Policies to address the climate emergency and steer innovation

The world faces a global pandemic of historic proportions leaving thousands dead with many more to be affected. Economic policy must focus on containing the disease while providing resources to alleviate its symptoms. It must minimise the disruption to societies wrought by the epidemic and the necessary measures to contain it.

But the tragedy of the virus does not alter the fact that the world still faces a climate emergency. However, as I argue here, the two can be addressed in a mutually supportive manner through a coordinated policy response to boost investment. I have also argued that neither unrestrained growth, nor attempts at degrowth are likely to deliver a resource-efficient clean economy.

Concerted effort is required to price the damage caused by emissions of greenhouse gases (GHGs) and steer investment and discovery towards low carbon, resource efficient technologies and behaviours. Strong and ambitious policy to reduce GHG emissions can confer competitive and economic advantage, helping economies and businesses to profit from productive new markets and technologies while boosting demand and supporting jobs at a time of heightened anxiety. But what policies are required? 

Pricing is a prerequisite

Greenhouse gas emissions are a form of pollution. Economists describe this as an externality of market transactions. A market failure. As greenhouse gas emissions rise, warming generates damages measured using the 'social cost of carbon'. A standard economic approach is to internalise this cost by pricing carbon to offset the market failure. This takes the form of a market-based policy instrument such as carbon tax or establishing emissions trading schemes.

Pricing is indeed an essential policy tool. Without it, overconsumption and overproduction of damaging activities is all but guaranteed. Prices send a transparent and non-discriminatory signal to all consumers and producers to guide the most efficient short-term emissions reductions. Because the market, rather than policymakers, drives investment, pricing reduces the scope for rent-seeking by powerful lobbies to secure lucrative public contracts. Pricing is also necessary to staunch the 'rebound effect' whereby the savings generated through more efficient use of resource are ploughed back into even greater consumption of those resources. Pricing helps steer those savings towards less damaging consumption.

But pricing is not enough

The damages caused by carbon are not the only market failure that needs to be overcome and the pricing of greenhouse gas emissions is a necessary, but not a sufficient requirement for efficient decarbonisation.
 

A second crucial market failure is associated with the need to innovate to drive decarbonisation. This results from the public nature of ideas – those who innovate do not capture the full rents from the knowledge spillovers they generate. Supporting innovation can take the form of grants and tax breaks for research, development and deployment, as well as subsidies, obligations and other mechanisms (such as feed-in tariffs for clean energy generation) to support deployment. Examples include the hundred billion dollar German Energiwender which drove the game-changing solar photovoltaic revolution and the UK's support for offshore wind farms which in a matter of years pushed contract prices down to the level of wholesale electricity.

This highlights the importance of not just promoting deployment nor facilitating private sector R&D spending, but also direct public investment in early stage riskier technologies. But, most importantly, innovation is driven by the desire to profit from growing new markets.

A third set of market failures defines non-price sensitive sectors prone to waste and inefficiency. In some cases, lack of information can be overcome by creating awareness of the different carbon contents of energy sources, and the options available for emission reductions, for example energy ratings on domestic appliances. In other cases, incentives to invest in efficiency improvements are absent. For example, tenants in leaky buildings will not want to pay for investment in buildings they don't own, but neither will landlords as they don't shoulder the higher bills which are paid by the tenant. Such cases may benefit from the creation of instruments such as energy service companies (ESCOs). These companies sell energy services to consumers, which include implementing energy-efficiency projects and refurbishing buildings to generate savings which are then shared with consumers in the form of lower bills.

A fourth set of market failures occurs because capital markets are limited in their ability to manage the risks associated with investment in new energy technologies. This is particularly because of the long-term nature of much of the investment, the high barriers to entry and network effects and the corresponding fact that it takes place in heavily regulated policy-driven markets like energy, buildings and transport.

Direct public support for new infrastructure must be matched by regulation to maintain investment and protect consumers from rent-seeking. The European Green Deal announced in December 2019 plans to promote at least €1 trillion of investment over the next ten years. It also drives forward policies and regulations to make finance consistent with the Paris temperature target, for example through the new EU regulation on sustainability-related disclosures.

There remains a lack of confidence in the duration and credibility of global policies to support decarbonisation. Publicly funded institutions such as infrastructure investment banks can promote risk sharing and risk reduction through guarantees, publicly backed equity stakes, feed in tariffs and carbon price floors. Public sector skin in the game thereby reduces private perception of policy risk, lowering the cost of capital. Legislated frameworks such as the UK Climate Change Act can enshrine a process for emissions reductions into law to the same effect.

Non-pricing mechanisms like efficiency standards on buildings, cars and domestic appliances have been shown to cut costs and generate innovation. Tough EU fuel efficiency and fleet average emissions targets for passenger cars induced a series of technological improvements which helped make European cars globally competitive.
 

At the same time, people are turning to the courts to ensure governments fulfil their commitments. The recent appeal court decision to rule a third runway at Heathrow illegal because it did not match the government's commitments to tackle the climate crisis, or the previous litigation against the Netherlands forcing accelerated emissions marks the start of a growing trend. Companies and governments found to have knowingly supported activities which undermine livelihoods will be held to account. There are currently 25 climate-related lawsuits brought against governments or their representatives.

Businesses are being sued too. In October 2019, Massachusetts joined New York in suing Exxon Mobile for allegedly hiding its knowledge of climate change and misleading investors on its financial impact. Cities and counties in New York, California, Colorado, Washington and Maine have filed civil lawsuits against oil and gas companies. The recent cases of PG&E and Bayer/Monsanto provide early examples of the power of litigation to undermine equity valuations.

Finally, supporting the green transition can and should be incorporated into short run macroeconomic policy. The recent corona virus pandemic constitutes a global demand and supply shock. Supply is constrained as workers stay home, trade and distribution lines are disrupted and demand is undermined as fear and panic reduce consumer spending. This causes negative wealth effects from downward asset price adjustments. The two can reinforce each other quickly into a full-blown recession, so early action is required.

Low real risk free interest rates, representing a surplus of desired saving chasing too little desired investment: a search for growth which can be put to good use in financing the transition and stimulating the economy.

The conventional model of pricing is flawed

The multitude of market failures means that the conventional approach to pricing carbon needs to be substantially augmented. Early economic studies argued that the most efficient response to global warming constituted a uniform global carbon price, rising with time. This allows investors to pick off the most cost-effective emissions reductions at the margin. However, the 'slow policy ramp' approach has since been challenged by economists who argue that carbon abatement costs are shaped by innovation so that once a technology becomes sufficiently competitive, it starts to change the entire environment in which it operates. For many advanced technologies, it makes better sense to start with the most expensive options so as to bring their costs down.

Early policy intervention can direct technical change. In place of a slow ramp, these authors argue for a clear and credible early policy shock, including a high carbon price, to kick start the green innovation machine and definitively shift investment.

We are already witnessing the power of this effect. Whether or not we care about carbon, past policy mechanisms such as subsidies for renewables and support for R&D on batteries are delivering cheaper electricity and better cars than fossil fuel based alternatives. The market alone would not have provided it and economists could never have predicted it.

Policy must acknowledge political reality

If the policy shock is socially as well as innovatively disruptive, it could meet resistance which sets back policy progress (as recent events in France and elsewhere testify). Understanding where the policy impact will be felt is becoming a central pillar of any climate strategy. It explains why much of the recent focus has been on a 'just transition' that is seen to be fair. This means enabling and insuring potential losers through institutions that reskill and retool workers, offer clean substitutes and provide social insurance. At the international level, it requires support for green finance and green technologies in developing countries with limited capacity or access to capital markets, including full disbursement of the Green Climate Fund. This is not just politically expedient; it is practically necessary if climate policies are to be enacted at sufficient scale and speed. That said, at a time of record low oil prices, the impacts of raising carbon prices on fuel bills will be far less pronounced.

Different market failures point to different policy instruments. Reliance on any one of these policy mechanisms will not deliver cost-effective decarbonisation, but the collection can be mutually reinforcing, providing a clear and compelling signal to entrepreneurs and investors alike.

Of course, consumers and investors are playing their parts too. They are part of a powerful, positive feedback loop in action today driving the climate transition. Without supportive policies, investor and consumer impact will not reach its full potential. But equally, the growing pressure from multiple sources for a more urgent transition is working in combination with technological advances across many industries and enabling cleaner to become cheaper. As this pressure builds, it encourages a more proactive policy approach, thus completing the positive feedback loop. Without policies like carbon pricing, reduced consumer demand for heating, flights or car journeys could prompt a 'rebound effect' in demand as air fares, fuel prices and congestion on roads fall. But global policies are likely to tighten further in anticipation of this effect.

To deliver the change in behaviour and technologies on the scale required, the response must be coordinated, coherent and credible. Like it or not, policy is a vital ingredient within the climate transition, reinforcing consumer, investor and technological trends. Together, these forces have the potential to shape the climate transition into the single, greatest investment opportunity of this century.