Published in the International Financing Review, in September 2008.
Accurately assessing carbon price risk as climate policy evolves will require a profound understanding of the interaction between policy and politics and the unique nature of the challenge this poses to policy makers. Many factors will shape the development of carbon prices – the scale and urgency of the task, the level of political will, how technologies and economies develop, how well, or badly, public policies are designed and much else besides. But, since climate change is the most global of challenges, the nature and pace of development of international agreements will be among the most important of those factors. It is hard to over-estimate the complexity and difficulty of these negotiations.
Climate policy is at least as complex as trade policy and far more difficult to negotiate. This difficulty stems from the centrality of access to affordable and ever greater supplies of energy to the smooth running of modern economies. Until very recently it was assumed that the efficient functioning of global markets would guarantee that access. Even before the current economic crisis collapsed confidence in such simple faith doubts about this assumption had risen sharply. Energy departments, which had largely been left to wither on the political vine, moved rapidly back into the centre ground of political attention.
About 70% of the greenhouse gas emissions responsible for the accelerating pace of climate change come from the combustion of fossil fuels. The rest come from agriculture, deforestation and other land-use changes. On current projections greenhouse gas emissions from the global energy system will increase by about 50% by 2030. The purpose of the United Nations Framework Convention on Climate Change (UNFCCC) is to reduce those emissions to the point where humanity avoids ‘dangerous’ changes to the climate. Europe’s political leaders have established the threshold of dangerous climate change as a 20C rise in global average temperatures above pre-industrial levels.
To have any chance of stopping at 20C overall emissions will need to peak within a decade and then decline rapidly. Since the emissions from agriculture and deforestation are caused by the decisions of hundreds of millions of individual decision makers they will be very difficult to bring under control. This means that the overwhelming burden of reductions will fall on the global energy system. Effectively, to avoid dangerous climate change the world must develop a carbon neutral energy system by about the middle of the century. This means climate and energy policy must become fully integrated.
This in turn implies the development of what would in effect be a common global energy policy. We face a shared dilemma. Everyone of the 200 plus nations on the planet needs access to secure supplies of affordable energy for its economy to grow in the face of rising population and expectations. If that energy arrives in its current carbon intensive form there is no prospect at all of maintaining the stable climate necessary for economies to grow. To resolve this dilemma we must coordinate global energy policies so as to deliver a carbon neutral energy system within forty years. Just how politically difficult this will be can be seen from the limited extent to which it has been possible within the European Union – with all the pressures of constructing a single market – to achieve an integrated energy policy even without the complications introduced by need to ensure that it is climate compatible.
Meeting the climate challenge successfully requires transformational change in our energy system. The core of the solution lies in making high capital, long life investments in carbon neutral energy technologies. Since a carbon neutral energy system will not be using fossil fuels for transport or for domestic and commercial heating and cooling this implies a huge increase in the already great growth in electricity. Infrastructure investment will be at least as important as investment in generating capacity, in many places, more so. It is difficult to see the scale and pace of the investment required being driven by marginal price signals. Yet this is the primary policy tool governments currently have in mind.
It is clear from the Stern Report that the world can confidently expect to solve this problem without damaging the economy, the 1 – 3% loss of GDP projected by even pessimistic analysts is within the margin of error on GDP calculations. But, there is no doubt that is will significantly alter the pattern of winners and losers within the economy. This may not pose significant economic risks, but it does pose very significant political risks. It is a truism of politics that losers complain loudly and winners offer their thanks quietly, if at all.
There will be vastly more winners than losers but the winners will be an amorphous and disaggregated mass with little political clout while the losers will powerful and well organised companies with major stakes in the status quo. This is a daunting prospect for politicians in today’s headline driven politics. The result will be to intensify their normal reluctance to act decisively on difficult and complex problems. Thus the dominant mode of the political response to climate change will be to prevaricate for as long as possible and then to panic. Long periods of glacial policy making will be interrupted from time to time as events – new science, extreme weather events, charismatic leaders – occur that precipitate spasms of rapid response.
This will make the already difficult task of forecasting carbon prices even more difficult. The early days of any new market are inevitably accompanied by price volatility as traders learn to make sound judgements. This is already clear from the short history of the current carbon market. It would be difficult enough to judge accurately the impact of climate policy on carbon prices if the policy context was mature and stable. But that context is neither mature nor stable.
Compounding the difficulty is the task of evaluating a completely new dimension of political risk. There are no tried and tested methodologies for assessing the likelihood of international agreements being reached. How is the willingness of the EU countries to continue with its present climate policy suite if there is no agreement to a ‘global deal’ in Copenhagen to be factored into the carbon price to be used to today in making a several billion dollar investment with a thirty year life? Clearly, if climate policies are successful, the volatility of carbon prices will decline. But how do you tell the difference between a world of policy success and one of policy failure?
It is difficult to see the scale and speed of the transformational energy investments necessary to meet the climate challenge being made in the face of a carbon price that is so uncertain – and potentially has no yet discernible upper limit – and so volatile. As this becomes more apparent and the pressure on governments to act increases, there will be an increasing likelihood that governments will look to other policy measures to address the problem without worrying over much about what that does to the carbon price.
Forests provide early illustration of the kind of tensions that could emerge. Conservationists concerned to preserve tropical forests for their biodiversity have been quick to spot the potential to create an economic value in keeping the forest standing by marketing carbon credits based on avoided emissions if the forest is cut. They have argued that the climate policy regime should allow these credits to be traded. This has led others to fear that the scale of credits thus made available would so depress the carbon price as to make it useless for driving low carbon investment in the energy sector.
All of these considerations and more will be in the melting pot in Copenhagen at the end of next year. It is not at all clear, even before the current chaos in the international financial system, that the political conditions for a successful ‘global deal’ were present. Normally, international treaties are outputs from political agreements not inputs to them. In this case we seem to have reversed the process and are hoping that the need to make a deal will generate the political conditions for agreement. Whatever the prospects were before the financial chaos began, they have not been improved by it.
No leader will want to leave Copenhagen without having saved the world so agreement will be declared whatever actually happens. Whether this will amount to the differentially interpretable text we have seen emerging from recent G8 meetings or to something closer to a substantive agreement remains to be seen. All negotiations become hugely disorderly in the end game. Copenhagen will be no exception. The biggest risk is that in the confusion there will be a failure to agree a second commitment period for the Kyoto Protocol or an exact equivalent. Should this happen, it will be the carbon market that will quickly cut through the spin to reveal, via the post-2012 carbon price, what really happened in the politics.