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What are the likely costs of the transition to a sustainable economy?

Meeting agreed climate targets requires an unprecedented structural transformation of the global economy over the next two or three decades. Yet conditional on action being taken early, the opportunities from the transition should significantly outweigh the costs.

The twenty-first century will not be like the twentieth. Most obviously, the economy of the future will be low-carbon, less reliant on fossil fuels, more efficient and highly digitised. It will need to put less pressure on natural resources, in particular the renewable kind, such as forests, fisheries and ecosystems that are prone to irreversible collapse. 

This affords great opportunities for investment in new clean and resource-efficient sectors, including energy, transport, agriculture, manufacturing and construction. But it also presents a growing risk of disruption and devaluation in existing carbon- and resource-intensive sectors and activities in the very same sectors. 

The landscape of risk and opportunity is changing

Meeting climate targets will mean getting more out of the resources we have. This requires a process of innovation to increase resource productivity and improve demand responsiveness to match the availability of changing supply (thereby circumventing the need to invest in additional capacity). The alternative of reduced final consumption and investment – or ‘degrowth’ – is neither politically appealing, nor economically and technologically necessary, provided that there is a clear and credible attempt to steer innovation.

If we are to meet climate targets consistent with limiting temperatures to 2° above pre-industrial times, a third of global oil reserves, half of gas reserves and 80% of current coal reserves will have to remain in the ground or, if they are burned, the emissions will have to be captured and stored. 

Downstream infrastructure, such as ports, pipelines, refineries and power generation, also risks being stranded or rendered obsolete before the end of its working lifetime. So too do fossil fuel-dependent heavy industrial processes. As these risks proliferate, they can quickly devalue the physical, human and intangible assets of slow-moving companies and regions. Financial service businesses that are heavily invested in fossil fuel-entangled assets will also be hit, with concerns around systemic risk and sovereign risk, if large financial institutions or governments become insolvent. 

The clean transition will inevitably touch everyone. Since the Industrial Revolution, the world’s economy has been powered by fossil fuels. Yet the costs of this structural transition may turn out to be manageable. There are already signs that efforts to avert climate catastrophe, aligned with self-interest and opportunity, are driving innovation and prompting a systemic shift to superior ‘we should have done this anyway’ behaviour. 

Clean innovation is spurring economies of scale in production and discovery 

Ten years ago, renewables and electric vehicles were seen as expensive luxuries. Since then, the price of solar photovoltaic energy has dropped by 83% since 2010, and the cost of wind by 40% (Figure 1). The sun doesn’t always shine and the wind doesn’t always blow – intermittency requires storage capacity. But here too the news is good: the cost of lithium-ion batteries has also fallen eight-fold over this period. 

Figure 1: Costs of electricity (constant 2019 US$ per kWh)

Source: Committee on Climate Change (CCC), 2020 
Note: Global average levelised costs of electricity are given in constant 2019 US dollars

These technologies are increasingly producing electricity that is cheaper than most coal-fired power plants and many gas-fired ones too. It is perhaps no surprise, therefore, that the world now invests more in renewable power generation (excluding nuclear and hydro) than in oil, gas and coal generation combined (see Figure 2). 

Figure 2: Global energy supply investment by sector

Source: International Energy Agency, 2021

The International Energy Agency estimates that ‘Renewables will overtake coal to become the largest source of electricity generation worldwide in 2025’. New coal plants are still being built around the world, but these are primarily for political reasons rather than commercial ones (ranging from understandable concerns about jobs, communities and livelihoods to less defensible incentives to preserve the support of influential political backers and party fundraisers). In the vehicle sector, no serious car manufacturer invests scarce research and development (R&D) in combustion engines.

The speed of the transition in these key sectors has caught everyone by surprise. And it has happened with minimal policy effort. Yet public policy and national regulators are increasingly implementing and enforcing action (through pricing, regulation and technology support) that encourages or forces businesses to improve resource efficiency, preserve renewable ecosystems and reduce their carbon footprint. 

All of this generates productivity-enhancing network effects, learning effects and economies of scale in production and discovery. This in turn drives the positive, reinforcing feedback where deployment induces cost reductions and cost reductions provide incentives for deployment. As a result of this virtuous innovation cycle, whether or not you care about the climate, the world is about to receive cheaper electricity and better performing, more efficient cars. 

The gains are not limited to the energy and transport sectors. Using data on one million patents and three million citations, one study finds that productivity-enhancing spillovers to other sectors (such as information technology, robotics, healthcare and aerospace) from low-carbon innovation are over 40% greater than from conventional technologies in the energy production and transport sectors. 

Once the clean innovation machine has been switched on and is running, it has the potential to become more innovative, efficient and productive than the conventional alternative, with a positive impact on productivity and GDP growth. 

Competition will matter too. As the world shifts to low-carbon, resource-efficient markets, any countries or firms that fall behind on policies and investments will increasingly find that high productivity activity may move elsewhere. 

recent study uses network analysis to demonstrate that it is easier for countries to become competitive in new green products that require similar production capabilities and know-how to existing sectors. This helps to demonstrate how green transitions are highly path-dependent: countries that invest in green capabilities early have greater success in diversifying into future green product markets.

Studies analysing revealed technological advantage indicate where opportunities for sustainable growth and recovery might reside. For example, by comparing broad categories of technologies, research finds that the UK is relatively specialised in ocean and wind energy (Martin et al, 2020). A complementary study shows how returns to public investments in these technologies are also high.

Upfront clean investment generates longer-term productivity gains

Making the transition to a sustainable, resilient and productive economy will not come free. It will require substantial upfront capital expenditure in transport, energy and buildings. Yet before long, the Committee on Climate Change estimates that operational costs in most sectors are likely to fall (if they have not already) below those of compatible fossil fuel generation (Figure 3). 

Figure 3: Capital and investment costs and operating cost savings in the balanced net zero pathway

Source: CCC, Sixth Carbon Budget 2021

This additional capital expenditure indicates an enhanced role for financial and capital markets. And there is a dawning recognition that these investments offer much better risk-adjusted returns than zero interest government bonds.

Access to cheap finance and investment will increasingly depend on demonstrating that assets will not be stranded in a carbon- and resource-constrained world. Outdated infrastructure, skills and ideas that were previously assets will become liabilities. 

The risk of stranded assets means that firms will have to go beyond merely disclosing their emissions and resource use. Business must now demonstrate that their revenue model is resilient to, and profitable in, the low-carbon, resource-efficient economy of the twenty-first century through rigorous stress testing of rapid change scenarios.

There is a growing appreciation that growth is not only compatible with sustainability, but it requires it. Efficiency, by definition, saves money and innovation boosts productivity. But there are also numerous near-term opportunities associated with tackling particulate pollution (local air pollution costs 6.2% of global economic output and can be markedly reduced by decarbonising electricity and vehicles), congestion, ill health, biodiversity loss and waste. 

Compact, digitally and physically connected cities allow urban densities that reduce resource use, make public and active transport preferable to car use and encourage social diversity and specialisation necessary to kick-start innovation and pilot new ideas. These will reduce resource use and emissions and, bring more liveable, innovative and attractive cities, which, in turn, will attract high-wage, high-skilled workers. 

The Global Commission on the Economy and Climate estimates that ‘at least half and possibly as much as 90%’ of the global emissions reductions required to meet a 2° target could generate net benefits to the economy.

This is especially true after the Covid-19 pandemic, which marks a period of dislocation and change. This in turn affords the potential to lock into pathways that create durable output and resilient future-proofed jobs.

The International Energy Agency estimates that economic growth will be around 0.5% higher in a 1.5°C scenario compared with under present-day policies. The International Monetary Fund recently argued that an additional £1 in public borrowing to invest in ‘job-rich, highly productive, and greener activities‘ would generate an additional £2.7 of additional output. This investment does not prohibit growth: it will encourage it.

Expectations also matter. The perception that new technologies are superior is leading to behaviour that facilitates their successful adoption. Game theorists talk of strategic complementarities, whereby the payoff to an individual’s action depends on the action of others. In this case, if people expect that the low-carbon transition will be cost-effective, they will invest in it, helping to make it a self-fulfilling prophecy.

Indeed, one of the key reasons that renewable capacity grew faster than anyone expected was because costs fell sharply. But this happened because capacity expanded faster than anyone expected. It doesn’t matter whether the chicken came before the egg: once a tipping point is reached, innate path-dependencies make it self-sustaining. An ambitious policy to generate a rapid clean energy transition would be costless, indeed it would be likely to generate considerable economic savings.

A recent study of the process of change defines a risk-opportunity assessment framework, based on complexity science, to guide policy-makers and investors. The authors conclude that conventional models based on inappropriate assumptions can’t cope with the destabilising dynamics that these amplifying feedbacks generate, so they miss them out entirely, together with the rapid cost reductions they entail. 

The good news is that expectations are shifting, as indicated in a recent survey of 231 experts from G20 central banks, businesses and finance ministries. Whereas ten years ago, there might have been a perceived trade-off between green and growth, the respondents clearly found that major fiscal recovery packages that focused on sustainable infrastructure were the most likely to deliver growth. In particular, they highlighted spending on clean R&D, clean energy infrastructure, connectivity infrastructure, building upgrades, energy efficiency and investment in green spaces.

We don’t know the future, but we can steer it

We don’t know what the low-carbon transition will cost, as it depends on the choices and investments we make todayand in the future. But the longer we wait to manage that transition, the bigger the dislocation, the higher the adjustment costs and the graver the environmental risks. 

We don’t know what technologies will drive the twenty-first century, but we know how to hedge against the risks and drive profitable new opportunities. It’s time for economists to stop fruitlessly forecasting the future and instead guide businesses and government to design and build it.

Where can I find out more?

Who are experts on this question?

  • Philippe Aghion
  • Jean-Francois Mercure
  • Penny Mealy
  • Hector Pollitt
  • Cameron Hepburn
Author: Dimitri Zenghelis
Photo by Afonso Coutinho

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