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Economics of carbon neutrality: Some thoughts on entailed transformations

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


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