Climate, Carbon, COP21 and Beyond
Chris Barrett, Executive Director, Finance and Economics, European Climate Foundation, and former Australian Ambassador to OECD. Chris is one of the discussion leaders at the OECD Forum IdeaFactory “Climate, Carbon, COP21 and Beyond” on Tuesday 2 June.
The ECF was established in 2008 as a major philanthropic initiative to promote climate and energy policies to cut Europe’s greenhouse gas emissions and to help Europe play an even stronger international leadership role to mitigate climate change. I run our finance sector policy program, and would like to give you an idea of how I see that work and its role in delivering climate mitigation.
We’re all shaped by context and in my case that context is more than a decade working on various versions of what would become Australia’s carbon tax in 2012. My colleagues like to tease me that once the Australian carbon tax was abolished in 2014 my “theory of change, changed” and there’s something to that.
But you don’t need a political mugging in a dark alley to understand that we’re asking a great deal of today’s governments to mandate the emissions cuts science tells us we need. The politics are always devilishly hard when the avoided damage appears (and I emphasise “appears”) to be far off in the future, and the costs of action appear (emphasis again) large and immediate.
That’s not to say we shouldn’t demand a strong deal in Paris – we absolutely should and must, and I recommend my World Resources Institute colleague Jennifer Morgan’s recent work as a great primer on the contours of a powerful and effective Paris deal.
But successful political action never occurs in a vacuum and we’re better to understand a “threshold logic” at work in which a great many forces (political pressure, observable climate phenomena, changing personal and corporate behavior) build up momentum and facts on the ground which can then crystallise in a new policy consensus.
We typically think of these things as happening very slowly, but only because our habits of thinking don’t cope well with transitions where an unsustainable state exists for a long time before suddenly it ceases being sustained. What we need are analogies – never perfect in themselves – to demonstrate a long run-up and sudden resolution in the past to give us scenarios for how our current climate collective action problem may cross a critical threshold.
I think there are two powerful analogies from the world of finance, each of which underpins a crucial message about the low-carbon transition.
Message one: the carbon bubble is real
Consider a banker in 2006 holding a portfolio of credit default swaps based on US sub-prime mortgages. That US housing values were unsustainable has now entered the canon of global economic history, but it’s worth reflecting on the investor assumptions that held sway in the years approaching the crisis: investors assumed the underlying investment was sound, that any defaults would be distant in time or isolated in number or both and perhaps most importantly, that even if the trend of increasing home lending in debt was unsustainable, any unwinding would be slow and orderly, or slow enough for that particular investor to sell before the crash.
Of course you know where I’m going with this. The carbon bubble popularised by Bill McKibben, Carbon Tracker and others argues powerfully that holders of carbon-intensive assets are soothing themselves with the same false assumptions: asset values are safe, carbon regulations that might devalue them are in the distant future, and any decarbonisation path will at worst be slow or gradual and well-telegraphed for the astute investor which of course includes them.
But unquestionably, this view is even more deluded than for our sub-prime investor in 2006. The analysis is there for anyone who cares to look – fully 80% of proven carbon reserves – sitting on the balance sheets of companies around the world – are unburnable if the world is to maintain the 2° warming scenario to which governments committed already in Copenhagen.
There is a ready-made explanation for this of course, namely that investors do not believe governments are serious about the 2° target and they will never feel the value-destroying regulations they are supposed to fear. As a piece of political analysis, this would worry me deeply if I were one of those investors, and for four reasons:
One, those regulations exist already, and the trend is towards their increase, even before Paris commitments are finalized – the EU Large Combustion Plant Directive, the US Clean Air Act, and even the recent proposed coal levy in Germany are all examples;
Two, regulations don’t need to target carbon to destroy the value of carbon-intensive assets. The biggest climate story of the year so far – the nearly 5% year-on-year fall in Chinese coal consumption – has been driven to a very large extent by air pollution concerns.
Three, there is economic stranding of assets too, as I hardly need to explain given recent plunges in fossil fuel commodity prices.
Four, the political heat is being turned up on a critical component of high-carbon asset values, namely the implicit and explicit subsidies on which they depend. Explicit subsidies are falling as government budgets come under more pressure and the lower oil price makes reform less politically painful. And implicit subsidies have just had a spotlight shone on them by one of the best pieces of public good economic research I have seen in recent years – the IMF quantifying them at the lion’s share of an astonishing $10 million a minute.
…and all of this is before we consider the gathering impact of divestment campaigns around the world, which have the ultimate aim of removing what I would call the “social licence to operate in capital markets” for fossil fuel companies. Just last week, we saw arguably the most spectacular and consequential example of this, namely the divestment decision by Norway’s giant sovereign wealth fund.
And then let me add a further reason to worry about a carbon bubble, and I proceed from another analogy:
Message two: low carbon economics are transformational
Consider you are a stockholder in Kodak in the mid-1990s and again let’s look at the underlying assumptions for why your investment is safe. People need your film to record their memories, it’s an inexpensive product, it’s ubiquitous, and your market position is strong. You’re thoroughly unprepared for a competitor – a digital camera – with a marginal cost of zero.
You see where I’m going here too. Solar PV, just to cite the most obvious example – dematerialises energy the same way as digital photography dematerialised photography. I didn’t name or compile this next chart, but it makes in very dramatic fashion a point my colleagues at Agora Energiewende in Berlin recently devoted a long and fascinating analysis to: solar outcompeting conventional new coal and gas fired plants by 2025.
And it is not just solar, of course, as recent announcements by Tesla of its move into home batteries have focused investors on the Moore’s Law cost trajectory of battery storage.
Nor is Kodak an isolated example. We have seen this again and again in recent decades with technology disruptions: floppy disks, video stores, CDs. Capitalism forces radical sectoral change all the time.
Reflections on the psychology of climate action
I started with personal stories, so let me finish with one. When we introduced the Australian carbon tax, our Treasury did some modeling to work out what the impacts on emissions and inflation might be. The impacts were extremely low – effectively a one-off increase in inflation of less than one percent, but the lived experience of the tax beat even that. When the tax was introduced, we saw emissions fall more than expected with a lower inflation impact than expected. As a practical matter, it always surprised me as an economist that we would spend decades in Australia pushing for a lightly regulated, flexible market economy and then freak out at the idea of the cost of one byproduct of production going up a bit in price.
This is just one example of my final message, which is that the costs of the low-carbon transition are routinely overestimated. Let me depart from economics and dabble for a moment in psychology. When we all (rightly) insist that climate change is an urgent and existential challenge, people almost automatically conclude the solutions must be painful and expensive. There’s no solution to this other than to be aware of it, and to be very disciplined about how we model and communicate the costs of action and repeat, repeat, repeat.
To re-cap, there are two powerful forces at work driving a low-carbon transition: a bubble building up in carbon-intensive assets, and transformative economics of many low-carbon investments. We have seen similar forces tip over into dramatic action in the past. And we needn’t fear the transition, since the costs will be lower than we expect.
What this all means for Paris is that the transition is coming, the question is how orderly it will be. In this context, the role for governments is clear – transitions are fairer, smoother and more durable when they are policy-led or at the very least, policy-enabled. And the clearer these underlying economic trends are to all players, the easier it will be for governments to act. Actually, a Paris deal has the chance to accelerate the transition and ensure a more orderly transition by sending clear signals reaffirming the messages that are flowing already. This is why we at ECF have a finance program, and why I’m delighted to be part of it.