Energy and Systemic Risk
There will soon be eight billion of us sharing this planet. All of us looking to live prosperous and secure lives in which to enjoy the extraordinary benefits that knowledge and technology are already making possible and could do so even more in the future.
We also know that these benefits are being bought at the price of growing stress on the bio-geochemical systems that support all of life on earth. We have become increasingly aware over the past four decades that they are not fairly shared among us.
The United Nations Sustainable Development Goals (SDGs) are a remarkable instance of the capability of our species to grasp the nature of the challenges we face and to devise innovative and, perhaps more importantly, cooperative, ways to tackle them. They set out a broad prospectus for what we must do to reduce the stress of human expectations on the earth and to build at the same time a fairer world.
We learnt the hard way in the 19th Century that if you wanted to economy to grow you had to invest in maintaining social cohesion as a system condition for prosperity. By the late 20th Century we had begun to grasp that you must also maintain the productivity of the natural resource base of the economy. Another system condition for prosperity. ‘Sustainable Development’ is simply economic development which maintains both the social and environmental conditions necessary for it to continue.
The world’s current model of development is manifestly unsustainable. The scientific community has shown that we are rapidly approaching breaches in the environmental system conditions. In effect, we are entering a new geologic era, the Anthropocene, defined by the impact of human activities on natural systems.
Of all those systems, the one that matter most is the climate. The whole of recorded human history has occurred within a benign climate whose stability is now being disrupted by our badly managed release of greenhouse gases into the atmosphere.
The SDGs 17 goals chart a high-level course to put us on track to sustainable development. Of all of those goals SDG 7, ‘affordable clean energy’ is the most urgent. If we cannot deliver energy that is affordable, we will not be able to maintain social cohesion. If we cannot deliver energy which is clean, we will not be able to avoid dangerous climate change. If the only way to deliver affordable energy services to eight billion people is to burn fossil fuels, then we cannot avoid dangerous climate change.
This is a true dilemma. Whichever of its horns you choose, you lose. If, like many governments and large institutions, you try to avoid making any choice, you lose twice as both horns wound. The only way to deal with a true dilemma is to step out from between the horns. That requires imagination, innovation and investment.
Engineers understand systemic risk. Most of us do not. Systemic risk is a consequence of a high level of interdependence in the components of a system. In such systems the failure of a single component not itself critical can trigger a cascade of subsequent failures that lead to the failure of the whole system – an aeroplane in flight for example.
Bankers did not understand systemic financial risk until 2008. Then the level of interdependence between banks had become so great that the failure of just one bank – Lehmann Brothers – triggered a near collapse of the whole global banking system. When you Google ‘systemic risk’ today the most searched for entries are about financial risk not engineering risk.
The financial community is now beginning to understand systemic risk. This may help to explain why it is now playing a leading role in responding to climate change.
Political Instability and Climate Change
We all understand now that the whole global economy nests within the global financial system. Money, especially in the form of capital for investment, really does make the global economy go around. If the money stops going around, the global economy grinds to a halt. But political stability is a system condition for the global financial system to work. Nothing stops investment more completely than political instability.
What is becoming clear, especially in the light of the latest report from the Intergovernmental Panel on Climate Change (IPCC) is that political instability is an inevitable consequence of dangerous climate change. This makes a stable, or at least manageable, climate a system condition for political stability, which is itself a system condition for a functioning global financial system which is in turn a system condition for the global economy.
Climate change is not just another environmental problem, to be dealt with by Environment Ministers. Decarbonising the economy, rapidly, is a strategic imperative for ensuring prosperity and security for all eight billion of us. It can only be dealt with successfully if climate policy is driven from the centre of governments.
Over the past three decades the IPCC has produced six reports on the state of the global climate. Each one has found that we are changing the climate faster than we first thought and that the consequences for humanity, indeed, all life on earth, are worse than we first thought.
Its latest report, published towards the end of 2018, makes clear that if we are to avoid catastrophic climate change, we need to fully decarbonise our economy by the middle of the century. We already know what we must do to have a chance of getting there. Simply, we must stop burning fossil fuels.
On its own this is not enough. It will decarbonise the energy system but not the whole of the economy. But decarbonising the energy system will buy us the time to tackle the more difficult challenges of non-energy emissions and those from agriculture and de-forestation.
At first sight this looks like an impossible task: too big a change of technology in too short a time and too expensive. Looked at more closely, it remains very difficult but not impossible. The biggest obstacles are neither engineering nor money.
Forecasting Energy Demand
We can make a good start by being less intellectually lazy in the way we forecast energy demand growth. The typical projections made by the IEA, the EIA and all the fossil fuel companies share a similar, highly misleading flaw. They all show something like a doubling of global energy demand by mid-century.
Fossil fuels are projected to meet most of this demand. Renewables will play a bigger but still relatively small part. Not meeting this demand would deprive millions of people of modern energy services and be immoral. The scale and pace of change needed to replace fossil fuels is simply too great to be met by mid-century.
These forecasts conceal more than they reveal about the future. Demand in all of them is projected as primary energy demand, calculated by measuring all forms of energy as billions of tonnes of oil equivalent. This may be very reassuring to oil company executives but to digital entrepreneurs this looks like a massive opportunity for disruption.
Up to 70% of that primary energy demand is waste heat which we do not have to replace with something else in order to meet the requirement of all of us for energy services. In the real world, as opposed to our models, the task of keeping the climate safe, if difficult, is much less demanding than we often think.
Renewables have a far bigger role in a decarbonised energy system than these misleading projections would have you believe. It will be much easier to mobilise political and financial support for decarbonising our energy system if we make more realistic forecasts of energy demand. This is not to minimise the difficulty of the overall task, only to suggest that the engineering and technology aspects of dealing with climate change are not the hardest part. Nor is affording the transition.
Whenever the cost of preventing dangerous climate change is raised it is accompanied by very large numbers of dollars: so large, it looks like an impossible sum for our economy to afford. However, the models used to estimate these costs are nothing like as reliable a guide to public policy as the models we use to understand the climate. Their outputs, as their authors often recognise and editors overlook, are hugely dependent on the socio-economic assumptions made.
They ask a rather academic question. ‘How much bigger or smaller would the global economy be if we took carbon out of the energy system and would this be a price worth paying for the avoided damage?’
Leaving aside the highly speculative nature of any estimate of the damage climate change might do, this is not hugely useful to policy makers and others faced with the existential challenge of preventing climate change. Climate policy makers have to answer a much more prosaic question: ‘How can we mobilise enough investment at a sufficient scale to keep the climate safe in the time we have available?’
A Portfolio of Options
One popular idea for tackling this issue is to put a price on carbon, preferably a global price. A carbon price can certainly help but is not enough on its own to drive carbon neutral energy investment to scale. A unique characteristic of climate policy is that we not only have to get to a specific goal – a zero carbon economy – but we have to get there by a specific time – the middle of this century.
We have yet to arrive at any firm conclusions about what that price might have to be to get us there. This is more than a mere technical difficulty. If you set the price too low, you risk not getting the right outcome in time. If you try to set it high enough to guarantee the right outcome in the right time you run the risk of massive political opposition and huge damage to social cohesion.
Furthermore, getting nations to agree to harmonise their tax policy is a far more difficult proposition politically than getting them to harmonise their emissions policy. So there is a further risk of making your economy less competitive. It seems increasingly clear that those calling for a global carbon price are either economists for whom theory has triumphed over experience or fossil fuel interests seeking to avoid other policy constraints.
Building a carbon free energy system is a collection of aligned tasks that will be financed in different ways and require different kinds of innovation.
Four main tasks are central to decarbonising the global energy system: energy efficiency, power, transport and heating and cooling. The policy regimes and the required blend of public and private finance to go to scale are different for each task and will differ from place to place.
Of these, improving energy efficiency is the fastest and highest value way to decarbonise energy use. It is a direct assault on the vast untapped resource of waste heat that accompanies the burning of fossil fuels.
The IEA has recently published a report showing that currently cost-effective efficiency measures with available technologies could result in lower emissions than today despite a doubling in size of the global economy. Amory Lovins, who has been right about energy futures more than most analysts, thinks this is hopelessly unambitious. In his view, taking a design driven systems approach to energy efficiency offers a far larger potential than can be seen through conventional economic modelling.
This is a policy option in which, combined with regulatory reform, relatively small amounts of public finance can leverage very much larger private investments.
For power and transport the very rapid and largely unforeseen fall in technology costs is already attracting very significant private investment into making the transition to carbon neutrality. The challenge for a successful climate policy is to accelerate the rate at which this transition is occurring by investing in the low carbon public infrastructure and regulatory frameworks to accelerate this investment.
In both these sectors, a relatively small number of decisions makers are making capital intensive decisions where the cost of capital is a far more significant influence on the rate of deployment than the cost of carbon. There is a role here for a national carbon price, not as a signal to these markets, but as a source of public revenue which can be used to help lower the cost of capital to less well understood, and therefore higher risk, renewable technologies. This, too, will accelerate deployment.
In both these cases, electrification is central to the transition away from fossil fuels. This will require a system redesign to value flexibility, and capital productivity, rather than scale in its generator suite. Something that today’s sophisticated sensors and data handling capacities now makes possible.
Dealing with heat and cooling is among the more difficult parts of the energy system to decarbonise. This is chiefly because it requires the alignment of decisions by a disaggregated set of decision makers. Here, it is the aggregation of a host of individual decisions that is important, not each individual decision in itself. A carbon price alone will not achieve this goal either. But it could support an integrated package of measures including regulation, standard setting and some public investment.
Last year the world invested $1.7 trillion dollars in energy. This is less than 2% of the world’s GDP for 2017. We know the world can afford the meet existing energy demand with its current expensive, inefficient and predominantly fossil fuel resources as it is already doing so. Successful climate policy will simply divert an increasing proportion of that spend into building a carbon neutral energy system.
As we decarbonise the energy system, we increasingly decouple the demand for modern energy services from primary energy demand. There is no a priori reason to suppose that a more efficient climate safe energy system would require more annual investment than we already know we can afford.
Investor Activism: momentum swings
Furthermore, there are growing signs that the financial institutions, both public and private have begun to grasp the full significance of climate change for financial stability. President Trump’s announcement that the United States would withdraw from the Paris Agreement attracted a torrent of critical headlines. Few people noticed a far more significant announcement three days earlier.
Three of the world’s largest asset managers – Blackrock, State Street and Vanguard – announced that they were voting against the Board of Exxon because it had not disclosed sufficient information about its exposure to climate risk. When Larry Fink and his peers want to send a message to the Board of Exxon, they invite the Chairman to come to their offices for a meeting. They do not communicate through the media. This public vote was intended more as a signal to the wider financial markets of how they saw the impact of climate change on the risk landscape. One of its immediate effects was to boost the internal status of sustainable investment units throughout the capital markets.
Risk is always accompanied by opportunity. As investor concern about the risks of a changing climate grows so, too, does their appetite for the opportunities that decarbonisation will generate. As their experience of both the risks and opportunities presented by climate change matures so too will their ability to make better judgements on the price of capital for decarbonisation and where best to allocate it to generate reliable returns.
The leading managers of private capital flows are not alone in recognising the potential risks of climate change. They are adding their voices to the central bankers who began to engage seriously with climate change just before the meeting of the Climate Convention in Paris in 2015. In a now famous speech Mark Carney, Governor of the Bank of England, spoke of the ‘tragedy of the horizon’ that climate change presents: the prospect that by the time it is obvious to all that we must decarbonise the economy it will too late to avoid dangerous climate change.
His concern was that climate change poses a significant and under recognised threat to macro-economic stability. His intervention led to the establishment of the Taskforce on Climate Related Financial Disclosures. This has now established global guidelines on how companies should report on the risk climate change poses to their business. They will enable investors to make better informed judgements of how to minimise their exposure to climate risk and how to identify better returns from decarbonisation.
These guidelines are currently voluntary but there are already signs that they may become mandatory. Recently the UK’s Financial Conduct Authority and the Prudential Regulation Authority both issued reports discussing how financial regulators will take climate change into account.
These measures to redirect the flow of private capital in response to climate change are being complemented by the Multilateral Development Banks (MDBs). These government owned bodies deploy large sums of public capital to promote economic development around the world. They play a significant role in advising countries on their economic pathways and leveraging private capital. The six largest MDBs have committed to align their financial flows to help deliver the outcome of the Paris Agreement. They are already coming under pressure to do more to fulfil this commitment. An index of their performance relative to each other in creating this alignment was recently published by a think tank.
These developments on climate change within the financial community have occurred with remarkable speed for a traditionally conservative sector. They mark a striking depth of understanding of the potential for dangerous climate change to disrupt the economy and a surprising willingness to redirect financial flows to meet this challenge.
If climate policy fails – by which I mean if we fail to keep the eventual rise in global average temperatures below 2°C – it will not be because we lack either the technology or the capital to succeed. It will be because we lack the political will to deliver the technology and capital on time.
Decarbonising the energy system will create a great number of jobs and opportunities for businesses. But they will not be jobs and opportunities for the same people, in the same places, with the same skills as fossil fuels. To get the politics of climate change right we must also think through the social adjustment that will accompany the technology and investment changes. That will also have to be paid for and provides yet another reason for national carbon taxes to be used to produce revenues rather than signals.
December 30th 2018
This article was originally published by the Oracle Partnership