The once-in-a-century COVID-19 pandemic has
compelled us to think more profoundly about the relationship between humans and
nature, especially relating to the urgent need to address climate change. The
Chinese government has pledged to achieve carbon peak by 2030 and carbon
neutrality, i.e., net-zero carbon emissions, by 2060. Across the Pacific, the
Biden administration has brought the US back to the Paris Agreement. Meanwhile,
the 27-member European Union has committed to increase emission cuts before
2030 and achieve carbon neutrality by 2050. Achieving carbon neutrality
requires not only coordinated efforts by government bodies and non-governmental
institutions but also close collaboration among nations. What kind of obstacles
and challenges will confront humanity on the road to carbon neutrality? What
new opportunities may emerge? How will carbon neutrality impact the global
economy and human society?
To answer these
questions, CICC Research and CICC Global Institute collaborated to compile our
latest report: Economics of Carbon Neutrality: Macro and Sector Analysis under
New Constraints. The report systematically analyzes the pathways for China to
achieve carbon peak and carbon neutrality, as well as their broader
implications. The research of carbon neutrality differs from our usual market
research in two critical aspects: 1) Carbon neutrality encompasses a wide range
of fields, covering economics, science, and social studies; and 2)Carbon neutrality is an unprecedented challenge
for public policy, which will undoubtedly play a pivotal role. Our report
represents the collaborative efforts of four macro research teams and more than
20 sector teams, along with invaluable contribution from external sources,
including a global research paper contest. This paper is the preface to the
main report.
I. Cost-effectiveness analysis under a clear goal
Since
the Industrial Revolution, human activities have disrupted the delicate balance
between carbon emission (“carbon source”) and absorption (“carbon sink”) in the
carbon cycles of our planet. The consumption of fossil fuels has led to a
dramatic increase in the CO2 density of the atmosphere, triggering the greenhouse
effect and global warming. Most scientists agree that human activities have caused
the climate to warm over the past century. Over the past five decades, we have
seen increasingly severe threats from climate change, such as melting glaciers,
rising sea levels, collapsing ocean ecosystems, growing water shortages,
disease transmission, as well as extreme weather conditions such as floods,
droughts and hurricanes.
The
Intergovernmental Panel on Climate Change (IPCC) predicted that the world’s
average temperature in 2100 will be 1.5–4.8 degrees Celsius higher than the
level recorded prior to the Industrial Revolution. If no action is taken and
the current trend continues, climate change’s impacts on the economy and
society may escalate. Therefore, emission reduction and carbon neutrality will
benefit human society in the long run.
However,
emission reduction incurs costs and may hurt the economy in the near term.
Carbon emissions resulted from economic activities, and fossil fuels have
played a vital role in the substantial improvement of living standards since
the Industrial Revolution. Carbon emissions can be reduced in two ways: 1)
electrification of economic activities, such as industrial production,
transportation and home heating; 2) switching from traditional fuels for
electricity generation to alternative energy sources (e.g., renewable energy
and nuclear energy), or adopting carbon capture and storage technologies to reduce
carbon emissions from fossil fuel consumption. However, these solutions face a
critical problem: Clean energy is more expensive than fossil fuels and requires
new infrastructure, while the increased cost is detrimental to economic growth.
Cost-benefit
analysis was an early approach to studies of the economic implications of
climate change and policy responses. This approach compares the long-term
benefits and short-term costs of emission cuts, and offers policy proposals
based on the analysis. However, the monetary evaluation of long-term impacts
from climate change is highly uncertain and often underestimates the benefit of
emission control measures, resulting in insufficient public policies.
In
most cases, economic analysis only captures economic activities that involve
market transactions and economic effects that can be measured in monetary
terms. However, impacts from climate change, such as the rising sea levels,
ocean acidification and ecological imbalances, often extend far beyond the
scope of traditional economic analysis, or simply cannot be measured in
monetary terms. Moreover, emission reduction incurs costs at present but
delivers benefits in the future. Most people, including public policymakers, focus
on near-term costs and impacts on the economy, but neglect the interests of
future generations.
As
climate change has drawn growing attention around the world, the necessity to
address this problem has become a global consensus. Instead of arguing whether
we should take action to control carbon emissions, discussions now focus more
on how to effectively achieve policy targets at the lowest cost. Hence, the
research method has changed from cost-benefit analysis to cost-effectiveness
analysis, i.e., comparison of the costs of different means to attain a
pre-determined policy goal, so as to find the most effective solution with
specific action plans.
When
we analyze China’s emission reduction targets, a critical issue is to estimate
the peak emission volume in 2030. A high emission peak means the country would
face relatively less pressure to curb carbon emissions over 2021–2030, but may
have to work hard over 2031–2060 to reduce net emissions to zero as promised.
The opposite would be true if the emission peak is low. Most studies on this
issue derive the peak emission target from China’s actual carbon emission in
2005 and the Chinese government’s pledge to reduce the country’s carbon
intensity (i.e., carbon emission per unit of GDP) by at least 65% over
2005–2030. However, the 2005 emission data from different sources are
inconsistent with each other. Fortunately, the data inconsistency has narrowed
over time and become insignificant in recent years. Based on China’s carbon
emission data for 2017, we derive the peak emission volume from the country’s
actual carbon intensity reduction and the government’s pledge to cut carbon
intensity by 65% over 2005–2030. Our calculation indicates that China’s peak
net carbon emission in 2030 should be 10.8bn tonnes.
How
to interpret the 10.8bn-tonne peak emission volume? China’s aggregate peak
emission volume is much higher than the EU’s (4.1bn tonnes) and the US’s (6.1bn
tonnes). Moreover, the duration from China’s emission peak to carbon neutrality
is shorter than the EU’s and the US’s. Both point to the need to significantly
reduce China’s carbon emissions after the peak. While a relatively high
emission peak seems to suggest that China does not have to substantially cut
carbon emissions over 2021–2030, an examination of the per capita emission
volume reveals a different picture. We estimate China’s per capita peak
emission volume at 7.4 tonnes in 2030, well below peak volumes in the US (19.6
tonnes) and the EU (9.9 tonnes). As the low per capita peak emission leaves
little upside for carbon emissions over 2021–2030, we believe China will have
to strictly curb emissions in this period. Since both aggregate and per capita
perspectives are essential to a complete picture of emission control, we
believe China will need to work hard to significantly reduce carbon emissions
both before and after the peak in 2030.
II. Correction of externality: What carbon
prices can and cannot do
Effects
of global endeavors to address climate change have been rather limited and far
from ideal. This poses a puzzling question: Why has climate change failed to
stimulate innovations in emission reduction when population aging has led to the
development of machines to replace humans? In our view, a key factor to explain
the paradox is the so-called “negative externality”: Economic activities that
emit carbon dioxide benefit individuals, but their consequences, such as air
pollution and climate change, harm human beings as a whole. Under such a
negative externality, prices of goods and services in the free market are
inconsistent with the public interest. For example, market prices of fossil
fuels are too low and their consumption volumes are too high.
Economic
activities involve many types of externalities. Most externalities, such as
financial risks and soil contamination, are limited to certain areas. However,
climate change is global – it affects every nation and all the people around the
world. The ongoing endeavor to contain COVID-19 is comparable to emission
control. Vaccination against COVID-19 shows a positive global externality as it
not only protects individuals but also helps stop virus transmission. Global
herd immunity could be achieved when each country vaccinates 70–80% of its
population. If governments fail to collaborate on vaccination, even 100%
vaccination in a single country is unlikely to end the pandemic, as the continued
spreading of the pandemic in other countries may cause the virus to mutate and
render existing vaccines ineffective.
However,
there is a key difference between the endeavor to address climate change and
the battle against COVID-19. Pandemic containment measures usually deliver
clear and instant results, but effects of the endeavor to address climate
change are barely predictable as they may be decades or even centuries in the
future. As the negative externality impacts the whole world and lasts into the
future, the private sector has hardly any motivation to participate in the
endeavor to address climate change. Meanwhile, effects of the free market’s
adjustment mechanism are very limited. As such, correction of the negative
externality holds the key to carbon neutrality.
To
correct the negative externality, intervention from public policies is
essential. A key concept here is carbon pricing, which measures the social cost
of carbon emissions. By requiring carbon emitters to pay for their emissions,
carbon pricing turns the social cost of carbon emissions into emitters’ costs, urging
them to reduce energy consumption and switch from fossil fuels to clean and
renewable energy. Discussions about and implementation of carbon pricing
policies involve two related but different issues: The form of pricing and the
proper price level.
In
theory, carbon prices should be based on the social cost of carbon emissions.
To determine a proper carbon price, we need to discount the future climate
damage caused by carbon emissions to derive its current cost. However, it is quite
difficult to forecast the effect of climate change decades in the future. The
choice of a proper discount rate may also cause disputes as it involves a
trade-off between interests of the current generation and those of our
descendants. For example, the Obama administration preferred a 3% discount
rate, which implies the US is willing to pay US$0.22 at present to avoid each
dollar of loss due to climate change five decades from now, or less than
US$0.05 at present to avoid each dollar of loss 100 years in the future.
Nicholas
Stern, a distinguished professor at the London School of Economics and the
former Chief Economist of the World Bank, estimated carbon prices in his report
on climate change in 2006, a masterpiece that has received worldwide attention.
The discount rate adopted by Professor Stern in his report is lower than the
rate adopted by the 2018 Nobel Prize laureate William Nordhaus, which implies
that Professor Stern gives a greater weight to the interests of future
generations. The carbon price derived with Professor Stern’s discount rate is
about US$266/tonne, well above estimates made by Professor Nordhaus
(US$37/tonne), the Obama administration (US$42/tonne), and the Trump
administration (less than US$10/tonne). Significant differences between these
estimates clearly illustrate their uncertainty and subjectivity.
Carbon
pricing can be implemented in two forms: Carbon tax and carbon trading price. Carbon
tax is a carbon price imposed directly by the government in areas where
market-based carbon prices are lacking. Carbon trading price is the price of
emission permits traded in a market established under a total emission cap set
by the government (i.e., the “cap-and-trade” system). Both carbon tax and
carbon trading price have pros and cons. Advantages of carbon tax include high
transparency and price predictability, which helps economic entities formulate
long-term plans. However, carbon tax is not directly or stably related to the
emission control target, so the volume of emission reduction can hardly be
predicted under the carbon tax framework. The cost of levying carbon tax is low
as it can leverage on the existing taxation system, although the introduction
of a new tax could face objections from the public.
Under
the carbon trading framework, policymakers need to design new trading
mechanisms and set a cap on the total volume of emissions permitted. As such,
the volume of emission reduction is more predictable under the carbon trading
framework than under carbon tax. However, carbon trading price is less
predictable as it is affected by multiple factors, such as economic cycles and
technological advancement. For example, carbon trading prices could decline due
to falling demand for carbon emissions in an economic recession, but could rise
due to growing demand in an economic boom. The main problem for carbon trading
is inelastic supply, which means all demand-side shocks would result in price
fluctuations. This may lead to excessive price volatility and significantly
disrupt business plans in companies and other economic entities.
Both
carbon tax and carbon trading price are valuable tools for the correction of
externalities. They are compatible with each other and can both be effective in
a well-designed framework. The main difficulty for policymakers lies in the
determination of an appropriate tax rate and an effective cap on emission
permits. An excessively low tax rate and an extremely high emission cap are
unable to impose an adequate constraint on carbon emissions or provide sufficient
incentives for emission cuts. On the other hand, the economy would face
significant adverse impacts if the tax rate is too high or the emission cap is
too low. As we discussed above, the fundamental problem still lies in the
significant uncertainties in setting an appropriate price for each tonne of
carbon emissions.
As
policymakers have set the target for carbon neutrality, the key question at
present is how to effectively achieve this target at a low cost rather than
assessing the long-term damage caused by climate change. How to set a proper
carbon price under the cost-effectiveness framework? When economic entities
choose between fossil fuels and clean energy, they usually base their decisions
on cost comparison. The carbon price that makes the cost of clean energy equal
to that of fossil energy is termed a “switching price” or “parity price”. When
describing the path to carbon neutrality, the International Energy Agency (IEA)
adopted the concept of switching prices instead of traditional carbon prices.
Another example of a switching price is the so-called “green premium”, a new
concept proposed by Bill Gates in his recent book How to Avoid a Climate
Disaster.
III. Green premium: A more practical tool for
analysis
The
green premium is defined as the difference in cost
between clean (zero carbon emission) energy and fossil energy for a certain
economic activity. A negative green premium indicates that the cost of
fossil energy is higher than that of clean energy – an incentive to switch to
clean energy and reduce carbon emissions. The green premium and carbon pricing
are compatible with and related to each other. However, the green premium has
three distinct advantages over carbon pricing as an analytical tool.
1)
The green premium concept is broader than carbon pricing. The scope of carbon
pricing, such as carbon tax and carbon trading price, is too narrow to fully
correct the negative externality of carbon emissions, which impacts the whole
world and lasts into the future. This compels regulators to intervene by
issuing public policies with broader coverage. In contrast, the green premium
provides a more comprehensive framework that encompasses not only carbon
pricing but also a range of alternative tools. Apart from carbon tax and carbon
trading, we may also lower the green premium by increasing public expenditures
on technologies and innovations, formulating green standards for various
industries and products, and constructing new infrastructure to reduce the cost
of clean energy consumption.
2)
The green premium focuses on the present, while carbon pricing involves the assessment
of future uncertainties. To determine a proper carbon price, we have to
discount the future climate damage caused by carbon emissions and climate
change to derive its current cost. In contrast, the green premium calculates
the difference between current costs of clean energy and fossil fuels, and extrapolates
from these results possible future trends. As policymakers have already set
long-term targets for emission peak and carbon neutrality, the green premium is
a more practical tool for analysis.
3)
Carbon prices are a uniform concept, but green premiums are highly structural
and vary significantly across industries due to differences in technologies,
business models and public policies. Calculating green premiums in different
industries helps policymakers to assess policy feasibility in different areas.
Based on a few assumptions about new technologies, new business models and the
threshold of economies of scale, the green premium may also help us identify milestones
and key indicators in the implementation of emission control policies.
A
key innovation we make in this report is the application of the green premium
concept in the context of China. Our in-depth industry knowledge has enabled us
to estimate green premiums in various sectors, and incorporate them as key
inputs into our analysis of the roadmap for emission reduction. They also serve
as a fundamental link to combine top-down macro analysis with bottom-up
microanalysis to form a comprehensive and systematic analytical framework for
carbon neutrality.
Our
sector teams assessed green premiums in eight industries with high carbon
emissions. Under current conditions, we estimate the green premium at 141% in
the transportation industry (excluding transportation by passenger vehicles[1])
and 138% in the construction material industry (e.g., cement and glass). In
other words, the cost of using clean and renewable energy in these industries
is 1–2 times higher than the cost of fossil energy. The green premium remains
positive at 3%–17% in industries with relatively mature technologies, such as
papermaking, nonferrous metals, steel, power, and passenger vehicles. These
figures suggest that market prices are unable to provide sufficient incentives
for a switch to clean energy in the eight industries, which collectively
account for as much as 88% of total carbon emissions in China.
We
calculated each of the eight industries’ proportions in total carbon emissions
and used them as weights to derive the current weighted average green premium
for these industries. The result (about 35%) implies an Rmb377/tonne parity
carbon price, i.e., the price that can reduce the green premium to zero.
Despite conceptual differences discussed above, the parity price is within the
range of estimates (US$37–266/tonne) found in global research literature. Based
on available data, we also calculated the eight industries’ historical weighted
average green premium since 2015 to compile the “CICC Green Premium Index”. The
Index shows that the switching price for clean energy has declined remarkably
in recent years despite significant differences between industries.
We
can lower the green premium by reducing the cost of clean energy and/or raising
the cost of fossil energy. However, relying solely on the second option could
cause severe adverse impacts on the economy, as it may require a sharp increase
in the cost of fossil energy. In our view, the optimal solution is to reduce
the cost of clean energy or energy consumption per unit of GDP, which calls for
technological advances and innovations in social governance. We believe this
would be a positive supply shock to the economy and may create new
opportunities.
It
is worth noting that the green premium is not stationary: It declines along
with prices of clean energy, but rises when prices of fossil energy fall due to
declining demand. If current clean energy prices drop below current fossil
energy prices, the result is not necessarily conducive to carbon neutrality. We
should keep track of changes in the green premium to analyze their
implications. Ultimately, we still need direct or indirect intervention from
public policies to set a floor for fossil energy prices and carbon prices.
While carbon prices measure the social cost of carbon emissions, the green
premium gauges incentives for the private sector to switch to clean energy. We
believe both are effective tools for analysis and policy implementation, so
they should be compatible with and complementary to each other.
IV. Technological advances and social governance
The
2018 Nobel Prize in Economics was shared by William D. Nordhaus "for
integrating climate change into long-run macroeconomic analysis" and Paul
M. Romer "for integrating technological innovations into long-run
macroeconomic analysis."[2] Although the sharing of the prize might be a coincidence, we believe the two
Nobel laureates’ research fields are indeed linked to each other, as
technological advancement is crucial to the endeavor to address climate change.
Moreover, technological advancement also shows externalities – individuals bear
R&D costs and risks, while the whole society benefits from R&D
accomplishments. That is why private sector R&D spending is too low to
generate enough social benefits.
Given
the negative externality of carbon emissions and positive externality of
technological advances, intervention from public policies is essential to both
emission control and technological development. Over the past few years, the
power industry has been the primary contributor to the sharp decline in China’s
overall green premium. However, green premiums remain high in a few industries,
and existing technologies are unlikely to significantly reduce the cost of
using clean energy in these industries in the foreseeable future. Only major
innovations and technological breakthroughs can effectively reduce green
premiums in these sectors. For example, only expensive carbon capture
technologies can effectively reduce emissions in a number of manufacturing
industries, such as cement and chemicals, as electricity consumption is not the
main source of carbon emissions in these industries.
The
green premium is already negative for power producers. Attributes of clean
energy production and application are similar to those of the manufacturing
industry. A good example is economies of scale: Growing production volumes and
user numbers reduce unit cost and improve project feasibility for wind energy,
solar energy and electric vehicles. The Chinese government’s support and
subsidies for the photovoltaic (PV) industry effectively boosted development of
the industry in its infancy. As the PV industry grows, it begins to benefit
from economies of scale and technological advances, and no longer needs
favorable policies or subsidies to support its business viability. This is a
typical example of successful technological advances supported by public
investment.
Innovations
are important for not only natural science and technology but also social
governance. Green premium's relation to emission reduction is not always linear
due to people’s habits, customs and path dependence.[3] Carbon pricing may adversely affect the economy in the near term as the
emission control target may require rather high carbon prices. Meanwhile,
technological R&D faces many uncertainties. To address these problems, we
need social governance reforms and administrative intervention from public
policies, as they can help push for emission cuts and energy conservation
(e.g., a healthier lifestyle) on the demand side. For example, campaigns
against wasting food may help free up some farm land for soil remediation,
carbon sink, or bio-energy production.
In
some sectors, rules and regulations are more effective tools than price-based
guidance to push for emission cuts and carbon neutrality. The introduction of
new products and technologies in these sectors may involve a steep learning
curve, while economies of scale could take a long while to develop. To overcome
these problems and uncertainties, policymakers should rely more on rules and
regulations, such as industrial and product standards, better urban planning,
and improved land management. Building new infrastructure, such as charging
stations and more convenient public transportation systems, may also facilitate
the switch to clean energy. In addition, development of the digital economy may
play an important role as well. The application of big data, for instance, may
help magnify benefits from clean energy and reduce their costs. In particular,
big data may help make wind energy and solar energy more predictable by
improving management efficiency on the demand side and matching demand with
supply more effectively.
V. Green finance: Correct vs. incorrect perceptions
To
understand the financial sector’s role in emission reduction and carbon
neutrality, we should analyze its relation with the real economy by examining
two cases: 1) Financial business results from activities in the real economy,
and the financial system effectively transforms savings into investment as long
as sufficient information is available. In this case, development of the
financial industry follows the steps of the real economy; 2) when the real
economy is unable to allocate resources efficiently the financial industry
helps remedy market failures in certain areas. A good example is the
development of inclusive finance. In other words, development of the financial
industry leads the way for the real economy.
We
believe green finance can contribute to emission control and carbon neutrality
in both cases discussed above. In the first case, the green premium has fallen
below zero, so entities in the real economy have financial incentives to switch
to green energy. Therefore, the financial sector’s role is to provide financing
for green projects. In the second case, the financial sector directly helps
lower the green premium. Although current financing data for green projects
cover both cases, we believe the second case, in which the financial sector
leads the way for the real economy, is perhaps more important from the
perspective of public policies.
Specifically,
we believe the financial sector can play an important role in emission control
and carbon neutrality by reducing the cost of financing, improving the
availability of financing, and creating new trading markets. The government may
intervene directly by providing favorable financing conditions, such as
subsidies on loan interest rates, or specifying the scope of industries
eligible for loans. Development financial institutions may play key roles in
the initial financing for green projects. In addition, financial instruments
may help balance investors’ perception of risks in green and “brown” projects.
The financial industry may also create new types of trading products to improve
the availability of financing for green projects.
To
effectively reduce carbon emissions, it is important to first determine key
sectors to be supported by green finance and main financial instruments to be
employed. We estimate that the green premium is only 17% in the power industry,
which accounts for more than 40% of total carbon emissions. Our estimate takes
into account amortization of fixed costs over asset life cycles. If we consider
only variable costs, the green premium in the power industry should have
already become negative, which means the variable cost of clean energy is lower
than that of fossil energy. Given the power industry’s enormous proportion of
total emissions and the high financial feasibility of going green in this
sector, we believe green finance should prioritize support to the power industry
and electrification in other sectors.
Given
the highly predictable risk-return profile of the projects we discussed above,
we believe credit loans, bonds and other fixed-income instruments should be the
primary means of financing for them. While this type of green finance can be
roughly categorized as the financial support we discussed in the first case
above, we believe the second case also applies here. In other words, financial
institutions may help directly lower the green premium and encourage
participation from the private sector by improving the availability of
financing or reducing the cost of capital for initial investment in a project.
This is especially important for low-carbon projects that require high initial
investment. As the green energy sector is essentially a manufacturing industry
while China is a manufacturing giant, we believe the green energy sector should
have strong economies of scale and spillover effects in China. Therefore, green
finance may help boost the Chinese economy as a whole, in our view.
Green
premiums are high in some industries, such as aviation, construction materials
and certain chemicals, due largely to limitations of existing technologies. For
example, carbon capture technology is still the only solution to emission
problems in some industries. Technological innovations and breakthroughs are
critical to these industries, but they need time and funding. A key part of the
financial support for these industries is public investment in fundamental
research, including fiscal expenditure and financing from development financial
institutions. On the other hand, an efficient capital market, notably the
equity market, can also facilitate high-risk, high-return innovations and
accelerate resource reallocation to more important areas.
While
the amount of green credit and green bonds has been growing rapidly in recent
years, the environmental, social and governance (ESG) criteria for investment
have become another trending topic. The total amount of ESG investment has
exceeded US$40trn globally. However, a number of studies on this subject
revealed that the average return from ESG investment is actually no lower than
traditional, unrestricted investment, and interest rates of green loans and
bonds are not lower than ordinary products. These findings suggest that taking
social and environmental responsibilities is actually not in conflict with
personal interests in investment activities, which appears rather
counterintuitive. We propose below three possible explanations for this
anomaly, and each of them has different policy implications.
1)
Financial business reflects activities in the real economy. ESG investment and
traditional investment deliver the same returns because externalities of carbon
emissions have already been corrected in the real economy. Although this explanation
is partially justifiable, we think it is incomplete, to say the least.
2)
Not all industries supported by green finance are really green, as the criteria
for green companies/industries are not clear enough. Evaluating a company’s
non-financial performance is not only a technical issue but also a social and
ethical challenge that requires a proper set of indicators to gauge the
company’s social and environmental performance, as well as a complete system of
baseline references and standards. At present, we still lack widely accepted
standards on critical issues, such as the composition of ESG criteria and the
extent to which we can trust the ESG data from companies. We believe this is a
critical problem for the development of green finance. Therefore, a pressing
issue for policymakers is to set up an elaborate system for the formulation and
assessment of green standards, which we believe should be the foundation and
key infrastructure for green finance.
3)
Financial institutions and investors hold positive views on the outlook of
green projects, which lower their demand for risk premiums. Optimism about new,
green assets enhances the appeal of financial instruments, as they usually
serve as tools for investment in new assets. On the other hand, existing assets
are also an important part of our analysis as the financial industry suffers
from path dependence as well. We believe existing assets related to traditional
energy face value impairments amid the green economic transformation. This
affects the financial industry as corporate borrowings related to such existing
assets are listed as financial assets in the balance sheet of financial
institutions.
The
balance between existing and incremental assets is critical to the financial
industry as it affects not only the industry’s support for the green economy
but also the stability of the financial system. We believe this is essentially
a public policy issue that calls for action by the central bank and other
regulators. Financial institutions should be required to fully disclose risks
of “brown” projects and assets in good time, and more stringent standards
should be imposed on capital- and liquidity-coverage ratios of these assets.
Regulators should discourage financial institutions from supporting investment
in high-emission assets, and hence facilitate investment in green projects. On
the other hand, effective mechanisms to deal with risk exposures in brown
assets help maintain financial stability amid the green transformation.
VI. New landscape in international cooperation and competition
International
collaboration is essential in our battle against climate change due to the
global externality of this crisis. A critical issue is how to strike a balance
between equality and efficiency. In theory, emission reduction efficiency would
be the highest if we impose a uniform carbon price around the world and
prioritize emission cuts in low-cost sectors regardless of their locations. If
we adopt these measures, the volume of emission cuts would be higher in developing
countries, as carbon prices are less affordable to low-income consumers in
these economies. The consequent losses in developing countries could, in
theory, be covered by transfer payments from developed economies.
However,
balancing equality and efficiency is a rather tricky task in reality. Thorny
problems for low-income countries include emission reduction’s significant
marginal impacts on consumption, the low possibility of fiscal transfer
payments between nations, and the greater urgency of poverty relief than
climate problems in the near term. In fact, developed economies are responsible
for most carbon emissions since the Industrial Revolution, while developing
countries actually suffer from insufficient energy supply – a key manifestation
of fundamental problems such as poverty and inequality in development. On the
other hand, low-income countries should not follow the same development path
adopted by advanced economies in the past, because that would create huge
demand for resources, especially energy, which is clearly unsustainable from a
global perspective.
To
better understand international cooperation and competition on climate change,
we need to examine price differentials in two key areas and their significant
implications.
1)
Given the income gap between developed and developing economies, the volume of
emission reduction in developing countries is more elastic to carbon prices. In
other words, the same carbon price would lead to higher emission cuts in
developing countries. This implies carbon prices should be lower in developing
countries than in developed economies. However, the differential in carbon
prices may lead to “carbon leakage”, i.e., the relocation of high-emission
industries to developing countries. To solve this problem, a number of
developed economies are discussing a “carbon border tax”. However, setting a
proper tax rate is a complex issue involving significant uncertainties. If
mishandled, the tax could be easily turned into a tool for trade protectionism.
2)
Interest rates are higher in developing economies than in developed countries.
A high discount rate means a low current value of the future benefits from
climate improvements. In emerging markets, a high interest rate also means high
returns from investment in sectors unrelated to climate change, which makes it
necessary to strike a balance between investments in emission control and in
other areas. Moreover, a high interest rate provides the financial industry
with additional space in which it can play its role, which leads to capital
flows from high-income economies into low-income ones. To solve these
international problems in green finance, we need bilateral and multilateral
cooperation to remedy market failures. Meanwhile, development financial
institutions may help reduce project risks and attract investment from the
private sector.
International
cooperation and competition to address climate change will no doubt
significantly impact the existing global governance system, in our view. A key
challenge for the international community is how to build a more binding
mechanism than the Paris Agreement for emission control. Substantial changes in
the international arena call for revamping of the governance structure of
international trade and financial systems established after the Second World
War, including the World Trade Organization, the International Monetary Fund
and the World Bank. As China is a large economy, carbon neutrality in China is
an important part of the global endeavor to address climate problems. Moreover,
China should play a key role in the establishment of a new international
governance system. A possible step in this direction is the country’s
cooperation with economies covered by the “Belt and Road Initiative".
Although
China is at a disadvantage in fossil energy due to limitations in its natural
resource endowments, the country’s superior strength in manufacturing and the
digital economy gives it a potential competitive edge in clean energy. We
believe that international peer pressure will compel all countries to adopt
similar strategies to address climate change, and emission reduction will
become a prevailing trend. Although this could be a challenge for China, we
believe the country has a first-mover advantage in emission control and carbon
neutrality.
VII. Stagflation or new opportunity: Thoughts about the real market economy
The
endeavor to address climate change and achieve carbon neutrality is, in
essence, transformation of development models and economic structures through
relative price changes. All measures to reduce carbon emissions, including
carbon tax, carbon trading price, administrative regulation and green finance,
take effect by raising fossil energy prices and lowering clean energy prices.
Under the new growth model, clean energy will serve as the foundation for
healthy life and sustainable development of the human civilization. However,
relative price change is a supply shock that causes friction in the economy’s
transition from the old equilibrium to the new equilibrium.
Effects
of carbon pricing are similar to impacts from falling oil supply: Production
cost rises on the supply side, while real income falls on the demand side. From
a macroeconomic perspective, these are characteristics of stagflation. How
strong is the pressure of stagflation? Our computable general equilibrium (CGE)
model shows whether China can achieve carbon neutrality by 2060 hinges on
technological advancement, which is an expensive proposition. A rising carbon
price could serve as an incentive for technological development, but it may
undermine GDP growth and drive up other prices. Our sector studies reveal that
reducing the current green premium to zero would raise costs significantly in
manufacturing industries such as chemicals and construction materials.
Our
structural analysis shows that certain economic activities, technologies and even
industries may be replaced by new models amid the transformation to achieve
carbon neutrality. Traditional energy industries, notably the coal industry,
may face severe adverse impacts. Therefore, we expect employment to decline in
infrastructure, manufacturing and service sectors related to traditional
energy. On the other hand, we believe employment will rise in clean/renewable
energy industries and related sectors. Given China’s size, we expect the
transformation’s impacts to vary across different regions of the country due to
their different natural resource endowments for fossil fuels. We expect severe
negative impacts in provinces and regions that produce high volumes of fossil
energy. Most of these regions are economically underdeveloped. Meanwhile,
prices of traditional energy may rise for some time amid the transformation to
achieve carbon neutrality. We believe this will hurt low-income groups more
severely than mid- to high-income groups. To address these problems in
structural adjustment and income distribution, we will need effective public
policies, notably fiscal policies.
From
a more fundamental perspective, carbon neutrality imposes on the economy a
single, quantitative constraint that affects all aspects of economic activities
but cannot be priced in the free market. This is an unprecedented challenge to
public policies and the market economy. Policymakers are confronted with a
multitude of problems that they have never encountered before: How to remedy
the absence of market mechanisms and avoid excessive government intervention at
the same time under rigid constraints? How to balance short-term and local
interests with the long-term and overall interests of the whole society? It
remains highly uncertain how carbon neutrality will affect the economy and
society, but we believe the most fundamental impact will probably be on
mainstream thoughts and ideas. How to analyze these complex issues?
Looking
ahead, we envision three possible scenarios: 1) efforts to achieve carbon
neutrality are unsuccessful or fail to reach the target in time, and global
climate change causes severe damage to humanity; 2) carbon neutrality is
achieved mainly by raising the cost of energy consumption, so the world economy
suffers from protracted stagflation; and 3) carbon neutrality is achieved
thanks to technological advances and innovations in social governance under
effective public policies and international cooperation. As a result, the world
switches to a new development pattern and people enjoy better, healthier lives.
All
three scenarios pose challenges to neoclassical economics, which has dominated
economic studies over the past four decades. As the spillover impacts from climate
change have long-term global implications, we doubt whether externality is an adequate
supplement to basic assumptions of neoclassical economics, i.e., complete
information, certainty and perfect competition. How to explain carbon
emission’s transformation from a single, quantitative indicator into a uniform
constraint on global economic and social development? How will interactions
between public policies, social governance mechanisms and market mechanisms
evolve amid the endeavor to achieve carbon neutrality? Perhaps only time can
tell. We believe the journey to carbon neutrality will lead to more profound
thoughts about differences between the real market economy and the ideal market
economy in neoclassical economics.
Neoclassical
economics’ deviation from reality calls for close reexamination of this school
of economic thought and points to the necessity of returning to classical
economics. Classical economists, such as Adam Smith and David Ricardo, realized
that human activities are subject to natural constraints, and emphasized
analysis from the perspective of political economics, including social, ethical
and cultural studies. The global endeavor to address climate change compels
economists to carefully reevaluate the role of nature in their analytical
framework. In addition to labor and productive capital, we should also take into
account natural capital such as water, air, forests, oceans and biodiversity.
As natural capital cannot be priced in free markets, effective public policies
and social governance are essential. Meanwhile, we believe people will attach
greater importance to equality in the equality-efficiency trade-off.
The
road to carbon neutrality is a long learning curve for everyone. While we have
tried our best to analyze carbon neutrality in this report, we are well aware
that mistakes and omissions might be unavoidable. We will keep a close watch on
China’s progress toward carbon neutrality, and update our analysis and
assessment when necessary.
[1] Passenger vehicles include most cars, station wagons and vans, but exclude taxis, buses, coaches, ambulances and all waterway/air vehicles.
[2] https://www.nobelprize.org/prizes/economic-sciences/2018/summary/
[3] Path dependence is “a phenomenon whereby history matters; what has occurred in the past persists because of resistance to change”. Source: https://www.investopedia.com/terms/p/path-dependency.asp