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The Economics of Mainstreaming Climate Action

The green transition threatens to create a stagflationary environment in which fossil-fuel energy is scarce while clean, renewable energy is still in short supply. Coping with such imbalances will be an ongoing challenge for policymakers, who would do well to get ahead of the problem now.

PARIS – The outcome of this year’s United Nations Climate Change Conference – COP27, in Sharm El-Sheikh, Egypt – is a true disappointment. In the run-up to the 2021 conference in Glasgow, 24 countries analyzed by the Climate Action Tracker, including major emitters like China, India, the European Union, and the United States, submitted or proposed stronger emissions-reduction targets. Despite the growing urgency of climate action, only five countries analyzed by the CAT stepped up their ambitions this year. Even Egypt, the host country, failed to strengthen its commitments.

Equally distressing is the divide between a fringe of climate militants – many of whom are relying on increasingly radical actions – and the vast majority of ordinary citizens, most of whom are concerned about their decreasing purchasing power. Europe, especially, is facing energy shortages, rising fossil-fuel prices, inflation, and a looming recession – all of which might make it lose sight of its climate ambitions.

Still, there is growing evidence that people are taking climate change more seriously than ever. This year’s extreme weather events have served as an eye-opener, even in the affluent West, by demonstrating that global warming is not some slow process that will materialize in the distant future. Climate change has become an imminent threat that policymakers cannot ignore when assessing the outlook for growth, jobs, inflation, and public finances. To paraphrase Clemenceau, the French statesman who famously quipped that war is too serious a matter to be left to the military: climate has become too serious to be left to the activists.

More broadly, capitalism has become a pitched battle between brown (fossil-fuel) and green (clean, renewable) industries. Because the necessary investment is so large, a carmaker cannot hedge its bets by investing in both electric and traditional internal-combustion-engine (ICE) vehicles. It must choose which side it is on and then throw all its forces into the effort. Whatever the outcome, some will win big, some will lose big, and there will be collateral damage.

The mainstreaming of climate action raises many new and still debated questions. Emission cuts over the next ten years are largely expected to result from substituting capital to replace fossil fuels: hydroelectric dams, nuclear power plants, and wind and solar farms all have low operating costs, but their up-front capital costs are high.

The transition to a low carbon economy thus brings new risks. Though ramping up investment to expand a capital stock usually pays off through higher productivity, and therefore higher output, the opposite could happen in this case. If some capital (such as fossil-fuel-powered plants) is discarded prematurely, even more capital will be needed to deliver the same quantity of electricity. Yes, the transition eventually will deliver additional benefits in the form of lower fossil-fuel imports and operating costs. But these will appear only later. In the first stage, more investment will be needed to make up for the fact that productive capacity will shrink or level off.

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The same mechanism applies to the substitution of electric vehicles for conventional ones: as old factories are dismantled, more capital will be needed to produce EVs, the electricity they consume, and the charging infrastructure they require. Likewise, renovating buildings to improve efficiency means that the same housing service will be provided but at a higher capital cost (and a lower operating cost thereafter).

There is nothing wrong with providing a service at near-zero marginal cost. That is the essence of the digital economy, and recent technological advances increasingly suggest that a world of widely available electricity from renewable sources is not out of reach. It is entirely possible that future generations will look at energy from oil and gas the same way we look at energy from coal: as outdated, dirty, inefficient, and obsolete.

At a horizon of 5-10 years, however, things look quite different. The necessary build-up of the capital stock will likely translate into higher demand set against a lower or unchanged supply, and factoring in reallocation costs will worsen the corresponding imbalance further. Some  skills will lose value, for example, among workers employed in the ICE car industry. Newly required skills, such as those of specialized construction workers, will be in short supply (or available, but in the wrong place).

Further complicating the outlook is the lack of credibility in climate policymaking. Many governments have pledged to reach carbon neutrality by mid-century, but their actions do not yet align with this objective. In the absence of stronger carrots or sticks, energy producers, unlike carmakers, can and still do hedge their bets. The result, according to the International Energy Agency, is that overall energy investment is critically insufficient to meet future demand.

Taken together, these developments threaten to create a stagflationary environment where brown energy is scarce and green energy is still in short supply. Coping with such imbalances will be an ongoing challenge for governments and central banks. Policymakers can no longer afford to overlook these issues, nor can they rely on fairy tales about what the energy transition entails. To convince citizens, they will have to define and implement a realistic agenda for managing the costs and complexities of the transformation.

Fortunately, there is much that policymakers can do to contain the harmful economic fallout from sweeping sectoral changes. There is no avoiding the temporary investment effort that the transition requires. But with an economically sound, credible, and fair strategy that makes sensible use of public funds, governments can lower costs substantially.

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