The economics of climate change and scarce resources

Dimitri Zenghelis*

*Visiting Senior Fellow at the Grantham Research Institute on Climate Change and the

Environment; Senior Economic Advisor to Cisco; Associate Fellow of the Energy, Environment and Development Programme at Chatham House,

International Conference on Low Carbon Energy and Economy

Taipei, May 2012.

Growth and resources

• Economics is about welfare maximisation subject to constraints

• How can human well-being be maximised s.t. projected constraints?

• Requires defining welfare:

– GDP or something else?

– Valuing non market variables

– Predicting relative prices

– Valuation across time and distance (value judgements e.g. discounting)

• Requires understanding resource constraints:

– Scientific projections

– Technological projections and substitution opportunities

– Risks and probability distribution

• Policy tools designed to match the market failure.

2

Economics to inform policy choices

Decision-making under uncertainty:

• What should be our goals and policies for managing resource

depletion and associated risks?

• How much risk to accept?

• How big the response and what are the likely costs/investments?

• How to create credible policies to foster change?

• What are the roles of different players?

These are some of the relevant policy questions we must ask.

3

Growth, but of what (I)?

• Gross domestic product (GDP) – a measure of the market

value of the flow (eg annual) of final goods and services.

• Excludes:

– (or roughly approximates) consequentialist non-market value, (eg

environment and health);

– Other non-consequentialist determinants of human welfare, eg security,

rights, opportunities, fairness and equity.

• Not a measure of wealth or assets (no account for degradation

of natural assets and biodiversity)

• But, is a known quantity, understood and consistently

measured, so stick with GDP...

4

Growth, but of what (II)?

• Evidence suggests GDP gains correlate with:

– happiness (Coyle 2010).

– reduction in poverty (Kanbur 2001 Collier, 2007)

– gender equality, tolerance, social mobility, physical/mental health and

education opportunities, rule of law, lower crime/conflict.

– Correlation not causalities. Causalities bi-directional and reinforcing.

• GDP a gauge of social welfare, esp in poorer societies.

• But no informative assessment can be reduced to a single

dimension or metric such as output or happiness.

• Therefore, more practical/informative to adopt a “dashboard”

of indicators in addition to GDP including human development

indices such as health, education, environment, happiness,

freedom of expression, and transparency.

5

Is sustainable growth possible?

• For welfare to continue to rise with economic growth, growth must

damage the environment at slower rate; eventually preserve the some

stock level of natural capital altogether (absolute decoupling).

• Is this feasible?

• Even in a materially stationary state, indefinite growth in well-being is

possible because of progress in the intellectual economy.

• Adam Smith argued that the division of labour is limited by the extent of

the market (Smith, 1776), and economic growth enlarges markets and

permits greater specialisation and variety; increasing returns to scale

stimulate economic growth (Young, 1928).

• Others adopt ‘Malthusian’ view (Tinbergen and Hueting 1992, Jackson

2009) and argue economy will eventually reach a stationary state.

6

TFP and innovation

Thankfully, intellectual economy infinite and weightless.

• GDP a function of factor inputs (people, capital and materials) in

production process ALSO processes, techniques, and technologies with

which inputs used = Total Factor Productivity (TFP).

• Growth accounting shows economic growth in rich countries stems

almost entirely from TFP growth (Aghion and Howitt 1998; Jorgensen

2007, Aghion 2011 and Acemoglu 2010).

• Second law of thermodynamics doesn’t apply to ideas.

• Knowledge and innovation which drive TFP and are dynamic concepts.

• New equipment enables new ideas and better technologies. For example,

investing in computers induces bright ideas on how to use them.

• Means increasing returns to scale in production, where investment in

knowledge begets increased output and resources for further investment;

a virtuous-growth spiral known as endogenous growth.

7

Endogenous growth opportunities

• Path-dependency means policymakers can steer growth path and

focus on the factors that generate knowledge and induce innovation if

they are to drive economic growth (Zenghelis 2011).

• The effects of ICT revolution are comparable and probably bigger

than those of steam or electricity. Can vastly increase resource

efficiency, monitoring and management.

• There is no previous example of a new technology whose price has fallen

so fast, or which has diffused through the economy as rapidly, as

innovations in computers and mobile communication.

• Means relative decoupling (GDP growth > resource use growth) has

begun in advanced societies (Jackson 2009).

• Unit resource intensity fallen driven by incentives to innovate .

• But strong sustainability requires transition to absolute decoupling.

• Ability to achieve absolute decoupling and growth depends on

innovation and substitution opportunities.

8

Economics of resource substitutability

• Scope for substitutes? Energy easy electrons ultimately from sun.

Moore’s law in renewables; competitive soon; shale gas in transition

• Pricing can staunch the rebound effect.

• But essential ‘elements’ (minerals like phosphorus, potassium, arable land,

soil, biodiversity, water) hard to substitute.

• Until a decade ago, there appeared to be empirical support for the view that

commodities were becoming more economically abundant (Johnson, 2000),

given the long-term trend of declining commodity, food, mineral, energy

prices over the 20th century (Dobbs, Oppenheim and Thompson, 2011).

• Past decade: reversal of century long commodity price declines.

• Growing demand from developing world middle classes (esp Asia).

• Supply increasing to meet demand but prices likely to remain higher: the

characteristics of this resource crunch differ from previous periods.

9

The technical opportunity

• Rising prices of resources have derailed many past recoveries and

growth episodes

• But greater efficiency can reduce pressure on these prices. (King 2012,

HSBC 2012).

• McKinsey&Co (2011) indicate 15 areas where there is great scope for

improvement in efficiency, including: energy efficiency in the built

environment; increasing yields on large-scale farms; reducing food

waste; reducing municipal water leakage; increasing transport fuel

efficiency; reducing land degradation; improving irrigation techniques;

and improving the efficiency of power plants. – See also, e.g. “Sustainable Materials - with Both Eyes Open: Future Buildings, Vehicles, Products and

Equipment - Made Efficiently and Made with Less New Material” http://withbotheyesopen.com/

• See Annex for commercial opportunities from the ‘green race’.

10

Where are we heading?

• Developed world may reduce-resource intensity by

2030.

• China and India will account for much of the increase

in resource demand, simply on weight of population

numbers and economic growth rates.

• Africa may be approaching 2 billion people by 2030.

• Without intensification of resource reduction

around the world, including technological leap-

frogging to resource-efficiency in developing world,

absolute decoupling not possible.

11

The structure of the science has key implications

• The scale, uncertainty, lags and the ‘publicness’ of the problem make

the politics and economics of policy very difficult (Stern 2012).

• risk-management on a great scale and over long periods.

• To present a convincing case for inaction or delay you have to show you

are: – confident that the risks are small, or;

– the risks of delay are small, or;

– that a magic antidote will be discovered, or;

– care little about the future (notwithstanding that BAU likely to lead to impoverishment of

many or most).

• Science/ethics suggest narrow CBA based on one-good model of

underlying growth can provide only part of the story (Romani et al 2010).

• Need broad risk-management approach, which is based on sound

economics and transparent ethics, rather than give undue precision.

12

How we cast the economic policy responses

• Must recognise the dynamics - delay is dangerous. Not like trade

negotiations (Stern 2011).

• Delaying or postponing coordinated climate policies is dangerous:

– Irreplaceable and non-substitutable resources depleted.

– Stock-flow of greenhouse gases.

– Lock in to high resource intensity:

infrastructure/cities/technologies/institutions/culture…

• Costly to unwind/replace infrastructure quickly retrospectively.

• Easier to manage transition and work with investment depreciation cycle.

13

The scale and costs of necessary investment (I)

• Expenditure must be analysed as an investment, rather than only

a net cost (many co-benefits).

• Inevitability of uncertainty as learning and discovery are central.

• Not simply static shift to higher input-output/coefficients and lower

growth. CGE models do not capture the story (Stern 2012). .

• Many narrow input-output models fail to adequately reflect crucial

parts of the crux of the policy problem and the empirical realities,

particularly the scope for co-benefits.

• Thus they essentially assume (not deduce) resource efficient

investment detrimental to growth and deduce that any action is

simply a cost and (dis)orient discussion to “affordability”. Weak

economics.

14

The scale and costs of necessary investment (III)

• “Co-benefits” include:

– Energy and resource efficiency gains (see work on efficiency by McKinsey 2011 and

also WEF 2012);

– Technological change,

– Greater energy security.

– Reduced pollution

– Greater bio-boidiversity.

– benefits beyond narrow GDP (e.g. migration/conflict/ill health/liberty/human suffering).

• Realising these overall benefits from investments and managing costs

will depend on how we manage market failures and how we work

together as a community.

• Induced innovation: the benefits of learning are already appearing,

e.g. factor of 5-6 fall in solar PV capital costs in last 5 years or so.

• Policies must be made attractive and convenient rather than coercive

and complex for households.

• Bad or not credible policy raises costs.

15

The new industrial revolution?

• Will require strong action and major investment in all regions of world and in all

economic sectors. Economy-wide, recasting of buildings, transportation, agriculture,

manufacturing, communications, IT, …

• Economic history tells us these periods of change are characterised by two types of

countries, “those where the new industries are being deployed, and those areas of

the world that are left out and falling behind” (Perez, 2002). Investment flows to the

pioneers. Perez analysis follows that of Chris Freeman who followed Schumpeter.

• Could bring two or three decades of dynamic, innovative and creative growth,

and large and growing markets (see Perez, 2002 and 2010).

• “Investment concentrates in these core countries, where the whole economy is

flourishing and opportunities across the complete industrial spectrum now abound. It

is the time of aggressive exports from the core countries.” (Perez, 2002)

• Both the transition to the low-carbon economy and a low-carbon growth path look

attractive. If UK moves with Europe as a whole even greater opportunities for new

sources of low-carbon investment, growth and development.

16

Waves of innovation

17

1ST WAVE

Industrial

(1770-1830) 2ND WAVE

Steam & Railways

(1830-1870) 3RD WAVE

Steel, Electricity

& Heavy Engineering

(1875-1920) 4TH WAVE

Oil, Automobiles

& Mass Production

(1910-1975) 5TH WAVE

Information

& Telecom

(1971-)

INN

OV

AT

ION

1800 1850 1900 1950 2000

Cleantech

& Biotech (2009-)

6TH WAVE

Source: DONG Energy (2009); diagram based on Perez (2002) drawing on

report by Merrill Lynch (2008) (schematic not precise quantitative vertical axis).

Policy – market failure (I)

• Policy for the market failures. Different failures point to different instruments, but the collection is mutually reinforcing (Bowen et al 2010):

– Mispriced resources: carbon taxes / cap-and-trade / regulation / fish;

– Inefficiency and waste: XXX

– R,D&D (research, development and deployment): tax breaks, research grants,

feed-in tariffs (FIT) for deployment;

– Imperfection in risk/capital markets: risk sharing/reduction through

guarantees, equity, feed-in tariffs, floors on carbon prices. FIT straddles first 3

imperfections;

– Networks: electricity grids, public transport, broadband, community-based

insulation schemes. Government frameworks needed;

– Information: labelling and information requirements on cars, domestic

appliance, products more generally. Awareness of options;

– Co-benefits: valuing ecosystems and biodiversity, valuing energy security,

regulation of dirty and more dangerous technologies.

18

Policy – market failure (II)

• Markets work best when: minimal monopoly of power; information is

symmetric; buyers and sellers both know what they are getting into;

barriers to entry are low; coordination failures can be overcome; all the

costs of production, including social and environmental costs reflected.

• Without properly valuing natural assets, it is hard to prevent overuse

and depletion of scarce resources, especially ones owned in common,

such as fish in the ocean or clean air.

• The absence of appropriate pricing of environmental goods means they

are over-consumed, and we are unable to easily measure their value.

This has distorted the development of advanced economies to make

them far too hungry for such resources.

• Dynamic public policy analysis required to deal with the issues of

fostering a transition on this scale (a 21st century view of economics).

Much market failure analysis à la Pigou is comparative statics, but

nevertheless basic to policy.

19

Policy – market failure (III)

• Inevitably some uncertainty as learning and discovery are central.

• Policymakers need to:

– tackle market failures especially those relating to mis-priced resources and

inefficiency and that lead to insufficient R&D spending by the private sector,

– help firms reap increasing returns to scale by supporting new networks.

– Shift tax base towards materials and resources, and away from intellectual

activity.

• Policy to promote learning must be managed in a flexible but predictable

way.

• Policy must be clear and credible with structured and predictable

provisions for flexible adjustment as scale/learning builds - policy risk is

very costly. Bad policy could raise costs substantially.

20

Political economy (I)

• Action involves radical change; there will be dislocation and winners and losers

– not all ‘win-win’

• Losers easier to identify; will lobby hard against action. Winners potential and

diffuse. Asymmetry in political influence. Vested interests will oppose change:

“merchants of doubt” industry.

• Policy must practically manage change, support, re-skill and retool threatened

sectors? This explains the

• People ready to act responsibly if they understand the scale of risks to future

generations and have clear sight what can be done.

• It is vital therefore to understand the political economy of change, problems in

communication and misinformation, and the role of public opinion.

• Open public discussion and engagement and building a common understanding

is essential for democratic choice, functional governance and the sustainability of

actions.

• Many barriers to early action are cultural, institutional, political not technological

or economic. Changing social norms means resource-efficient activities will be

accepted in time (witness initial response to smoking, seatbelts and drink driving).

21

Political economy (II)

• Global public good means international interaction is crucial.

• ‘Bottom-up’ local and national action reinforces/and is

reinforced by ‘top-down’ international agreements.

– easier to sell local action when others are moving strongly;

– equally it is easier to make demands at the international negotiating table when you

can point to effective domestic action.

• International agreements on overfishing, climate change and

resource depletion, have been slow and imperfect, but far from

ineffective. This is because this is not just about narrow free-

riding/gaming. There is a positive sum game from collective

action.

• Benefits and market opportunities to managing that transition early.

Examples abound of a healthy green race - China, Korea, various

European countries and states and cities in the US.

22

The size of the ‘green’ opportunity • Even in the present uncertain global green policy environment with lack

of ambitious, coordinated policy response:

– Renewable energy generation and energy efficiency investment has

quadrupled since 2004 according to Bloomberg New Energy Finance (BNEF);

– New investment in clean energy surpassed investment in conventional

energy generation in 2010, rising to between US$180 and US$200 billion.

• HSBC forecasts the global low-carbon energy market (revenues) will triple to

US$ 2.2 trillion p.a. by 2020 (HSBC, 2010):

– Around US$10 trillion in cumulative capital investments required 2010-2020;

– Energy efficiency themes will surpass low-carbon power as the major

investment opportunity by 2020, including, electric vehicles;

• UK low-carbon and environmental goods and services sector had sales of

£116.8 billion in 2009-10, up 4.3 per cent from the previous year (BIS) and

placing us sixth in the global league table.

• Investors have to take a medium to long term view and high-carbon

investments are looking ever riskier.

23

How are countries moving? China

• China (around 7t/cap) - China’s 12th five-year plan represents a radical

change in strategy. It identifies three key new objectives: increasing the share

of consumption, moving to a low-carbon and less polluting economy,

increasing innovation and R&D (Stern, 2011).

• China already has a target to reduce emissions per unit of GDP (emissions

intensity) by 40–45% between 2005 and 2020, with a target of 17% during the

12th plan (2011-2015).

• The 12th plan seeks to achieve this change in part through massive

investment in seven strategic low-carbon and resource efficent industries, to

achieve a 15% share of the economy by 2020, compared with 3% now.

• A green race it intends to win.

24

How are countries moving? Korea

• Korea (12t/cap) has adopted a National Strategy and Five-Year

Plan for Green Growth.

• Involved a “Green New Deal” launched on 6 January 2009 as part of

a wider economic stimulus package. A total of US$ 30.7 billion

(about 80% of the package) was allocated (2009-2012) across a

range of low-carbon initiatives, including renewable energy, energy

efficiency, transport, and water and waste management.

• The five-year green growth plan 2009-2013 incorporates many

projects from the Green New Deal package.

• Outlines a set of three strategies, ten policy directions, and 50 core

projects to shift Korea onto a resource-efficient growth path. A total

of US$ 83.6 billion will be allocated to the plan, around 2 per cent of

GDP. See UNEP (2010) for a more detailed description of the plan.

25 Source: UNEP, 2010, Overview of the Republic of Korea’s Strategy for

Green Growth.

How are countries moving? US

• Much movement outside Washington DC:

– US Navy and biofuel trials. Target to run a “Great Green Fleet” by 2016, a carrier strike

group composed of nuclear ships and hybrid electric ships running only on biofuel (and

aircraft flying on biofuel). Ambitious 2020 target for 50% of total energy consumption,

ashore and afloat, to come from non-fossil fuel sources;

– California cap-and-trade scheme. Begins 1 January 2013;

– NYC green growth plan “plaNYC”: including target to reduce emissions 30% 2005-

2030, currently 13% below 2005 levels (US around 8% below);

– Texas: largest wind farm capacity of any US state at around 10GW (Iowa second

largest at around 4GW). Plans to double capacity by 2013. Attracting investment from

China;

– General Motors - new range extended electric vehicle, ‘Volt’ in US and ‘Ampera’ in EU.

• EPA Mercury and Air Toxics Standards (MATS) for power plants. Will force coal to adopt

more stringent pollution controls (many older and dirtier coal plants may close or convert

to gas). More rules proposed to regulate emissions, e.g. Cross-State Air Pollution Rule.

26

Private saving and fiscal dis-saving

• Annual private sector net saving (investment-saving) at record levels.

• $1.1 trillion last year, equivalent to 7 per cent of US GDP (blue line) ~ confidence crisis.

• Recession a better time to steer investment than boom:

– Low resource costs/limited ‘crowding out’;

– No lack of private money (seeking low-risk profitable new markets);

– Perceived lack of opportunity and confidence

Sector financial balances*, % of GDP

United States United Kingdom

27

-12

-9

-6

-3

0

3

6

9

12

87 89 91 93 95 97 99 01 03 05 07 09 11

Private sector

Public sector

Current account balance

-12

-9

-6

-3

0

3

6

9

12

87 89 91 93 95 97 99 01 03 05 07 09 11

Private sector

Public sector

Current account balance

Source: Bureau of Economic Analysis/Office of National Statistics, quarterly data to fourth quarter of 2011.

*net borrowing, or saving minus investment

The potential power of policy credibility

• The role of environmental policies in setting expectations and providing

incentives to induce innovation is huge. Even modest and uncertain movement has

generated a strong response.

Innovation in climate change mitigation technologies

Patenting activity in Annex-I countries (3-year moving average, indexed on 1990=1.0)

Based on ‘claimed priorities’ (CP) deposited at any patent office worldwide, classified by technological field, from

identification developed by the EPO/OECD World Patent Statistics database (PATSTAT). OECD (2010).

28

Credibility a prerequisite for confidence

• Private sector not investing as heavily as it could in resource efficiency

innovation/infrastructure because of a lack of confidence in future

returns in this policy-driven sector.

• The Government should incentivise low-carbon investment by itself taking

charge of the elements of the policy risk which it ‘controls’.

• By backing its own resource efficiency policies, the Government can

stimulate additional net private sector investment.

• For instance, by allowing the Green Investment Bank to operate as a

lending institution: its presence reduces policy risk and it is a more

trusted convenor and syndicator than a private investment bank (see

EBRD experience).

• Must not convey the (false) impression that we have to make a choice

between environmental responsibility and economic growth, he

undermines the confidence of private sector investments.

29

Conclusion

• Absolute decoupling and growth feasible, desirable, profitable.

• Requires early action and strong domestic and international policy steer.

• Informed by economic analysis of risks, uncertainly, dynamics of path-dependency

and costs of delay (narrow CBA modeling won’t do).

• Indecision costly: risks the double failure of missing opportunity to lock-in new low-

carbon infrastructure and unnecessarily extending the economic crisis.

• Recession a better time to steer investment than boom.

• Credible long-term policy can reduce uncertainty, lower costs as well as drive

investment, restore growth and leave a lasting resource efficient legacy.

• Policymakers also need to:

– tackle market failures especially those relating to mis-priced resources and inefficiency

and that lead to insufficient R&D spending by the private sector.

– steer the creation of new markets and drive endogenous growth.

– help firms reap increasing returns to scale by supporting innovation and new networks.

– Shift tax base towards materials and resources, and away from intellectual activity.

30

Presentation to HM Treasury Stern and Zenghelis (forthcoming)

‘A strategy for restoring confidence and economic growth through

green investment and innovation’ Zenghelis 2012

http://www2.lse.ac.uk/GranthamInstitute/publications/Policy/docs/PB-

Zenghelis-economic-growth-green-investment-innovation.pdf

‘Lionel Robbins Memorial Lectures’ Stern (Feb 2012).

http://cep.lse.ac.uk/_new/events/event.asp?id=140

‘Prosperity with Growth: Economic growth, climate change and

environmental limits’ Hepburn and Bowen (forthcoming).

These also include more comprehensive referencing.

31

References