The empirical evidence on trade and location decisions, however, suggests that only a small number of the worst affected sectors have internationally mobile plant and processes. Moreover, to the extent that these firms are open to competition this tends to come predominately from countries within regional trading blocs. This suggests that action at this regional level will contain the competitiveness impact.
Trade diversion and relocation are less likely, the stronger the expectation of eventual global action as firms take long-term decisions when investing in plant and equipment that will produce for decades.
International sectoral agreements for GHG-intensive industries could play an important role in promoting international action for keeping down competitiveness impacts for individual countries.
Even where industries are internationally mobile, environmental policies are only one determinant of plant and production location decisions. Other factors such as the quality of the capital stock and workforce, access to technologies, infrastructure and proximity to markets are usually more important determinants of industrial location and trade than pollution restrictions.
11.1 Introduction
All economies undergo continuous structural change through time. Indeed, the most successful economies are those that have the flexibility and dynamism to cope with and embrace change. Action to address climate change will require policies that deter greenhouse gas emitting activities, and stimulate a further phase of structural change.
One concern is that under different speeds of action, policies might be disproportionately costly to countries or companies that act faster, as they might lose energy-intensive production and exports to those who act more slowly. This could lead to relocation that simply transfers, rather than reduces, global emissions, making the costs borne by more active countries self-defeating.
Even where action is taken on a more uniform collective basis, concern remains that different countries will be affected differently. Some countries have developed comparative advantages in GHG-intensive sectors and would be hit hardest by attempts to rein-in emissions and shift activity away from such production.
The “competitiveness” of a firm or country is defined in terms of relative performance. An uncompetitive firm risks losing market share and going out of business. On the other hand, a country cannot “close”, but low competitiveness means the economy is likely to grow more slowly with lower real wage growth and enjoy fewer opportunities than more competitive economies. At the national level, promoting competitiveness means applying policies and re- vamping institutions to enable the economy to adapt more flexibly to new markets and STERN REVIEW: The Economics of Climate Change 1
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opportunities, and facilitate the changes needed to raise productivity. Carefully designed, flexible policies to encourage GHG mitigation and stimulate innovation need not be inconsistent with enhancing national competitiveness. On the contrary, the innovation associated with tackling climate change could trigger a new wave of growth and creativity in the global economy. It is up to individuals, countries, governments and companies to tailor their policies and actions to seize the opportunities.
Section 11.2 looks at the likely distribution of carbon costs across industrial sectors and assesses their exposure to international competition. Section 11.3 examines evidence behind firms’ location decisions and the degree to which environmental regulations influence trade patterns. Climate change policies may also help meet other goals, such as enhanced energy security, reduced local pollution and energy market reform and these issues are addressed in detail in the next chapter.
11.2 Distribution of costs and implications for competitiveness
To assess the likely impact of carbon costing, a disaggregated assessment of fossil fuel inputs into various production processes is required. For many countries, this can be by analysing whole economy disaggregated Input-Output tables. Using the UK as a detailed case study, direct and indirect carbon costs can be applied to various fossil fuel inputs, and traced through the production process, to final goods prices (see Box 11.1). This reveals the carbon intensity of production. It also gives a crude estimate of the final impact on total consumer prices, and so reflects the reduction in consumer purchasing power1.
The impacts of action to tackle climate change are unevenly distributed between sectors
Input-Output tables can be used to look at the distribution of carbon costs across sectors of the economy. For illustrative purposes, the UK, with energy intensity close to the OECD average, is used as a case study of disaggregated cost impacts. However, the lessons drawn for the UK need not be applicable to all countries, even within the OECD.
An illustrative carbon price of £70/tC ($30/tCO2)2 can be traced through the economy's disaggregated production process, to final consumer prices. Adding the carbon price raises the cost of fossil fuel energy in proportion to carbon intensity of each fossil fuel input (oil, gas and coal) see Box 11.1.
The overall impact is to raise consumer prices by just over one per cent on the assumption of a full cost pass-through. However, the impact on costs and prices in the most carbon- intensive industries, either directly or indirectly through, say, their consumption of electricity, is considerably higher. In the UK, six industries out of 123 would face an increase in variable costs of 5% or more as a result of the impact of carbon pricing on higher energy costs (see table 11A.1 at end). In these industries prices would have to rise by the following amounts for profits to remain unchanged: • • • • •
1 gas supply and distribution (25%); refined petroleum (24%); electricity production and distribution (16%); cement (9%); fertilisers (5%);
This assumes no behavioural response and no substitution opportunities and 100% pass through of costs. It is in theory possible to use older full supply-use Input-Output tables and the inverse Leontief matrix to gauge the rough magnitude of higher order indirect impacts. The study has not done this, but extending the analysis to include more multipliers shows the numbers converging to zero quite quickly, suggesting this analysis offers a close approximation. 2 drawn for different carbon costs. Ideally this figure should correspond with the social cost of carbon (see Chapter 13), which to put it into context, is slightly above prices quoted in the European Emissions Trading scheme – ETS – over the much of the past year. It is important to distinguish tonnes of carbon from carbon dioxide as the two measures are used interchangeably. £1/tC = £0.273/tCO2 so £70/tC = £19/tCO2. Exchange rates are calculated at 2003 purchasing power parities. STERN REVIEW: The Economics of Climate Change 2
ga rti fin ise ed tro leu tra ct io pr El tri as ro Co di str ut io itr en Fi Re fin ric sh ul in tu ,f or try Ch Cem en ica pe ls leu pr Fe El rti lis ste Ga Tr sd tri ec an ist cit or y rib t (p ut ro io d/ ds Part III: The Economics of Stabilisation • fishing (5%) Although this analysis is restricted to the UK, it is these same industries, together with metals, chemicals, paper/pulp, and transport that dominate global carbon emissions from fossil fuels the world over. The competitiveness impacts in these sectors will be reduced to the extent that they are not highly traded. In the UK, combined export and import intensity for these sectors is below 50% (see Box 11.3)3. Box 11.1 Potential costs to firms and consumers; UK Input-Output study The primary users of fossil fuels (oil, gas and coal) as direct inputs include refined petrol, electricity, gas distribution, the fossil fuel extraction industries and fertiliser production. Figure A shows the share of oil & gas and coal in variable cost for these primary users.
Input-Output analysis can trace the impact of carbon pricing on secondary users of oil, gas and coal – defined as those industries that use inputs from the primary oil, gas and coal users such as electricity. Outputs from these sectors are then fed in as inputs to other sectors, and so on. For illustrative purposes, Figure B shows the impact of a carbon price of £70/tC, but the effects are linear with respect to price and so different impacts for different prices can be assessed using the appropriate multiple. Chapter 9 showed that although the average abatement cost may fall as new technologies arise, the marginal abatement cost is likely to rise with time, reflecting the rising social cost of carbon as the atmospheric carbon stock increases. As industry becomes decarbonised, the whole-economy impact is likely to begin to fall. But going the other way will be the rising social cost of carbon and the corresponding marginal abatement cost (this is illustrated in Box 9.6). This will have an increasing impact on costs in remaining carbon-intensive sectors. Figure A Share of oil & gas and coal extraction in variable costs, percent Figure B Product price increases from £70/tC pricing (full pass-through), percent 0 20 100 80 60 40 O il a nd s ex Re Fe l
m pe rs
n od ec cit y d/ ds G
(p ib
) al
n Cem t Gas Coal Oil 30
20
10 Ag re g
es ed m od em tro t Iro na nd el ers itr) 0
sp n Gas Coal Oil 3 The largest users of petroleum-products include agriculture, forestry and fishing, chemicals and the transportation sectors. The main users of coal are electricity and cement. The main users of electricity include the electricity sector itself, a number of manufacturing industries and the utilities supplying gas and water.
Total fossil fuel energy costs account for 3% of variable costs in UK production. When the illustrative carbon price of £70/tC ($30/tCO2) is applied, whole economy production costs might be expected to rise by just over 1%. Only 19 out of 123 sectors, accounting for less than 5% of total UK output, would see variable costs increase of more than 2% and only six would undergo an increase of 5% or more4.
Mapping costs through to final consumer goods prices, the aggregate impact on consumer prices of a £70/tC would be of the order of a 1.0% one-off increase in costs, with oil‘s contribution accounting for just under half and the remainder split between gas and coal5.
Trade intensity defined as total and exports of goods and services as a percentage of total supply of goods and services, plus imports of goods and services as a percentage of total demand for goods and services. Output is defined as gross, so the maximum value attainable is 200. 4 5 STERN REVIEW: The Economics of Climate Change 3
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Electricity and gas distribution for example are almost entirely domestic, and to the extent energy intensive industries do trade, this is mostly within the EU. Trade intensity falls by a factor of two to seven for the key energy-intensive industries when measured in terms of non- EU trade only. See Annex table 11A.1 for details of trade intensity among carbon-intensive activities. Nevertheless: •
•
• The magnitude of the impact on a small number of sectors is such that it could provide incentives for import substitution and incentives to relocate to countries with more relaxed mitigation regimes, even though these sectors are not currently characterised by high trade intensity. Further, many industries suffering smaller price increases are more open to trade: these include oil and gas extraction or air transport. The competitiveness impacts will be reduced if climate change action is coordinated globally.
It is likely that some sectors (for example steel and cement or even electricity for a more inter-connected country) may be more vulnerable in countries bordering more relaxed mitigation regimes. Such countries should conduct similar Input-Output exercises to assess the vulnerability of their tradable sectors.
In addition, there is a problem of aggregation. Aluminium smelting for example is among the most heavily energy-intensive industrial processes. Yet the upstream process is classed under broader ‘non-ferrous metals’ (of which aluminium accounts for around half). Hence although it is correct to conclude that overall value-added is not at much as risk, to infer that aluminium production is not at risk would be wrong. In general, upstream metal production tends to be both the most energy-intensive and tradable component, something that analysis at broad level of aggregation may not reveal.
The forgoing analysis offers an indication of the distribution of static costs among various sectors from pricing-in the cost of GHG emissions. However, there is a risk that action to reduce GHG emissions could generate dynamic costs, for example, scrapping capital prematurely and de-skilling workers might retard the economy’s ability to grow. Before assessing these costs, it is important to re-emphasise that under ‘business as usual’ policies, dynamic costs relating to early capital scrapping and adjustment are liable to be even larger in the medium term. Timely investment will reduce the impact of climate change. Chapter 8 showed that a smooth transition to a low GHG environment with early action to reduce emissions is likely to limit adjustment costs.
The dynamic impacts from a transition to a low-GHG economy should be small. The change in relative prices that is likely to result from adopting the social cost of carbon into production activities is well within the ‘normal’ range of variation in prices experienced in an open economy. Input cost variations from recent fluctuations in the exchange rate and the world oil price, for example, are likely to far exceed the short-run primary energy cost increases from a carbon tax required to reflect the damage from emissions (see Box 11.2). rough magnitude of this higher order indirect impact. Because data disaggregated to a level commodity output per unit of domestically met final demand has not been published in the UK since 1993, the study has not adopted this approach and has not been able to follow the impact through the entire supply-chain. However, extending the analysis to include more multipliers seems to make little difference to the results, suggesting the numbers presented here are a close approximation to the price impacts that would be derived using an up-to-date inverse Leontief. STERN REVIEW: The Economics of Climate Change 4
Box 11.2 Part III: The Economics of Stabilisation
Vulnerability to energy shocks: lessons from oil and gas prices Past energy price movements can be used to illustrate the likely economic impact of carbon pricing. Energy costs constitute a small part of total gross output costs, in most developed economies under 5%, in contrast to, say, labour costs, which account for up to a third of total gross output costs. Nevertheless, past movements in energy costs can offer a guide to the potential impact of carbon proving.
UK I-O tables show that oil and gas together account for more than ninety percent of UK fossil fuel energy consumption, but only three-quarters of fossil fuel emissions, as coal is more carbon-intensive. The I-O data reveal that a £10/tC ($4/tCO2) carbon price would have a similar impact on producer prices as a $1.6/bl rise in oil prices with a proportionate gas price increase.
To put this in context, the sterling oil price has risen 240% in real terms from its level over most of the period 1986-1997($18/bl) to around $69/bl (as of May 2006), and by 150% in real terms since 2003 (average), when the price of Brent crude hovered at around $26/bl for most of the year. On this basis, the change in the real oil price since 2003, assuming a proportionate changes in gas prices, is likely to have had a similar impact on the economy as unchanged oil and gas prices and the imposition of a £260/tC ($132/tCO2) carbon price6. Or, alternatively, a £70/tC ($30/tCO2) carbon resource cost is likely to have a similar impact as a $11/bl real oil price increase (at 2003 prices), according to I-O tables.
Gross estimate of impact on UK consumer prices and GDP* Brent spot price $ per barrel (real) % change Consumer prices, GDP % change (prod'r prices) £/T carbon $/T CO2 2003 average, 26.3 38 40 60 80 100 0 30 37 90 143 196 0.0 0.9 1.1 2.6 4.2 5.8 Equivalent Carbon cost *Uses 2003 prices and Input-output tables; assumes no substitution in producer processes or consumption patterns and assumes all revenues are lost to economy. Source: Stern using 2003 UK Input-Output tables, Carbon Trust carbon intensity and UK DTI energy price statistics.
In practice, the overall impact on GDP from oil and gas price rises is likely to have been far smaller than suggested here at the national and global level. This is because the rise in the oil price in part reflects a transfer of rent to low marginal cost oil exporters, who in turn will spend more on imported goods and services from oil-importers. The presence of rent in the oil price means the impact on GDP is likely to be over-estimated even for oil importers. Furthermore, to the extent that carbon taxes generate transfers within the economy, the impact on GDP will also be exaggerated. Finally, the use of fixed Input-Output tables assume consumer and producer behaviour is static.
In practice, costs will be lowered as firms and consumers switch out of more expensive carbon-intensive activities. Consequently, the total impact of both carbon pricing and oil price changes on GDP will be lower than the numbers presented here, which should be regarded as an illustrative upper-end estimate of the costs of mitigation in the energy sector for applying any given carbon price. 0 70 84 206 329 451 0.0 -1.2 -1.5 -3.6 -5.7 -7.9 6 The exercise assumes that gas prices change in full proportion with oil prices, but that coal prices remain unchanged. In reality oil and gas prices tend to co-move as they are partial substitutes within a fossil fuel energy market and are linked contractually. STERN REVIEW: The Economics of Climate Change 5
Oct-91 Oct-93 Oct-95 Oct-97 Oct-99 Oct-01 Oct-03 Oct-05 50
40
30
20
10 70
60 Carbon price equivalent £260/TC
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The recent rise in the Brent spot price, US $ per barrel (2003 prices)
£300/TC
£250/TC
£200/TC Source: Ecowin, Stern
The economic literature investigating the impact of energy cost changes focuses disproportionately on resource, capital and energy-intensive sectors and firms. While this is understandable from a policy perspective, since regulation is likely to disproportionately affect these sectors, it also indicates a significant gap in data on other sectors in particular services, which constitute up to three quarters of some developed economies output.
The analysis also assumes that carbon costs are fully passed through to final prices. In practice this need not be the case, especially for tradable sectors that face sensitive demand and are likely to “price-to-markets” to avoid a loss of market share. In addition, the presence of competing inputs, and the opportunity to change processes and reduce emissions, also serve to limit the impact on both profits and prices. However, this analysis still gives an indication of which sectors are most vulnerable to a profit squeeze if carbon pricing is applied to emissions.
The nature of the policy instrument and the framework under which it is applied will also lead to sectoral distributions of costs. For example: •
•
•
7 Who bears the costs/gains from emissions trading depends on whether the allowances are auctioned or given out for free.
The scope of trading schemes also matters. The EU ETS, for example, extends to primary carbon-intensive sectors, but does not allocate permits to secondary users, such as the aluminium sector, which relies heavily on electricity inputs7.
The structure of the electricity market also helps determine outcomes. In highly regulated or nationalised electricity markets, for example, carbon costs are not necessarily passed through, in which case the impact would be felt through the public finances. With regulation limiting cost pass-through in a private sector industry, there will be a squeeze on profits with impacts felt by shareholders. Different impacts will be felt across the globe, but the analysis here gives an indication of the sectors likely to be directly affected.
For analysis of the structure and impact of the EU ETS see: Frontier Economics (2006); Carbon Trust (2004); Grubb (2004); Neuhoff (2006); Sijm et al. (2005) OXERA (2004) and Reinaud (2004).
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International sectoral agreements for such industries could play an important role in both promoting international action and keeping down competitiveness impacts for individual countries. Chapter 22 shows how emissions intensities within sectors often vary greatly across the world, so a focus on transferring and deploying technology through sectoral approaches could reduce intensities relatively quickly. Global coverage of particular sectors that are internationally exposed to competition and produce relatively homogenous products can reduce the impact of mitigation policy on competitiveness. A sectoral approach may also make it easier to fund the gap between technologies in developed and developing countries.
Countries most reliant on energy-intensive goods and services may be hardest hit.
The question of the distribution of additional costs applies to countries also. Some small agricultural or commodity-based economies rely heavily on long-distance transport to deliver products to markets while some newly-industrialising countries are particularly energy- intensive. Primary energy consumption as a percent of GDP is generally three or four times higher in the developing world than in the OECD8, though in rapidly growing sectors and countries such as China and India, primary energy consumption per unit output has fallen sharply as new efficient infrastructure is installed (see Section 7.3). Some of these countries may benefit from energy efficiency improvements and energy market reforms that could lower real costs, but the distribution of costs raises issues relating to design of policies and different speeds of action required to help with the transition in certain countries and sectors (see Part VI).
The impact on oil and fossil fuel producers will depend on the future energy market and the rate of economic diversification in the relevant economies during the transition, which will open up new opportunities for exploiting and exporting renewable energy and new technologies such as carbon capture and storage. Producers of less carbon-intensive fossil fuels, such as gas, will tend to benefit relative to coal or lignite producers.
Where transfers are involved, the extra burden on rich countries need not be significant given the disparities in global income. For illustration, assume GHG stabilisation requires a commitment of 1% of world GDP annually to tackle climate change. If, in the initial decades, the richest 20% of the world’s population, which produce 80% of the world’s output and income, agreed to pay 20% more – or 1.2% of GDP, this would allow the poorer 80% of the worlds population to shoulder costs equivalent to only 0.2% of GDP9. Similarly, transfers to compensate countries facing disproportionately large and costly adjustments to the structure of their economies could also be borne at relatively small cost, if distributed evenly at a global level. Questions of how the costs of mitigation should be borne internationally are discussed in Part VI of this report.
11.3 Carbon mitigation policies and industrial location
The impact on industrial location if countries move at different speeds is likely to be limited
The transitional costs associated with implementing GHG reduction policies faster in one country than in another were outlined in the previous section. In the long run, however, (when by definition, resources are fully employed and the impact for any single country is limited to the relocation of production and employment between industries), openness to trade allows for cheap imports to substitute domestic production in polluting sectors subject to GHG pricing. This is likely to reduce the long-run costs of GHG mitigation to consumers, while some domestic GHG-intensive firms that are relatively open to trade lose market share. 8 9 International Energy Agency (2005). OECD economies account for 15% of the world’s population and just over 75% of world output in terms of GDP at current prices using World Bank Statistics (2004). Use of market prices overstates the real value of output in rich countries relative to poorer countries because equivalent non-tradable output in general tends to be cheaper in poorer countries. However, in terms of ability to transfer income globally at market exchange rates, market prices are the appropriate measure. STERN REVIEW: The Economics of Climate Change 7
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A reduction in GHG-intensive activities is the ultimate goal of policies designed to reduce emissions. However, this aim is most efficiently achieved in an environment of global collective action (see Part VI). This is because if some countries move faster than others, the possible relocation of firms to areas with weaker GHG policies could reduce output in countries implementing active climate change policies by more than the desired amount (that is, the amount that would prevail in the case where all countries adopted efficient GHG policies). At the same time, global emissions would fall by less than the desired amount if polluters simply re-locate to jurisdictions with less active climate change policies10.
This risk should not be exaggerated. To the extent that energy-intensive industry is open to trade, the bulk of this tends to be limited to within regional trading blocks. UK Input-Output tables, for example, suggest trade diversion is likely to be reduced where action is taken at an EU level (see Box 11.3). However, several sectors are open to trade outside the EU. To the extent that variations in the climate change policy regime between countries result in trade diversion in these sectors the impact on GHG emissions will be reduced. Box 11.3 The risk of trade diversion and firm relocation – a UK Input-Output case- study
By changing relative prices, GHG abatement will reduce demand for GHG-intensive products. Sectors open to competition from countries not enforcing abatement policies will not be able to pass on costs to consumers without risking market share. The short-run response to such elastic demand is likely to be lower profits. In the long run, with capital being mobile, firms are likely to make location decisions on the basis of changing comparative advantages.
I-O analysis helps identify which industries are likely to suffer trade diversion and consider relocation: in general the list is short. Continuing with the £70/tC ($30/tCO2) carbon price example, the figure below maps likely output price changes against exposure to foreign trade11. With the exception of refined petrol and coal, fuel costs are not particularly exposed to foreign trade. Under carbon pricing, the price of electricity and gas distribution is set to rise by more than 15%, but output is destined almost exclusively for domestic markets. In all other cases, price increases are limited to below – mostly well below – 10%.
Vulnerable industries: price sensitivity and trade exposure, percent 0 20 120
100
80
60
40 0 5 10 15 20 25 30 Electricity Gas distribution Export & import intensity
High direct impact
Refined petrol Cement Transmitters Aerospace Electronics Water Organic transportchemicals Pulp & paper Plastics Iron Steel Gases Fishing
Fertilisers Total industry Price change The bulk of the economy is not vulnerable to foreign competition as a result of energy price rises. However, a few sectors are. Apart from refined petrol, these include fishing, coal, paper Coal 117% price change 10 The ‘desired amount’ refers to the amount consistent with relative comparative advantages in an ‘ideal’ world with collective action, where gains form trade are maximised. 11 imports of goods and services as a percentage of total demand for goods and services. Output is defined as gross, so the maximum value attainable is 200. STERN REVIEW: The Economics of Climate Change 8
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and pulp, iron and steel, fertilisers, air and water transport, chemicals, plastics, fibres and non-ferrous metals, of which aluminium accounts for approximately half of value added. In addition, the level of aggregation used in I-O analysis masks the likelihood that certain processes and facilities within sectors will be both highly energy-intensive and exposed to global competition.
The impact on competitiveness will depend not only on the strength of international competition in the markets concerned, but also the geographical origin of that competition. Many of the proposed carbon abatement measures (such as the EU ETS) are likely to take place at an EU level and energy-intensive sectors tend to trade very little outside the EU.
Trade intensity falls seven-fold in the cement industry when restricted to non-EU countries, as cement is bulky and hard to transport over long distances. Trade in fresh agricultural produce drops by a factor of 5 when restricted only to non-EU countries. The next largest drop in trade occurs in pulp and paper, plastics and fibres. Here trade intensity is quartered at the non-EU level. Trade intensity in plastics and iron and steel and land-transport as well as fishing and fertilisers drop by two-thirds. Trade intensity for air transport and refinery products halves in line with the average for all sectors (complete non-EU trade intensities are listed in Annex table 11A.1). All of these sectors are fossil fuel-intensive; suggesting that restrictions applied at the EU level would greatly diminish the competitiveness impact of carbon restrictions.
Trade diversion and relocation are also less likely, the stronger the expectation of eventual global action. Firms need to take long-term decisions when investing in plant and equipment intended for decades of production. One illustration of this effect is the growing aluminium sector in Iceland. Iceland has attracted aluminium producers from Europe and the US partly because a far greater reliance on renewable electricity generation has reduced its exposure to prices increases, as a result of the move to GHG regulations (see Box 11.4).
Box 11.4 Aluminium production in Iceland
Over the last six years, Iceland has become the largest producer of primary aluminium in the world on a per capita basis. The growth in aluminium production is the result both of expansion of an existing smelter originally built in 1969 and construction of a new green-field smelter owned by an American concern and operated since 1998. The near-future looks set to see a continuing sharp increase in aluminium production in Iceland. Both existing plants have plans for large expansions in the near future. These projects are forecast to boost aluminium production in Iceland to about one million tonnes a year, making Iceland the largest aluminium producer in western Europe.
Power-intensive operations like aluminium smelters are run by large and relatively footloose international companies. Iceland has access to both the European and US aluminium market, but its main advantage is the availability of water and emission-free, renewable energy. Emissions of CO2 from electricity production per capita in Iceland is the lowest in the OECD: 70% of its primary energy consumption is met by domestic, sustainable energy resources. Iceland is also taking action to reduce emissions of fluorinated compounds associated with aluminium smelting. Expectations of future globalisation action to mitigate GHG emissions is already acting as a key driver in attracting investment of energy-intensive sectors away from high GHG energy suppliers and towards countries with renewable energy sources.
The impact on location and trade is likely to be more substantial for mitigating countries bordering large trade-partners with more relaxed regimes, such as Canada which borders the US, and Spain which is close to North Africa. For example, Canada’s most important trading partner, the United States, has not signed the Kyoto Protocol, raising concerns of a negative competitive impact on Canada’s energy-intensive industry.12 However, even for open markets such as Canada and the US, or states within the EU, firms tend to be reluctant to relocate or 12 For an interesting discussions see the Canadian Government’s Industry Canada (2002) report, as well as the representations of the Canadian Plastic Industry Association.
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trade across borders, when they have markets in the home nation. This so-called “home-bias” effect is surprisingly powerful and the consequent necessity for firms to locate within borders to access local markets limits the degree to which they are footloose in their ability to relocate when faced with carbon pricing13.
Theory suggests that country-specific factors, such as the size and quality of the capital stock and workforce, access to technologies and infrastructure, proximity to large consumer markets and trading partners, and other factor endowments are likely to be the most important determinants of location and trade. In addition, the business tax and regulatory environment, agglomeration economies, employment law and sunk capital costs are also key determinants. These factors are unlikely to be much affected by GHG mitigation policies. Overall, empirical evidence supports the theory, and suggests environmental policies do affect pollution-intensive trade and production on the margin, but there is little evidence of major relocations14 15.
Environmental policies are only one determinant of plant and production location decisions. Costs imposed by tighter pollution regulation are not a major determinant of trade and location patterns, even for those sectors most likely to be affected by such regulation.
The bulk of the world’s polluting industries remain located in OECD countries despite tighter emissions standards16. By the same token, 2003 UK Input-Output tables show that around 75% of UK trade in the output of carbon-intensive industries is with EU countries with broadly similar environmental standards, with little tendency for such products to be imported from less stringent environmental jurisdictions.
One way of assessing the impact of environmental regulations is to see if greater trade openness has led to a relocation of polluting industries to poorer countries, which have not tightened environmental standards. Antweiler, Copeland and Taylor (2001) calculated country-specific elasticities of pollution concentrations with respect to an increase in openness over the latter part of the twentieth century (Figure 11.1). A positive value for a country implies that trade liberalisation shifts pollution-intensive production towards that country, in effect signalling that it has a comparative advantage in such production. 13 This was the finding of McCallum’s seminal 1995 paper, further reinforced by subsequent discussions such as Helliwell’s assessment of Canadian-US economic relations, and Berger and Nitsch’s (2005) gravity model of intra-EU trade, both of which found significant evidence of home-bias where borders inhibit trade despite open markets and short distances. 14 environmental regulations and location decisions. See also Levinson et al (2003), Smita et al. (2004) Greenstone (2002), Cole et al. (2003), Ederington et al (2000, 2003), Jeppesen (2002), Xing et al. (2002), UNDP (2005). 15 international location and direct investment decisions – factors such as the availability of infrastructure, agglomeration economies and access to large consumer markets. The study of the influence of air pollution regulations carried out by AEA Metroeconomica found that “it is extremely difficult to assess the impact of air pollution on relocation from the other factors that determine location decisions.” 16 fact alone suggests the location of dirty-good production across the globe reflects much more than weak environmental regulations. See also Trefler (1993) and Mani et al (1997). STERN REVIEW: The Economics of Climate Change 10
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References
General discussions defining competitiveness are few and far between, reflecting the fact that the definition varies depending on the context. An entertaining account of the problems associated with defining “competitiveness” and the limitations to the notion when applied at a national level can be found in Krugman (1994) and at a more applied level in Azar (2005). There are a number of very thorough and well-researched sectoral analyses of the competitiveness impact of climate change policies; particularly informative are Demailly and Quirion’s (2006) study of competitiveness in the European cement industry and Berman and Bui’s account of location decisions in the fossil fuel price sensitive refinery sector. There are also a host of in-depth studies of specific regional policies, in particular the competitiveness impact of the EU ETS. Among the many notable reports listed below are: Frontier Economics (2006); Oxera (2006); Grubb Neuhoff (2006), and Reinaud (2004).
Perhaps the most authoritative and comprehensive account of the evolving literature on firms’ location decisions in the presence of differential national environmental policies can be found in Copeland and Taylor (2004). Smita et al. (2004) and Lowe and Yeats also undertake in- depth analyses of the degree to which environmental regulations influence trade patters. McCallum (1995) and Nitsch and Berger (2005) provide illustrations of the impact of country borders in containing trade, even where borders are open and goods are highly tradable. Antweiler, W., B.R. Copeland and M.S. Taylor, (2001): 'Is free trade good for the environment?' American Economic Review 91(4): 877–908
Azar, C. (2005): 'Post-Kyoto climate policy targets: costs and competitiveness implications', Climate Policy journal 309-328
Berman, E. and L. Bui (1999): 'Environmental regulation and productivity: evidence from oil refineries' Review of Economics and Statistics 2001 83(3): 498-510, available from http://www.mitpressjournals.org/doi/abs/10.1162/00346530152480144
Brunnermeier, S.B. and Cohen M. (2003): 'Determinants of environmental innovation in U.S. manufacturing industries', Journal of Environmental Economics & Management, 45(2): 278- 293
Burtraw, D. (1996) "Trading emissions to clean the air: exchanges few but savings many," Resources, 122 (Winter): 3-6
The Carbon Trust (2004): 'The European Emissions Trading Scheme: implications for industrial competitiveness', London: The Carbon Trust.
The Carbon Trust (2005): 'The UK climate change programme: potential evolution of business and the public sector', London: The Carbon Trust.
Cole, M.A. and R.J.R. Elliott (2003): 'Do environmental regulations influence trade patterns? Testing old and new trade theories' The World Economy 26 (8):1163-1186
Copeland, B.R. and S. Taylor (2004): 'Trade, growth and the environment', Journal of Economic Literature, XLII: 7–71
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Xing, Y. and C.D. Kolstad (2002): 'Do lax environmental regulations attract foreign investment?' Environmental & Resource Economics, 21(1): 1-2 STERN REVIEW: The Economics of Climate Change 14
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Annex table 11A.1 Key statistics for 123 UK production sectors (ranked by carbon intensity).17 Carbon intensity (ppt change at £70/tC) total costs intensity* Export and Energy % Export and import import intensity* Non-EU Percent total UK output Metal ores extraction Private households with employed perso 0.00 0.00 0.00 0.00 67.17 0.78 62.86 0.33 0.00 0.50 Financial intermediation services indire 0.00 0.00 23.82 10.75 -4.68 Letting of dwellings Owning and dealing in real estate Estate agent activities Membership organisations nec Legal activities Market research, management consulta Architectural activities and technical con Accountancy services Other business services Computer services Insurance and pension funds Other service activities Recreational services Health and veterinary services Advertising Footwear Banking and finance Education Auxiliary financial services Transmitters for TV, radio and phone Telecommunications Receivers for TV and radio Social work activities Construction Office machinery & computers Tobacco products Ancillary transport services Medical and precision instruments Pharmaceuticals Leather goods Aircraft and spacecraft Research and development Motor vehicle distribution and repair, aut Renting of machinery etc Printing and publishing Jewellery and related products Retail distribution Confectionery Other transport equipment Hotels, catering, pubs etc Postal and courier services Electronic components Electrical equipment nec Wearing apparel and fur products Public administration and defence Soap and toilet preparations Motor vehicles Sewage and sanitary services Railway transport Made-up textiles Cutlery, tools etc Other food products Electric motors and generators etc Furniture Agricultural machinery Machine tools General purpose machinery Weapons and ammunition Insulated wire and cable Soft drinks and mineral waters Special purpose machinery 0.03 0.08 0.11 0.14 0.16 0.17 0.17 0.20 0.20 0.23 0.24 0.25 0.26 0.26 0.27 0.27 0.27 0.28 0.30 0.30 0.31 0.31 0.31 0.32 0.33 0.33 0.33 0.35 0.36 0.38 0.41 0.42 0.43 0.45 0.45 0.45 0.47 0.47 0.47 0.48 0.48 0.49 0.49 0.49 0.49 0.51 0.52 0.54 0.56 0.56 0.56 0.61 0.61 0.62 0.63 0.64 0.65 0.65 0.67 0.67 0.68 0.07 0.23 0.29 0.37 0.43 0.46 0.47 0.53 0.55 0.60 0.67 0.68 0.64 0.59 0.72 0.60 0.78 0.68 0.73 0.64 0.82 0.63 0.84 0.77 0.69 0.84 0.97 0.80 0.77 0.82 0.90 1.10 1.22 1.25 0.90 0.89 1.26 0.80 1.10 1.26 1.37 0.89 1.10 1.02 1.31 1.15 1.10 1.47 1.40 1.30 1.27 1.47 1.42 1.48 1.48 1.40 1.56 1.31 1.37 1.44 1.59 1.10 0.35 0.11 0.00 11.04 9.44 15.31 6.77 36.76 13.32 10.15 2.28 18.47 1.49 11.46 46.59 7.66 2.88 56.36 100.70 9.28 47.26 0.03 0.23 81.43 15.53 8.03 61.60 77.84 62.28 97.80 46.57 1.04 4.87 14.87 69.70 1.68 17.80 25.34 19.02 5.69 88.97 55.50 36.55 0.96 30.60 61.50 2.33 11.11 20.02 54.00 28.70 65.78 21.64 64.12 74.32 56.89 25.19 53.54 16.32 72.01 0.47 0.20 0.06 0.00 6.58 5.58 8.98 3.96 21.98 5.76 8.10 1.16 10.64 0.63 6.53 21.14 4.56 1.57 35.31 24.66 4.27 24.36 0.02 0.09 31.86 8.03 3.94 33.79 31.70 34.31 64.35 27.48 0.48 2.48 7.02 54.02 0.70 4.48 12.58 8.38 2.71 40.31 24.19 22.00 0.58 8.91 14.54 1.15 4.67 12.84 22.75 7.94 32.83 8.29 19.21 33.24 22.56 14.51 24.58 3.93 35.36 7.90 1.89 0.50 0.59 1.39 1.15 1.95 0.99 3.53 2.93 2.36 0.64 2.87 4.99 0.67 0.03 4.05 6.01 0.88 0.14 2.29 0.08 1.80 6.20 0.24 0.12 1.81 0.56 0.64 0.02 0.54 0.42 2.24 1.07 1.64 0.04 5.73 0.22 0.10 3.32 0.86 0.13 0.21 0.17 5.12 0.20 0.85 0.67 0.29 0.07 0.15 0.26 0.23 0.37 0.05 0.07 0.40 0.06 0.04 0.10 0.27 …/(continued) key statistics for 123 production sectors. 17 by 123 industry Standard Industrial Classification (SIC) level STERN REVIEW: The Economics of Climate Change 15
Part III: The Economics of Stabilisation Carbon intensity (ppt change at £70/tC) total costs intensity* Export and Energy % Export and import import intensity* Non-EU Percent total UK output Meat processing Bread, biscuits etc Mechanical power equipment Knitted goods Domestic appliances nec Alcoholic beverages Paints, varnishes, printing ink etc Rubber products Wood and wood products Sports goods and toys Water supply Pesticides Grain milling and starch Metal boilers and radiators 0.70 0.70 0.71 0.72 0.73 0.73 0.74 0.76 0.77 0.78 0.80 0.80 0.81 0.81 1.80 1.60 1.51 1.48 1.76 1.71 1.67 1.70 1.95 1.94 1.56 1.83 2.01 1.78 21.72 14.22 79.07 74.07 34.84 29.24 29.78 52.40 32.75 20.48 0.42 77.22 22.74 31.36 4.83 2.72 41.72 40.57 13.75 13.36 8.75 17.45 10.07 12.46 0.21 30.00 5.38 7.21 0.34 0.32 0.26 0.04 0.11 0.29 0.12 0.16 0.28 0.05 0.30 0.05 0.10 0.07 Wholesale distribution 0.82 2.48 – – 4.41 Textile fibres Other metal products Plastic products Dairy products Other textiles Other chemical products Carpets and rugs Miscellaneous manufacturing nec & recy Animal feed Fish and fruit processing Metal forging, pressing, etc Textile weaving Shipbuilding and repair Ceramic goods Structural metal products Paper and paperboard products Coal extraction Non-ferrous metals Agriculture Metal castings Forestry Glass and glass products Water transport Articles of concrete, stone etc Plastics & synthetic resins etc Oil and gas extraction Textile finishing Other mining and quarrying Industrial gases and dyes Man-made fibres Other land transport Sugar Organic chemicals Air transport Pulp, paper and paperboard Inorganic chemicals Iron and steel Structural clay products Oils and fats Fishing Fertilisers Cement, lime and plaster Electricity production and distribution Refined petroleum Gas distribution 0.87 0.88 0.90 0.91 0.93 0.96 0.97 0.97 0.99 0.99 1.03 1.04 1.05 1.08 1.09 1.17 1.22 1.32 1.37 1.40 1.44 1.53 1.65 1.73 1.85 1.89 1.95 2.03 2.03 2.21 2.21 2.37 2.38 2.39 2.42 2.58 2.69 2.73 2.86 4.28 4.61 9.00 16.07 23.44 25.36 1.68 2.03 1.99 2.56 1.85 2.22 2.23 2.39 2.34 2.56 2.46 1.78 2.36 2.42 2.47 2.02 7.24 2.36 3.96 2.84 4.18 3.44 5.26 2.96 4.57 5.73 3.34 4.64 4.31 4.60 7.04 3.20 6.27 7.64 4.23 5.64 7.02 6.61 5.87 12.78 13.31 5.00 26.70 72.83 42.90 41.41 42.92 33.69 21.26 55.12 84.83 19.26 22.33 14.74 29.87 0.00 77.76 44.94 42.51 13.27 15.19 33.24 73.75 27.99 0.00 21.64 33.62 81.65 15.97 62.56 53.30 1.76 88.90 49.69 88.19 7.74 28.83 86.31 53.03 66.07 34.51 55.40 3.78 38.48 40.35 25.69 8.11 1.35 25.66 0.32 18.12 18.03 11.10 3.66 19.46 34.01 4.09 13.03 3.35 12.38 0.00 36.85 28.82 18.75 4.56 3.99 24.76 36.90 11.34 0.00 6.90 9.55 28.76 4.67 15.31 30.28 0.80 61.53 20.32 24.96 2.33 22.36 31.19 23.82 16.52 11.75 18.32 0.63 14.49 14.74 9.54 1.20 0.11 11.75 0.18 0.03 0.24 0.63 0.14 0.05 0.17 0.03 0.20 0.07 0.20 0.46 0.03 0.10 0.08 0.30 0.28 0.05 0.10 0.96 0.07 0.03 0.14 0.24 0.25 0.12 2.06 0.03 0.16 0.09 0.02 1.94 0.04 0.17 0.55 0.10 0.06 0.12 0.04 0.02 0.04 0.02 0.05 1.08 0.27 0.36 *Trade intensity defined as total and non-EU exports of goods and services as a percentage of total supply of goods and services, plus total and non-EU imports of goods and services as a percentage of total demand for goods and services. Output is defined as gross, so the maximum value attainable is 200. STERN REVIEW: The Economics of Climate Change 16
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Opportunities and Wider Benefits from Climate Policies Key Messages
The transition to a low-emissions global economy will open many new opportunities across a wide range of industries and services. Markets for low carbon energy products are likely to be worth at least $500bn per year by 2050, and perhaps much more. Individual companies and countries should position themselves to take advantage of these opportunities.
Financial markets also face big opportunities to develop new trading and financial instruments across a broad range including carbon trading, financing clean energy, greater energy efficiency, and insurance.
Climate change policy can help to root out existing inefficiencies. At the company level, implementing climate policies can draw attention to money-saving opportunities. At the economy-wide level, climate change policy can be a lever for reforming inefficient energy systems and removing distorting energy subsidies on which governments spend around $250bn a year.
Policies on climate change can also help to achieve other objectives, including enhanced energy security and environmental protection. These co-benefits can significantly reduce the overall cost to the economy of reducing greenhouse gas emissions. There may be tensions between climate change mitigation and other objectives, which need to be handled carefully, but as long as policies are well designed, the co-benefits will be more significant than the conflicts. 12.1 Introduction Climate change policies will lead to structural shifts in energy production and use, and in other emissions-intensive activities. Whilst the previous chapters focused on the resource costs and competitiveness implications of this change, this chapter considers the opportunities that this shift will create. This is discussed in Section 12.2.
In addition, climate change policies may have wider benefits, which narrow cost estimates will often fail to take into account. Section 12.3 looks at the ways in which climate change policies have wider benefits through helping to root out existing inefficiencies at the company or country level.
Section 12.4 considers how climate policies can contribute to other energy policy goals, such as enhanced energy security and lower air pollution. Conversely, policies aimed at other objectives can be tailored to help to make climate change policies more effective. Energy market reform aimed at eliminating energy subsidies and other distortions is an important example, and is considered in Section 12.5.
In other areas, there may be tensions. The use of coal in certain major energy-using countries, for instance, presents challenges for climate change mitigation – although the use of carbon capture and storage can sustain opportunities for coal. Climate change mitigation policies also have important overlaps with broader environmental protection policies, which are discussed in Section 12.6.
Thinking about these issues in an integrated way is important in understanding the costs and benefits of action on climate change. Policymakers can then design policy in a way that avoids conflicts, and takes full advantage of the significant co-benefits that are available. STERN REVIEW: The Economics of Climate Change 269
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Opportunities from growing markets Markets for low-carbon energy sources are growing rapidly
Whilst some carbon-intensive activities will be challenged by the shift to a low-carbon economy, others will gain. Enormous investment will be required in alternative technologies and processes. Supplying these will create fast-growing new markets, which are potential sources of growth for companies, sectors and countries.
The current size of the market for renewable energy generation products alone is estimated at $38 billion, providing employment opportunities for around 1.7 million people. It is a rapidly growing market, driven by a combination of high fossil fuel prices, and strong government policies on climate change and renewable energy. Growth of the sector in 2005 was 25%1.
Within this overall total, some markets are growing at an even more rapid rate. The total global installed capacity of solar PV rose by 55% in 2005, driven by strong policy incentives in Germany, Japan and elsewhere2, and the market for wind power by nearly 50%3. The market capitalisation of solar companies grew thirty-eightfold to $27 billion in the 12 months to August 2006, according to Credit Suisse4. Growth in biofuels uptake was not quite as rapid, but there was still a 15% rise to 2005, making the total market over $15 billion.
Growth rates in these markets will continue to be strong, creating opportunities for business and for employment opportunities.
Looking forward, whilst some of these very rapid rates may not be sustained, policies to tackle climate change will be a driver for a prolonged period of strong growth in the markets for low-carbon energy technology, equipment and construction. The fact that governments in many countries are also promoting these new industries for energy security purposes (Section 12.5) will only strengthen this effect.
One estimate of the future market for low-carbon energy technologies can be derived from the IEA’s Energy Technology Perspectives report. This estimates the total investment required in low-carbon power generation technologies in a scenario where total energy emissions are brought back down to today’s levels by 20505. It finds that cumulative investment in these technologies by 2050 would be over $13 trillion, accounting for over 60% of all power generation by this date. The annual market for low-carbon technologies would then be over $500bn per year. Other estimates are still higher: recent research commissioned by Shell Springboard suggests that the global market for emissions reductions could be worth $1 trillion cumulatively over the next five years, and over $2 trillion per year by 2050.6
The massive shift towards low-carbon technologies will be accompanied by a shift in employment patterns. If it is assumed that jobs rise from the current level of 1.7 million in line with the scale of investment, over 25 million people will be working in these sectors worldwide by 2050.
Climate change also presents opportunities for financial markets
Capital markets, banks and other financial institutions will have a vital role in raising and allocating the trillions of dollars needed to finance investment in low-carbon technology and the companies producing the new technologies. The power companies will also require access to large, long-term funds to finance the adoption of new technology and methods, both 1 2 3 4 5 6 REN21 (2006). Renewables Global Status Report, 2006 update: REN21. Clean Edge (2006). Quoted in Business Week, “Wall Street’s New Love Affair”, August 14 2006. This investment excludes the transport sector, but includes nuclear, hydropower, and carbon capture and storage. Shell Springboard (2006). This is an estimate of total expenditure on carbon abatement, and so would include all emission reduction sources. Figures are based on a central scenario.
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See, for instance, Shell Springboard (2006). Cleantech Venture Network (2006). Salmon and Weston (2006). See Ceres (2006) . World Bank (2006a). CEAC (2006). Part III: The Economics of Stabilisation
to conform to new low-carbon legislation and to satisfy rising global power demand from growing populations enjoying higher living standards.
The new industries will create new opportunities for start-up, small and medium enterprises7 as well as large multinationals. Linked to this, specialist funds focusing on clean energy start- ups and other specialist engineering, research and marketing companies are emerging. Clean technology investment has already moved from being a niche investment activity into the mainstream; clean technology was the third largest category of venture capital investment in the US in the second quarter of 20068.
The insurance sector will face both higher risks and broader opportunities, but will require much greater access to long-term capital funding to be able to underwrite the increased risks and costs of extreme weather events9. Higher risks will demand higher premiums and will require insurance companies to look hard at their pricing; of what is expected to become a wider range of weather and climate-related insurance products10.
The development of carbon trading markets also presents an important opportunity to the financial sector. Trading on global carbon markets is now worth over $10bn annually with the EU ETS accounting for over $8bn of this11. Expansions of the EU ETS to new sectors, and the likely establishment of trading schemes in other countries and regions is expected to lead to a big growth in this market. Calculations by the Stern Review as a hypothetical exercise show that if developed countries all had carbon markets covering all fossil fuels, the overall market size would grow 200%, and if markets were established in all the top 20 emitting countries, it would grow 400% (the analysis behind these numbers can be found in Chapter 22).
This large and growing market will need intermediaries. Some key players are set out in Box 12.1. The City of London, as one of the world’s leading financial centres, is well positioned to take advantage of the opportunities; the most actively traded emissions exchange, ECX, is located and cleared in London, dealing in more than twice the volume of its nearest competitor12. 7 8 9 10 11 12
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Financial intermediaries and climate change The transition involved in moving to a low-carbon economy creates opportunities and new markets for financial intermediaries. Emissions trading schemes in particular require a number of key financial, legal, technical and professional intermediaries to underpin and facilitate a liquid trading market. These include:
Corporate and project finance: trillions of dollars will be required over the coming decades to finance investments in developing and installing new technologies. Creative new financing methods will be needed to finance emission reduction projects in the developing world. And emissions trading will require the development of services needed to manage compliance and spread best practice.
MRV services (monitoring, reporting and verification): these are the key features for measuring and auditing emissions. MRV services are required to ensure that one tonne of carbon emitted or reduced in one place is equivalent to one tonne of carbon emitted or reduced elsewhere.
Brokers: are needed to facilitate trading between individual firms or groups within a scheme, as well as offering services to firms not covered by the scheme who can sell emission reductions from their projects.
Carbon asset management and strategy: reducing carbon can imply complex and inter- related processes and ways of working at a company level. New opportunities will arise for consultancy services to help companies manage these processes.
Registry services: these are needed to manage access to and use of the registry accounts that hold allowances necessary for surrender to the regulator.
Legal services: these will be needed to manage the contractual relationships involved in trading and other schemes.
Trading services: the transition to a low carbon economy offers growing opportunities for trading activities of all kinds, including futures trading and the development of new derivates markets.
Companies and countries should position themselves now to take advantage of these opportunities
There are numerous examples of forward-looking companies which are now positioning themselves to take advantage of these growth markets, ranging from innovative high- technology start-up firms to some of the world’s largest companies.
Likewise, governments can seek to position their economy to take advantage of the opportunities. Countries with sound macroeconomic management, flexible markets, and attractive conditions for inward investment can hope to win strong shares of the growing clean energy market. But particular countries may also find that for historical or geographical reasons, or because of their endowment of scientific or technical expertise, they have advantages in the development of particular technologies. There may be grounds for government intervention to support their development, particularly if promising technologies are far from market and needs to be scaled up to realise their full potential – Chapter 16 discusses how market failures and uncertainties over future policy justify action in this area.
Implementing ambitious climate change goals and policies may also help to create a fertile climate for clean energy companies. Hanemann et. al. (2006) analysed the economic impact of California taking the lead in adopting policies to reduce GHG emissions. They concluded that, if it acts now, California can gain a competitive advantage, by becoming a leader in the new technologies and industries that will develop globally as international action to curb GHG emissions strengthens. They estimate that this could increase gross state product by $60 billion, and create 20,000 new jobs, by 2020. STERN REVIEW: The Economics of Climate Change 272
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Climate change policy as a spur to efficiency and productivity Climate change policies can be a general spur to greater efficiency, cost reduction and innovation for the private sector
Predictions of the costs of environmental regulations often turn out to be overestimates. Hodges (1997) compared all cases of emission reduction regulations for which successive cost estimates were available, a dozen in total. He found that in all cases except one (CFCs where costs were only 30% below expectations due to the accelerated timetable for phase- out of the chemical), the early estimates were at least double the later ones, and often much greater.
One example is the elimination of CFCs in car air conditioners. Early industry estimates suggested this would increase the price of a new car by between $650 and $1200. By 1997, the cost was $40 to $40013.
When such numbers come to light, companies are often accused of inflating initial cost estimates to support their lobbying efforts. But there is a more positive side to the story. The dramatic reduction in costs is often a result of the process of innovation, particularly when a regulatory change results in a significant increase in the scale of production.
And the process of complying with new policies may reveal hidden inefficiencies which firms can root out, saving money in the process (Box 12.2). Box 12.2 Reducing Business Costs Through Tackling Climate Change An increasing number of private and public sector organisations are discovering the potential to reduce the cost of goods and services they supply to the market. A study of 74 companies drawn from 18 sectors in 11 countries including North America, Europe, Asia, and Australasia revealed gross savings of $11.6 billion, including14: •
•
• BASF, the multi-national conglomerate and chemical producer, has reduced GHG emissions by 38% between 1990 and 2002 through a series of process changes and efficiency measures which cut annual costs by 500 million euros at one site alone;
BP established a target to reduce GHG emissions by 10% on 1990 levels by 2010, which it achieved nine years ahead of schedule, while delivering around $650 million in net present value savings through increased operational efficiency and improved energy management. Between 2001 and 2004, the organisation contributed a further 4MtC of emission reductions through energy and flare reduction projects. $350 million investment in energy efficiency is planned over 5 years from 2004.
Kodak began tracking its greenhouse gas emissions in the 1990s, and set five-year goals for emissions reductions. To help to achieve this, the company performed short, focused energy assessments – “Energy Kaizens” – across different areas of its business, aimed at reducing waste. Between 1999 and 2003, this and other initiatives resulted in overall savings of $10 million.
Tackling climate change may also have more far-reaching effects on the efficiency and productivity of economies. Schumpeter (1942)15 developed the concept of “creative destruction” to describe how breakthrough innovations could sweep aside the established economic status quo, and unleash a burst of creativity, investment and economic growth which ushers in a new socio-economic era. Historical examples of this include the introduction of the railways, the invention of electricity, and more recently, the IT revolution. Dealing with 13 14 15 American Prospect, “Polluted Data”, November 1997. The Climate Group (2005). See also Aghion and Howitt (1999). STERN REVIEW: The Economics of Climate Change 273
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climate change will also involve fundamental changes worldwide, particularly to energy systems.
In particular, the shift to low-carbon energy technologies will result in a transformation of energy systems; the implications of this are explored in the following sections.
12.4 The links between climate change policy and other energy policy goals
Climate change policies cannot be disconnected from policies in other areas, particularly energy policy. Where such synergies can be found, they can reduce the effective cost of emissions reductions considerably. There may also be tensions in some areas, if climate change policies undermine other policy goals. But as long as policies are well designed, the co-benefits should outweigh the conflicts.
Climate change and energy security drivers will often work in the same direction, although there are important exceptions
Energy security is a key policy goal for many developed and developing countries alike. Although often understood as referring mainly to the geopolitical risks of physical interruption of supply, a broader definition would encompass other risks to secure, reliable and competitive energy, including problems with domestic energy infrastructure.
Energy efficiency is one way to meet climate change and energy security objectives at the same time. Policies to promote efficiency have an immediate impact on emissions. More efficient use of energy reduces energy demand and puts less pressure on generation and distribution networks and lowers the need to import energy or fuels. For developing countries in particular, who often have relatively low energy efficiency, this is an attractive option. Indirectly, they also help with local air pollution, by limiting the growth in generation.
Improving efficiency within the power sector itself has similar effects. Box 12.3 gives an example of the scale of the potential to reduce emissions from making fossil fuel production processes more efficient. STERN REVIEW: The Economics of Climate Change 274
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Economic opportunities from reducing gas-flaring in Russia In total, leaks from the fossil fuel extraction and distribution account for around 4% of global greenhouse gas emissions. Within this, gas flaring – the burning of waste gas from oil fields, refineries and industrial plants – accounts for 0.4% of global emissions. Increasingly, there has been a move to capture these gases, driven by economic as much as environmental reasons. This is by no means universal, and in some countries the potential for emissions savings in this area remains significant.
The post-Soviet collapse of Russia’s energy-intensive economy cut carbon emissions and left it with a surplus of transferable emission quotas under the Kyoto protocol. Decades of under- investment, however, mean that current 6-7 per cent GDP growth, spurred by higher energy and commodity prices, is both raising emissions and putting pressure on the infrastructure. Sustaining growth requires very large energy and related infrastructure investment. In June 2006 the government approved a $90bn investment programme to replace ageing coal and nuclear generating plants, increase generating capacity and strengthen the grid system.
A recent IEA report16 on Russian gas flaring, however, indicates that without accompanying price and structural reforms, especially in the gas sector, investment alone is unlikely to deliver the full potential for efficiency gains or reductions in GHGs.
The report indicates that low prices for domestic gas, coupled with Gazprom’s monopoly over access to both domestic and export gas pipelines and the high levels of waste and inefficient technology, restrict its ability to satisfy rising export and domestic demand, and to reduce both gas losses and GHG emissions.
In 2004 Gazprom lost nearly 70 billion cubic metres (bcm) of the nearly 700bcm of natural gas which flowed through its network because of leaks and high wastage from inefficient compressors. Gas related emissions amounted to nearly 300 MtCO2e of GHG, including 43 MtCO2e from the 15bcm of gas flared off, mainly by oil companies unable to gain access to Gazprom’s pipes. On this basis, Russia accounted for around ten per cent of natural gas flared off globally every year. However, an independent study conducted by the IEA and the US National Oceanic and Atmospheric administration, calibrated from satellite images of flares in the main west Siberian oilfields, indicated however that up to 60bcm of gas may be lost through flaring – over a third of the estimated global total17.
Gas flaring represents a clear illustration of the potential efficiency gains from new technology linked to more rational pricing policies and other structural reforms. These would also yield significant climate change mitigation benefits.
A more diverse energy mix can be an effective hedge against problems in the supply of any single fuel. As climate change policy tends to encourage a more diverse energy mix, it is generally good for energy security. And conversely, policies carried out for energy security reasons may have benefits for climate change. The expansion of a range of sources of renewable power and, where appropriate, of nuclear energy can reduce the exposure of economies to fluctuations in fossil fuel prices, as well as reducing import dependence.
Coal is an important exception to this rule. Coal is much more carbon intensive than other fossil fuels: coal combustion emits almost twice as much carbon dioxide per unit of energy as does the combustion of natural gas (the amount from crude oil combustion falls between coal and natural gas18). Many major energy-using countries have abundant domestic coal supplies, and hence see coal as having an important role in enhancing energy security. China, in particular, is already the world’s largest coal producer; its consumption of coal is likely to double over the 20 years between 2000 and 202019. 16 17 18 19 IEA (2006). IEA (2006). Energy Information Administration (1993). Chinese Academy of Social Sciences (2006). STERN REVIEW: The Economics of Climate Change 275
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As well as using coal directly for energy production, coal-producing countries including the US, Australia, China and South Africa are investing in coal-to-liquids technology, which would allow them to reduce their dependence on imported oil and use domestic coal to meet some of the demand for transport fuel. But it has been estimated that “well-to-wheel” (full lifecycle) emissions from the production and use of coal-to-liquids in road transport are almost double those from using crude oil20.
However, extensive deployment of carbon capture and storage (as discussed in Chapter 9), can reconcile the use of coal with the emissions reductions necessary for stabilising greenhouse gases in the atmosphere.
Supporting sufficient investment in generation and distribution capacity also requires a sound framework capable of bringing forward required investment. Clear, long-term credible signals about climate policy are a critical part of this. If there is uncertainty about the future direction of climate change policy, energy companies may delay investment, with serious consequences for security of supply. This is discussed in more detail in Chapter 15.
Access to energy is a priority for economic development There are currently 1.6 billion people in the world without access to modern energy services21. This restricts both their quality of life, and their ability to be economically productive. Providing poor people with access to energy is a very high priority for many developing countries, and can have significant co-benefits in reducing local pollution, as the next section discusses.
Increasing the number of energy consumers, by providing access to energy, would tend to push emissions upwards. But well-designed policies present opportunities for meeting several objectives at once. New renewable technologies, developed with climate change objectives in mind, can help to overcome barriers to access to energy. Microgeneration technologies (see Box 17.3 in Chapter 17) such as small-scale solar and hydropower, in particular, remove the need to be connected to the grid, and so help raise availability and reduce the cost of electrification in rural areas. And as discussed below, the replacement of low-quality biomass energy with modern energy can cut emissions and pollution.
As well as access, affordability is a key issue in both developed and developing countries. Poverty is determined by people’s capacity to earn in relation to prices. Energy prices are one significant aspect, along with food and other essentials.
But it is inappropriate to deal with poverty by distorting the price of energy. Addressing income distribution issues directly is more effective. There are a number of ways to achieve this. One is indexing social transfers to a price index, taking account of different consumption patterns of poorer groups in the relevant price index for those groups. Other more direct means include making special transfers to those with special energy needs such as the elderly, and the use of “lifeline tariffs”, whereby people using a minimal amount of power pay a sharply reduced tariff for a fixed maximum number of units.
Climate change policies can help to reduce local air pollution, with important benefits for health
Measures to reduce energy use, and to reduce the carbon intensity of energy generation, can have benefits for local air quality. Most obviously, switching from fossil fuels to renewables, or from coal to gas, can significantly the levels of air pollution resulting from fossil fuel burning.
A recent study by the European Environment Agency22 showed that the additional benefits of an emissions scenario aimed at limiting global mean temperature increase to 20C would lead 20 Well-to-wheels emissions from fuels such as gasoline are around 27.5 pounds of CO2 per gallon of fuel. This compares with 49.5 pounds per gallon from coal-to-liquids, assuming the CO2 from the refining process is released into the atmosphere. See Natural Resources Defence Council (2006). 21 22 STERN REVIEW: The Economics of Climate Change 276
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to savings on the implementation of existing air pollution control measures of €10 billion per year in Europe, and additional avoided health costs of between €16-46 billion per year.
Local air pollution has a serious impact on public health and the quality of life. These impacts are particularly severe in developing countries, where only malnutrition, unsafe sex and lack of clean water and adequate sanitation are greater health threats than indoor air pollution23. In China, a recent study24 showed that for CO2 reductions up to 10-20%, air pollution and other benefits more than offset the costs of action.
Forthcoming analysis from the IEA (Box 12.4) shows that combustion of traditional biomass for cooking and heating in developing countries is associated with high GHG emissions and adverse indoor air quality and health impacts, which switching to a cleaner fuel could reduce. Box 12.4 Use of traditional biomass in developing countries In developing countries, 2.5 bn people depend on traditional biomass such as fuel wood and charcoal as their primary fuel for cooking and heating because it is a cheap source of fuel. The emissions associated with this biomass are relatively high because it is not combusted completely or efficiently. Aside from the climate change impact, combustion of biomass is associated with a range of detrimental effects on health, poverty and local environment including:- •
•
• Smoke from biomass from cooking and heating was estimated to cause 1.3 m premature deaths in 2002. Women and children are most severely affected because they spend most time in the home doing domestic tasks. More than half the deaths are children because their immune systems are poorly equipped to deal with the local air pollution. Time spent collecting the biomass is time that could otherwise be spent by women or children in education or other productive work. The collection of biomass may also involve hard physical labour that deteriorates the health of the women and children doing it. Collection of biomass causes localised deforestation and land degradation. If animal dung is used as a fuel rather than a fertiliser then soil fertility suffers. The widespread use of fuel wood and charcoal can mean local resources getting used up so people have to travel further to collect it.
Switching away from traditional biomass towards modern, cleaner cooking fuels can save GHG emissions and reduce the health, poverty and local environment concerns outlined above. The UN Millennium Project has adopted a target of reducing by 50% the number of households using traditional biomass as their primary fuel by 2015; this means giving an extra 1.3 bn people access to clean fuels by this date. If this were achieved by switching these users to liquid petroleum gas, it would cost $1.5 bn per year for new stoves and canisters, increase global demand for oil by just 0.7% in 2015, and result in a small reduction in GHG emissions.
Source: IEA (in press).
Sometimes climate change objectives will conflict with local air quality aims. This is a particular issue in transport. In road transport, switching from petrol to diesel reduces CO2 emissions, but increases local air pollution (PM10 and NOx emissions). High blends of biodiesel can also emit slightly more NOx than conventional diesel. The US and EU are in the process of implementing stronger policies to reduce CO2 emissions from diesel vehicles, although this will take time to have an effect.
In the case of aviation, there are multiple links between objectives25. One of the ways of achieving CO2 improvements in aircraft is to increase combustion temperatures in engines. 23 24 25 WHO (2006). Aunan et al (2006)
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