ISSUES FOR A CARBON WEALTH FUND. ADAM WHITMORE RESPONDS

Adam has responded to some of the questions I raised in my recent blog reporting on his proposal for a carbon wealth fund.

John raises some interesting questions in relation to my proposal for a carbon wealth fund.  I will try to answer them briefly here.  I will assume that national funds are the only practical way forward in the short to medium term, and look at a UK sovereign wealth fund based on carbon revenue. 

Use of a global public good

First, John notes that there are some differences between conventional resources, such as oil and gas, held by nations, and the atmosphere, a global public good[1].  The distribution of a global public good will inevitably be contentious.  However existing carbon pricing regimes or simply emitting free of charge already use up a global public good.  Giving citizens and governments a greater stake in increased carbon prices is likely to decrease the quantity of emissions, and so the proportion of the global commons used[2].  This makes the approach I have proposed more compatible with good stewardship of the global commons than existing arrangements, at least for the next 50 years until revenues start to decline. 

Macro-economic effects

John also raises the issue of the macro-economic effects on exchange rates and economic activity.  However these effects would probably not be large.  The payment into a UK fund would be around £16 billion p.a. at present, a little under 1% of GDP per annum[3].  This would be unlikely to cause major economic dislocation, especially if phased in over a period of perhaps 5 years.  The fund would grow large over time, reaching around £860 billion by the end of the century[4].  However this is not vastly larger than the Norwegian fund today, which is for a very much smaller economy.  Furthermore any fund would have the effect of redirecting revenue from consumption to investment, which would probably have a positive macroeconomic effect in the context of historic UK underinvestment. 

Would it be regressive?

Then there is the question of whether increasing revenue from carbon pricing would be socially regressive.  The concern here is that poorer households spend a larger proportion of their income on energy than richer households, and so energy taxes tend to hit them disproportionately harder.  However poor households still spend less on energy, and therefore carbon, in absolute terms than richer households, so an equal dividend, as I’ve proposed, would have the potential to have net progressive effect.   Furthermore, households account for only a minority of energy use, but would get the full benefit of dividends (or at least a large proportion), increasing the extent to which it is progressive.

However there are some important intergenerational issues to consider.   The proposal for a fund takes the view that present generations should safeguard capital assets so they retain value to future generations.  This is in line with the standard definition of sustainable development[5].  However there are distributional issues here which need to be addressed.  Some present citizens will be worse off. 

Use of green taxes

The proposal is clearly consistent with using green taxes more widely as a policy instrument.  What’s different from the standard approach to green taxes is the suggestion of placing revenue in capital fund rather than using revenue to fund current expenditure.  The landfill tax to which I referred in my original post currently raises around a billion pounds per annum[6].  It would be natural to add this revenue to a UK wealth fund. 

Other uses of funds

Finally, there is no reason some of dividends from the fund should not be used to fund things like R&D.  As I have previously discussed there are many legitimate calls on revenue from carbon pricing.  However there are many compelling arguments for allocation direct to citizens, and this should in my view be a priority for the fund. 

There are also other issues to consider, such as governance structures.  Many of these have been reviewed in the wider literature on sovereign wealth funds[7].  Doubtless much work is needed to elaborate on these details, as would be the case for any new institution.  However the prize is worth the effort.

I very much welcome John raising these questions.  They are exactly the sort of issues that need to be discussed, and I hope the debate will not stop here.

Adam Whitmore - 20^th February 2017

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[1] There is an interesting question as to whether countries should have full property rights to natural resources within their territories, as is often assumed at present, but this is too large a subject to go into here.

[2] The assumption here is that increasing prices from current low levels will increase revenue.  Carbon prices would increase by a factor of say five or more in many cases, and it is unlikely that emissions would decrease by an equal factor – though if they did it would be very good news.

[3] This assumes 400 million tonnes of emissions are priced, compared with 2015 totals of 404 million for CO₂ and 496 total greenhouse gases (source BEIS), implying a high proportion of emissions are priced.  Carbon price is assumed to be £40/tonne, roughly the Social Cost of Carbon at current exchange rates and well above current levels.  This would give total revenue of £16 billion in the first year, less than 1% of UK GDP of approximately £1870 billion in 2015. (source: https://www.statista.com/statistics/281744/gdp-of-the-united-kingdom-uk-since-2000/ )

[4] Assuming that the UK reduces its emissions in line with the Climate Change Act target of an 80% reduction from 1990 levels by 2050, and then to zero by the end of the century, and that 80% of emissions are priced at the Social Cost of Carbon as estimated by the US EPA, converted at current exchange rates of $1.25/£.

^[5] Sustainable development is usually characterised as meeting the needs of present generations, without compromising the ability of future generations to meet their own needs.

[6] https://www.uktradeinfo.com/Statistics/Pages/TaxAndDutybulletins.aspx

[7] See here for a specific proposal for a UK wealth fund:  http://www.smf.co.uk/press-release-conservative-mp-calls-for-uk-sovereign-wealth-fund-to-address-long-term-and-structurally-ingrained-weaknesses-of-the-economy/  and Cummine (2016) cited in my original post for further details.

ARCTIC ICE, CLIMATE CRISIS AND PLANETARY SCALE ENGINEERING

Arctic ice has for some time been a key indicator of the scale of global warming, and the pace at which ice cover is reducing has become a major demonstration of a global threat. Summer Arctic ice is not just an indicator (along with surface temperatures or sea levels). It also has the potential to be an important factor itself, in accelerating the pace of global warming and climate change. One reason is that ice cover reflects solar radiation to a much greater extent than open water, so loss of ice will increase the rate of warming. What happens to the Arctic also has knock-on effects on climate across the globe.

Some scientists are now so concerned at the potential consequences of the evident and increasing loss of Arctic sea ice that they have proposed a massive geo-engineering scheme in an attempt to reduce the rate of ice loss and stabilise ice cover. The basic proposal is to build up to 10 million wind powered pumps which could be used to increase the thickness of ice during winter. The giant water pumps, placed on buoys floating in the Arctic Sea, would take up water from beneath the ice, store it in a tank and then spray the water on top of the ice. The top of the ice sheet is the coldest part, so getting the water on top of the ice would make it freeze faster, according to one of the proponents of the scheme, Professor Desch of Arizona State University.

The proposal faces some obvious objections and questions. One is an assessment of whether the measure would be both effective, in thickening the ice, and whether it would be practical in terms of engineering challenges and realistic in terms of financial cost. Moreover this is at best a sticking plaster. It is not an alternative to reducing greenhouse gas (GHG) emissions in order to mitigate and limit future damage.

However the proposal is in one sense a milestone. It marks the end of a period when the climate debate appeared to be primarily about reducing present fossil fuel consumption in order to avert long term, and for climate change deniers and sceptics, unproven consequences. The evidence of Arctic ice melt is now incontrovertible, and Desch and others claim that the Arctic is now warming twice as fast as climate models were predicting only a few years ago. On some measures recent polar temperatures have been up to 20^o C above average. Incredibly, there are still plenty of websites pumping out misleading information to suggest nothing is happening. But the serious debate will inevitably shift to how the world copes with the consequences, adapting as well as trying to prevent or limit warming.

This is arguably the first time that a serious geo-engineering “solution” has been proposed as a means to address a very specific threat from a warming world, and has caught the imagination of serious scientists.  In the language of climate policy, we can describe this kind of measure as adaptation to a warming world, a piece of geo-engineering which will postpone some of the climate change impacts of a melting Arctic. The boundary between mitigation and adaptation is in practical terms a rather fuzzy one. It is usually assumed that adaptation will consist of series of local initiatives, for example in flood defences, whereas mitigation very obviously depends on global cooperation. This proposition makes it clear that adaptation will also be a global issue.

The scale and ambition of a project of this kind mean that many people will dismiss it as fanciful or even hare-brained, and I suspect the most that we should reasonably expect in the near term is some pilot exercises to test whether such a scheme could be effective. That would involve quite modest expenditure, easily justified as creating an option for the future, another possible instrument that we may welcome as the climate consequences of our past failures to manage emissions become more apparent.

The full cost of the scheme has been provisionally estimated as 500 billion dollars over a period of about 10 years. This may seem a very large sum but an annual figure of about 50 billion dollars is, to create a sense of perspective, approximately the exit fee (cost of residual liabilities) estimated for the UK in leaving the European Union. In other words it is big enough to attract political controversy, but as serious economic and financial commentators have observed, it is in macro-economic terms relatively trivial.

And there are some deeper lessons to learn, and questions to ponder, that arise simply from thinking about this ambitious project.

One is that we shall soon be moving from an era of non-binding targets and emissions promises to one of real, difficult and immediate choices. This immediately raises questions of who is going to pay and what decision making processes, in what international settings, will determine the choices that are made.

Another is the analytical question of how these choices might be evaluated, assuming a suitable institutional framework were in place. There will be many more geo-engineering proposals, targeted both at mitigating or limiting change and at adapting to it. Some of these may be national and local. Others may have negative spillover effects on neighbours, and unintended consequences.

The proposal provides just a first indication of the potential costs of adaptation to climate change. It is likely to be followed by many more.

CARBON WEALTH FUNDS TO SAVE THE PLANET

Adam Whitmore argues in his recent blog “How not to squander $ 130 trillion” that carbon pricing should be used to establish wealth funds from which current and future citizens can benefit.  This is very timely given the Baker and Shultz (Republicans) proposals now under discussion in the US.  He makes the classic environmental economics arguments for carbon pricing.

At the moment only a very small proportion of greenhouse gas emissions is priced adequately.  Most emissions remain unpriced, and the growing proportion that is priced is mostly sold at well below both the cost of damages, and well below the value of an increasingly scarce resource.  A valuable scarce resource is thus being given away or sold below cost, subsidising emitters.  Huge natural wealth is being squandered.  And once gone it can never be replaced.

It would be better to use revenue from carbon pricing to create a wealth fund to benefit both current and future generations …

… in the form of a fund for citizens, with proceeds from carbon pricing (the sale of allowances or taxes) at adequate levels paid into the fund.  Carbon pricing should be comprehensive, with prices at adequate levels.  The finite volume of the resource implies it is best used to establish a wealth fund, where financial capital is built as natural capital is used up.  The fund would belong to all citizens.  Granting its value to citizens would surely encourage better management of the atmosphere, and thus the climate, and higher carbon prices than generally prevail at present.

Most environmentally concerned economists will support the arguments for much higher prices to attach to greenhouse gas emissions (GHG), and it is well worth examining some of these ideas further. Adam develops the basic idea and sets out his vision for how it might work.

Dividends from the fund could be used in many ways.  One approach with a range of advantages is distributing benefits to all in the form of a “citizen’s dividend”.  There is already a feature of the Alaskan wealth fund derived from oil revenues, where distribution is in the form of a Permanent Fund Dividend to all citizens.  This is widely considered to have helped build and maintain public support for the scheme.

This approach is closely related to the idea of “tax and dividend” carbon pricing.  I have previously argued that such approaches have merit, and indeed tax and dividend has recently been advocated by senior Republicans in the USA.  However, there is an important difference between a fund and tax and dividend as often presented, in that revenues are used to establish a fund that is intended to be permanent, whereas tax and dividend proposals often assume revenues to be distributed in full.

Adam also links his idea to other political objectives especially in the context of redistributive measures, both nationally and in a global context.

There is also a relationship between the idea of a citizen’s dividend and a universal basic income, which is much discussed at the moment and subject to a few trials.  … There is a natural case for distributing dividends equally, as all have equal rights to the atmosphere.  The atmosphere is a global resource, and climate change knows no borders, so it is natural to make any fund global.  However establishing such an arrangement is likely to be too great a political challenge. …

The global challenge is clear enough. And the idea of developed countries (sometimes deemed to have a historic responsibility in this context) subscribing to development funds to assist developing countries in both low carbon initiatives and in adapting to climate change, is already part of the currency of international climate negotiations.

Establishing national funds will have many challenges.  However the prize seems large enough to be worth pursuing.  The current system of simply allowing emissions to be dumped into the atmosphere, often free of charge and almost always too cheaply, is a waste of a unique and irreplaceable asset.  Irreplaceable natural wealth such as the atmosphere should be managed carefully, not squandered recklessly.

This amounts to a series of challenging propositions. It is intuitively appealing, and the connection of ideas in providing for the future, taxing emissions to correct a market failure, and providing for a “fair” allocation of proceeds is attractive.

However it will be necessary to explore the idea in the context of potential macro-economic and other implications, and we can expect quite a lot of exposure for these ideas in the near future, not least reflecting their surprising emergence from US Republicans. A few of the questions deserving consideration, and to which we may return in future blogs, are:

1  There are some clear differences from the sovereign wealth funds put in place to preserve the long term position of countries that are depleting a scarce natural resource eg Norway and oil. One feature of the latter is that they can prevent a potentially dangerous exchange rate appreciation which destroys part of the country’s economy. UK failure to establish a wealth fund for North Sea oil was one of the factors that undermined UK manufacturing in the 1980s. But this feature does not translate to a global context, nor, would it necessarily make sense for an individual country to set up such a fund in isolation.

[Economists will also note that oil is a “private” good, whereas the GHG absorbing capacity of the planet is very much part of the “global commons”.]

2  Would the creation of such a fund immediately remove purchasing power from the economy and, in the absence of offsetting measures, provoke recession? One can imagine, for example, some very negative effects from the immediate adoption of such a measure in the German and eurozone economy for example.

3  Is it not simpler to view the proposal simply in the context of additional sources of tax revenue, Green taxes, which would increasingly substitute for other and unpopular forms of taxation? Or should the revenues be hypothecated to other clearly needed climate policies, for example on research and development?

4  Energy taxes are often seen as quite regressive. How could this be remedied?

My own view is that this is a welcome and timely proposal and it, perhaps in a modified form, could be used as a welcome rallying point for more effective action on climate; but we will need to think hard about its practical and political aspects. As ever the devil will be in the detail. But it will also be in the packaging and the presentation.

EU EMISSIONS TRADING SCHEME AND EUROPE’S CLIMATE POLICY. A FLAGSHIP FLOUNDERING

Speaking at last Wednesday’s BIEE Climate Policy Seminar Boris Lagadinov of Sandbag, the Brussels and London based think-tank that addresses climate issues, gave an excellent summary description of the development of the EU Emissions Trading Scheme (ETS), its successes and shortcomings, and the prospects for remedying its defects in the 2020s, notably the status of Phase 4 (2021-2028) reforms and the overlap with other policies. The presentation is available online (at least to BIEE members), but the fuller version of his analysis is also readily available on the Sandbag website. It is an excellent exposition and I will not try to repeat its detail, but rather aim to concentrate on some of the lessons and implications discussed at the seminar and that we might draw from the ETS experience.

The broad picture is well known. The EU ETS has achieved compliance with its targets, largely as the result of initially very undemanding targets (a result of  extensive industry lobbying) combined with recession induced falls in demand, but it has in the view of most commentators wholly failed to produce carbon prices that are likely to have any significant effect in reducing emissions, let alone incentivise the kind of transformative change that is required across the energy sector or more broadly in the economy or in lifestyle choices. In other words it provides no incentives for economy wide decarbonisation.

Boris outlined the structural reform measures associated with so-called “backloading” and the creation of a Market Stability Reserve (MSR), but the scale of the surplus in the ETS stands at about 3 billion tonnes in 2016 and Sandbag expect this to rise to about 4 billion tonnes by 2020. In broad terms this is about a full year’s EU emissions, but about two years for emissions falling within the scope of the scheme. The reform proposals may be structurally sensible but the Sandbag analysis indicates there is no real prospect that they will lead to a significant increase in carbon prices any time soon.

In terms of fundamentals, the EU ETS is a highly oversupplied system. Emissions have fallen much faster than the “cap”, but it is quite clear that this has been entirely due to other factors including the impact of so-called “overlapping policies” such as national policies for the power sector, and for energy efficiency. It is very hard to argue therefore that EU achievements in reducing emissions owe very much, if anything, to its flagship policy, the ETS. 

For economists, for whom adequate pricing of the emissions externality is usually assumed to be one of the simplest and most efficient and effective policies, this is a difficult pill to swallow. In global terms the EU ETS was one of the earliest and is the world’s largest attempt at using price and market mechanisms to control emissions. But the outcome is that, in one of the largest players in the world economy, the carbon price is having little impact and playing little or no part in policy. And it now appears condemned to irrelevance for at least the next decade.

There is therefore a clear contrast between the lofty ambitions of Paris, which the EU (including the UK) have endorsed, and the reality of this core EU policy. And there are some clear practical and philosophical lessons to learn, both in the EU and for other regional schemes.

1    The first is the importance of being clear about objectives. The required level of long term global emissions reduction may be a clear target, but “region EU” contributions, defined over relatively short time periods were always at best a partial reflection of the real objective, which is to set in motion the massive changes required in moving to a low carbon economy. It was and remains the case that the long term objective requires very substantial transformative change, and that the incentive of a significant carbon price should be playing a major role in this. Failure of the EU ETS to deliver meaningful prices should therefore have been interpreted as an early signal that the short and medium term targets were far too slack and were certainly not consistent with EU ambitions to be a global leader on climate.

2    Cap and trade mechanisms are badly suited to the cumbersome and inflexible nature of much of EU decision taking, demonstrated by the slow and inadequate progress of MSR and related reforms. Cap and trade is intrinsically inflexible, given the need to provide participants with some degree of confidence in the rules and duration of the market. What is needed is policy instruments with the ability to adjust to events, such as the recession, over reasonably short timescales. Adaptive mechanisms permit a learning process. In this context using price directly as a policy instrument (through a carbon tax) could have been a much more effective policy instrument.

Unsurprisingly member states with high levels of ambition have developed their own policies. These include “floor prices” for carbon in order to support low carbon investments, but also other direct interventions. It has been claimed that, paradoxically, these so-called “overlapping policies” will in some instances give rise to implicit “costs of carbon reduction” an order of magnitude higher than the actual carbon price that would emerge even from a reformed ETS.  Whatever the truth of this, the weakness of the ETS means that we are likely to see more rather than fewer “overlapping policies”.

These unilateral initiatives have also led on to further disputes over policy. It can be argued that they have undermined the carbon price and the ETS, and this finds its expression in one conventional view that additional measures do not decrease cumulative emissions, since they merely substitute for reductions that would otherwise have occurred within the EU ETS “carbon bubble”. Sandbag analysis of this argument, often described as the waterbed effect, and the growing scale of ETS surpluses, suggest that the waterbed myth is entirely fallacious, but that has not stopped the myth giving rise to some damaging public policy consequences.

One example was the objection on competition policy grounds to proposed closure of five coal power plants in the Netherlands, as part of a national agreement to move towards cleaner energy. Since this was to be done on the basis of an agreement between producers, it hit problems of competition law. The companies pleaded a “public interest” defence, namely reduction in CO2 emissions. However the Dutch competition authority concluded that the agreement was in violation of the cartel prohibition, arguing that the proposal would not reduce CO2 emissions, as claimed by the producers, since the redundant emission rights would be sold on the open market and would therefore only be relocated. In other words the “waterbed myth”  was used to obstruct an “overlapping” policy that would have resulted in a real and immediate emissions reduction.

Inter alia this shows that the impact of policy failures can go beyond simple failure to achieve expectations, and can act as a barrier to other effective initiatives. Regular readers of this blog will be aware of my opposition to the UK’s exit from the EU, but the EU ETS has not proved to be a good example of successful EU policy. It may still be sensible for the UK to participate post Brexit, in the hope of its ultimate reform, but the UK will clearly need to continue its own policy initiatives, as it has to date.

There are numerous other issues for energy and decarbonisation policy that will spring from Brexit, and that is the subject of the next Climate Policy Seminar, on 5^th April when Anthony Froggatt of Chatham House and Owen Bellamy of the Committee on Climate Change are addressing the topic of “Brexit and Decarbonisation”

MORE THOUGHTS ON NETWORK CHARGING

MikeDG, commenting on my last blog on this subject, focuses on other competition analogies in telephony, and poses the question of how much difference there is likely to be between transmission and distribution networks. So I will try to partially answer this question while at the same time reflecting on the conflicting objectives to which network charging in the power sector might be subjected. I cannot pretend to have a clear and unambiguous answer, and it is probable that no solution will satisfy all the objectives, but it is at least worth rehearsing the questions.

One set of basic challenges stems from the fact that there is a strong case for using network pricing to convey economic messages for energy production and consumption, given the network structure that is already in place, but also to influence future investment in production and consumption and in the network infrastructure itself. The problem is that these worthwhile objectives can themselves produce conflicting answers, for the simple reason that there is a huge gulf between short run marginal costs, which matter for operational purposes, and long run marginal costs, which include the much larger capital costs associated with constructing or reinforcing transmission and distribution networks.

The other set of challenges stem from the history of the electricity sector, and the high voltage transmission and lower voltage distribution networks within it, as regulated monopolies. On the one hand this means that private investors have to be guaranteed a “reasonable” rate of return on their investment. But it also means that they are subject to a number of constraints that reflect social objectives, such as requirements to provide something approaching a universal service, and to set prices that are deemed to be fair and equitable, even if this conflicts with economic efficiency.

It is also in this context that competition issues are most likely to arise. Electricity networks are usually assumed to be natural monopolies, and this assumption is now generally much stronger than it is for mobile telephony. The competition issues are not about competing networks but relate to regulatory and licence requirements for network operators to provide broadly similar non-discriminatory terms to all parties in those competitive markets, such as power generation and retail supply of electricity, which depend on the network for transport to their customers. 

Given these potentially conflicting objectives and constraints for network pricing, the transformation to a low carbon power sector is going to pose some new problems, not least because of the additional electrical loads associated with electric vehicles. Here are a few.

1.       Network operators want to encourage consumers to avoid overloading networks at peak times, and can impose time of day charges for network usage that are highly differentiated and reflect operational objectives, short term costs and capacity constraints. But with conventional approaches to time of day tariffs, attempts to smooth peaks can be highly unstable, requiring regular tariff adjustments which undermine the incentive properties as far as consumers are concerned. Large commercial consumers can shift their load significantly through battery technology and other demand management measures, but if the utility is relying on highly differentiated prices to recover its allowed revenue requirement it will be forced back to higher reliance on fixed charges, negating any investment the consumers have put.

2.       The basic structure of network costs is that they are dominated by the fixed costs associated with the network, essentially the costs associated with installing wires and transformers. The future of the power sector is one which is increasingly dominated by fixed rather than variable (fuel) costs in generation and storage as well as in the networks, and this will put an increasing pressure on utilities to reflect this in charging structures. If they do not, then they may be vulnerable to cherry picking and adverse selection problems from customers going “off-grid” and paying too little for the back-up services they receive.

3.       Traditional regulatory pressures will militate in the opposite direction, continuing to seek an equitable approach to pricing that essentially equates to an averaging of costs over all units consumed.

4.       There is evidence that some new loads, including electric vehicles and heat pumps, will pose particular issues in rural networks, which have relatively tight thermal and voltage constraints. Dealing with this may require much more differentiated pricing signals, but this will run against traditional practices and also raise discrimination questions.

We should expect these factors to generate an increasing number of analytic and policy issues as we move towards an increasing electrification of the energy economy.