like sugar, soybeans, oil, and gas are relatively standardized products, meaning that they can be traded instantly and globally through the use of derivative contracts. But because these contracts price in assumptions about the future, commodity prices can fluctuate wildly. And that variability complicates environmental planning in three important ways.
For starters, price unpredictability makes it virtually impossible to detect the depletion of natural resources merely by looking at short-term changes in value. On the contrary, the more uncertainty there is about the scarcity of a resource, the greater the price swing, which only compounds the planning difficulty. As the French mathematician Nicolas Bouleau observed in a 2013 paper, “markets cannot spell out trends; it is absolutely impossible on an ontological level.” If resource-related trends were discernible from outcomes in financial markets, those who could see them would trade accordingly and the trends would disappear.
Second, uncertainty about the future price of any commodity makes it exceedingly risky for producers to invest in whatever new technologies might help reduce greenhouse-gas emissions. For most producers and consumers, it usually makes more economic sense to maintain the status quo than to change their habits, even if they know that the status quo will be disastrous for the environment.
Finally, although it’s possible to put a price tag on precious but non-marketable natural resources – like the capacity of a boreal forest to absorb atmospheric CO2 – the price fluctuations for resources that can be traded make most conservation strategies untenable in the long run. That’s because at some point, the volatile price of the tradable resource will exceed the fixed cost of destroying it.
The pressure to plunder can be especially strong when a combustible resource is found. As Canadian Prime Minister Justin Trudeau conceded at a March 2017 energy conference in Houston, Texas, “no country would find 173 billion barrels of oil in the ground and just leave them there.”
Financial volatility is like a superstorm on an already-warming planet. Not only does it make it impossible to see what lies ahead; it is itself also a force of environmental devastation, leaving irreparable damage in its wake. “Market volatility is ill suited to environmental cycles,” as MIT’s Janelle Knox-Hayes puts it. “Economic systems recover from market turmoil in time. Environmental systems do not have the same luxury; their cycles of reproduction are inflexible.”
Ecological devastation should be expensive, and the world no doubt needs workable strategies to move people away from dirty sources of energy toward greener, more sustainable alternatives. But to defer to markets to overcome the environmental woes of capitalism is a blueprint for disappointment – and a recipe for planetary suicide.
Financing the Climate-Change Transition
POTSDAM, PARIS, ZURICH – Unless the world reduces greenhouse-gas emissions rapidly, humanity is likely to enter an era of unprecedented climate risks. Devastating extreme-weather events are already increasing in frequency, but much of the worst climate-related damage, such as a sustained rise in sea levels, will be recognized only once it is too late to act.
Clearly, the climate system’s time horizon does not align well with the world’s much shorter political and economic cycles. Listed companies report on a quarterly basis, and recent regulatory changes, such as those mandating increased use of mark-to-market accounting, limit long-term thinking.
Governments usually have legislative cycles of no more than four years, and they must also respond to immediate developments. Yet stabilizing the climate requires sustained and consistent action over an extended period.
AXA and UBS, together with the Potsdam Institute for Climate Impact Research, CDP (formerly the Carbon Disclosure Project), and the EU’s Climate-KIC (Knowledge and Information Community) recently organized a conference in Berlin. There, they discussed with leading experts in green investments and fossil-fuel divestment how financial intermediaries can help to address climate risks.
The financial industry’s active involvement is urgently needed. In the Paris climate agreement reached last December, countries worldwide agreed to limit global warming to well below 2° Celsius, thereby defining the track on which the world must progress rapidly. Over the next 15 years, an estimated $93 trillion will be needed for investments in low-carbon infrastructure.
Government funding alone cannot meet this demand, so the financial sector must help fill the gap. By redirecting capital flows toward proactive efforts to mitigate and adapt to climate change, financial institutions can protect client assets from global climate risks, and from the economic risks that will attend a warming planet. They are also demonstrating their social responsibility for the wellbeing of future generations.
But financing change requires changing finance. And this process is already underway. Development institutions such as the World Bank are reconsidering their investment policies. And, in the private sector, there is growing enthusiasm for “green” bonds, loans, indices, and infrastructure investments.
Still, as the European Commission notes, less than 1% of institutional assets worldwide are invested in environmentally friendly infrastructure assets. Given historically low interest rates and the general lack of attractive investment options, this is an ideal moment to tap into investors’ growing appetite for green financial products.
Many large financial institutions have recently joined a global initiative promoting fossil-fuel divestment. Research findings indicate that global CO2 emissions must be restricted to less than one trillion metric tons between 2010 and the end of the century to comply with the Paris agreement and limit global warming to below 2°C. This means that most available coal, oil, and gas reserves must stay in the ground.
As a result, investments in fossil-fuel energy sources will continue to lose value over time, eventually becoming stranded. Thus, the financial sector’s revaluation of such holdings not only helps to stabilize the climate, but also better protects its clients’ investments, and, by preventing the creation of a “carbon bubble,” helps to stabilize economies. But selling off these holdings will not suffice; the freed-up assets must also be redirected to more sustainable businesses.
For financial institutions and investors to do their part, they urgently need a better understanding of the relevant climate-related investment risks, which the Financial Stability Board (FSB) has divided into three categories: physical, transitional, and liability. Informed investment decisions will require sound, scientifically grounded data and uniform standards to assess these risks, and to quantify opportunities against them.
Effective disclosure will hence be a key part of any new framework. An FSB taskforce – comprising representatives from banks, insurers, institutional investors, rating agencies, consultants, and auditors – is currently shaping voluntary standards, so that companies provide consistent and comparable climate-related financial disclosures to their stakeholders, whether investors or lenders. This will also allow companies to gain valuable insights into their own potential for change, reflecting a time-honored principle: what gets measured, gets managed.
This is no easy task. For example, carbon footprints on their own will not steer investments in the right direction. Instead of identifying the champions of environmentally friendly solutions, these figures merely reveal which companies currently emit the most greenhouse gases. Meaningful disclosure standards must take account of sector-specific information and the impact on business strategies of the transition toward a low-carbon economy.
All the governments that signed the Paris agreement can now be expected to adopt a range of measures to enable them to implement their de-carbonization strategies. In this context, carbon pricing will be an essential part of the policy toolbox. Some governments have already taken steps to promote the development of green products, via tax or market incentives. Overall, such changes to legal frameworks must support, not impede, the private financial sector’s efforts to tackle climate change.
Financing the infrastructure projects that are too expensive for some national governments to finance on their own, but that are essential to the transformation of our energy system – such as wind farms and long-distance power lines – will require a new class of global infrastructure bonds. In the past, governments have encouraged investment in government bonds. Now, in order to increase private investment in building up clean infrastructure, investor-protection measures and dispute-resolution mechanisms must be considered.
The financial sector is ready to spearhead the shift to sustainability. When Germany takes over the G20 presidency next year, it will have the opportunity to convince its partners to create an adequate framework to encourage change in the financial sector that ensures a smooth adjustment to a low-carbon economy. For both public and private actors, the time to act is now.
No Blank Check for Development Banks
The kind of large-scale, sustainable infrastructure projects needed to forestall catastrophic climate change are rarely attractive investments for the private sector or even most governments. That means development banks have a crucial role to play, so long as they put the climate first.
NEW YORK – Global financial leaders are convening in Washington, DC, this week for the annual spring meetings of the World Bank Group and the International Monetary Fund. This year, they will ask the world’s taxpayers to grant the World Bank and other multilateral development banks (MDBs) more capital to fill global infrastructure gaps.
Increasing the capital – and optimizing the existing capital – of the world’s MDBs is of the utmost importance. But doing so makes sense only if that financing is used to move the world economy in a direction consistent with the United Nations Sustainable Development Goals (SDGs) and the 2015 Paris climate agreement.
According to researchers at the Brookings Institution, the world needs to invest an additional $3 trillion per year in sustainable infrastructure in order to keep global warming below 2°C relative to pre-industrial levels – the target enshrined in both the SDGs and the Paris agreement. Today, however, infrastructure contributes heavily to global warming, with about 70% of all greenhouse-gas emissions coming from its construction and operation.
That means that the infrastructure we build – or cease to build – can determine whether we will achieve global climate goals. It will also determine whether safe and affordable infrastructure services (for example, water, sanitation, electricity, and health care) can be scaled up to meet other SDGs, such as eliminating poverty.
Here, MDBs can play an essential role, given that the private sector and national governments often shy away from such investment. Private capital markets are inherently biased toward short-termism, and tend not to finance long-term investments in infrastructure. Although global economic growth is accelerating, private-sector financing of infrastructure has been falling, according to the World Bank, from $210 billion in 2010 to $38 billion in 2017.
And while national governments provide more than 75% of financing for infrastructure, they tend to avoid massive expenditures for new projects, particularly sustainable infrastructure. Moreover, many governments have come to prefer public-private partnerships that allow them to keep liabilities off-budget. And, as the IMF recently found, governments often launch infrastructure projects as a way to swing votes in the run-up to elections. Longer-term sustainability concerns (including infrastructure maintenance) thus usually take a back seat to political motives.
In light of these shortcomings, development banks have a unique role to play in harnessing expertise and bringing together stakeholders to finance the right kinds of infrastructure. To that end, in 2015, the World Bank and other MDBs launched a strategy to increase development financing “from billions to trillions,” by using public finance to “crowd in” private investment, especially from large institutional investors like pension and insurance funds.
But, since then, the World Bank has rebranded its approach as “maximizing finance for development” (MFD), while failing to demonstrate how it will actually achieve the SDGs. This strategic uncertainty should serve as a reminder that, while MDBs have a critical role to play, they should not be given carte blanche.
At Boston University’s Global Development Policy Center, we estimate that the MDBs could increase lending by up to $1.9 trillion. That said, a blank check would be disastrous, given that the current financing pattern of the MDBs – and particularly the World Bank Group – is highly carbon-intensive. Moreover, a recent study by the Inter-American Development Bank documents how MDB-financed projects under the current model have fueled social inequity and conflict in different parts of the world.
Taxpayer money for closing global infrastructure gaps should thus be conditioned on the MDBs’ recalibration of their strategies toward the SDGs and the Paris climate agreement. This will require reforms to MDBs’ board- and project-level governance. The goal should be to ensure that developing countries – especially those most vulnerable to climate change – have more say in development banks’ board-level decisions. In addition, poorer and vulnerable communities need to be included in the process from the beginning, so that they can provide full prior consent. Affected communities should be sharing the benefits, not absorbing the costs, of new infrastructure investments.
To address climate change directly, all infrastructure investments should be subject to a “Paris test” to confirm that projects are being carried out in accordance with the goal of keeping global warming well below 2°C, or even below 1.5°C. The World Bank’s pledge to end financial support for upstream oil and gas is a step in the right direction, but it should be expanded and become the norm for all MDBs. Moreover, more impact assessments are needed to ensure that road, rail, and waterway projects do not destroy livelihoods or nearby ecosystems, leading to further greenhouse-gas emissions and a loss of vital biodiversity.
Finally, we will need adequate monitoring and evaluation systems to enforce a new compact for MDBs. Without accountability and clear targets set by the SDGs and the Paris agreement, the MDBs will continue to operate according to their own taxpayer-financed discretion, to the detriment of the climate, the environment, and social equity worldwide.
Time for a Global Financial Makeover
In the past three years, the world has made some progress toward the United Nations Sustainable Development Goals for 2030, but the fundamental issue of financing the SDGs remains unresolved. And, with the financial sector strongly oriented toward short-termism, the necessary investments may never materialize.
NEW YORK – In 2015, United Nations member states came together and committed to achieving a comprehensive and universal set of 17 Sustainable Development Goals (SDGs) spanning all dimensions of economic and social development.
Investment will be indispensable to achieving the SDGs, which aim to eliminate poverty, end hunger, combat climate change, build resilient infrastructure, and promote inclusive and sustainable economic growth. Yet, three years on, we still have not done nearly enough to leverage our financial systems in pursuit of the SDGs.
The UN, in coordination with almost 60 agencies and international institutions, recently published an assessment of the world’s progress toward changing financing, policies, and regulations to achieve the SDGs. It finds that, despite positive momentum on sustainable investment, the goals will not be met unless we shift the entire financial system toward long-term investment horizons, and make sustainability a central concern. Without a long-term perspective, certain risks, especially those associated with climate change, will not be priced into private investment decisions.
Global financial flows are vast, yet the quality of investment matters. Currently, short-term investment patterns are driving capital-market and exchange-rate volatility, and significantly raising the costs and risks of sustainable investment, particularly for developing countries. If we create incentives to steer the flow of financing toward long-term infrastructure projects like bridges, roads, and water and sewage systems, we would be making a major contribution to both development and stability.
And those investment projects must be more environmentally and socially sustainable. Because today’s investments, particularly in energy systems, will lock in development paths for decades to come, more must be done to ensure that investments now, and in the future, do not undermine our efforts to address climate change. Moreover, as with all economic policies, gender equality needs to become a central consideration.
Transforming finance will not be easy. Today’s capital markets are highly oriented toward short-termism, as evidenced by capital-flow volatility and the short holding period of stocks in some developed markets, which has fallen from an average of eight years in the 1960s to eight months today. And while long-term institutional investors hold around $80 trillion in assets, with about half of these representing long-term liabilities, nearly 75% are held in liquid instruments, whereas just 3% are in infrastructure.
The same tendency is prevalent in the real economy. In 2016, S&P 500 companies spent more than 100% of their earnings on dividends and share buybacks, which boost stock prices in the short run, rather than raising long-term value through investment. A February 2017 McKinsey Global Institute survey found that 87% of corporate executives and directors feel “pressured to demonstrate strong financial performance within two years or less,” while 65% say that “short-term pressure has increased over the past five years.” Moreover, 55% said they would delay investments in projects with positive returns in order to hit quarterly balance-sheet targets.
Shifting investors from short-termism toward long-term thinking is a prerequisite for achieving all of our economic, social, and environmental goals. But the private sector will not make this transition by itself. Policymakers must step in and provide leadership. Markets do not operate fairly and in the public interest without well-considered and well-enforced rules set by governments. Aside from public investment, this is one of the state’s most essential functions.
Specifically, transforming global finance will require changes in prudential regulations, capital requirements, investment-firm culture, and executive compensation, which will require new and more appropriate longer-term benchmarks. Reforms to accounting practices, especially for illiquid investments, will also be necessary, for example, to reduce the short-term bias introduced by mark-to-market accounting. And institutional investors must adopt a broader interpretation of fiduciary duty, which should focus on the long term and incorporate all factors that have a material impact on returns, be they financial, environmental, social, or governance-related.
With 12 years to go, it may seem like the world has plenty of time to make progress toward the SDGs. But the UN’s past experiences with goal-oriented initiatives show that it is important to take decisive action early on in the process. Making matters worse, escalating geopolitical and trade tensions threaten to set us back, rather than take us forward. Such disagreements must not stand in the way of reaching the SDGs and building a sustainable future.
Above all, that future needs to be financed. Though many public and private institutions at various levels of international finance have already started to change, the overall financial system has yet to experience the sort of transformation that is needed. We have all agreed on what we need to do; now we must do it.