Thursday, June 29, 2017
Debates on policies to combat climate change often include a collection of long running arguments around the cost of capital, or the time discount rate for comparing costs and benefits. These were prominent in arguments over the recommendations of the Stern Review, mainly in attempts at a cost benefit analysis (CBA) of the public policy case for action to mitigate climate change. But assumptions on cost of capital do also matter a lot in what are now the very real questions of comparing alternative investments to reduce emissions. And of course the actual cost of capital employed will have a major impact on the affordability of future energy use, and prices to consumers. Sadly this is one of the areas where the disciplines of economics and finance have been at their weakest, in failing to provide a rigorous and consistent approach to the subject, at least in relation to the public discourse.
Let us start with the public policy arguments around climate policies, and the claim sometime made that the case for action depends on the assumed discount rate, the rate at which we discount the significance of future benefits or costs. One version of this argued that the costs calculated by Stern could only justify action to mitigate climate change if the time discount rate could be assumed to be 1% or lower. Given that even a modest probability of human extinction (or more realistically of the massive forced reductions in population of the kind against which some environmentalists warn us) might be considered to have a near infinite cost, the approach was always intrinsically unlikely to convince anyone. At times, much of the debate on this subject resembled nothing so much as the supposed discussions of mediaeval scholars as to how many angels could stand on the head of a pin.
The real problem in these arguments was the weakness of a cost benefit approach in dealing with systemic risks and possible catastrophes on a long term and global basis. CBA is usually targeted on situations where the alternatives can in some sense all be considered “at the margin”, Inter alia it became increasingly clear that the real problem lay less in evaluating notional GDP projections in alternative climate scenarios, and much more in the climate induced consequences, including migration and conflict. These considerations were compounded by the problem CBA has in dealing with uncertainty and with risks that are not amenable to simple probability quantification. Add to that the nature of the potential risks, which are on an unimaginable scale, and it ought to be clear why the calculation of the costs of a dystopian future, for comparison against an almost equally impossible set of counterfactuals as a baseline, is a rather futile exercise.
Economic models designed for fairly simplistic macro-economic analysis (and they often prove to be not very good even for this relatively straightforward task) were applied to timescales and hypothetical events well beyond their design capability, and it was quickly recognised that they did not come remotely close to capturing the true nature of climate risk. What is now accepted, and is implicit in the international acceptance of the Paris agreement, is that the risk of climate catastrophe is simply too big to be borne, and that mitigatory or remedial action is therefore a necessity.
Fortunately this part of the argument over climate policy is now settled in the public domain, with almost all nations united in their recognition of the need for actions of the kind indicated in Paris. Cost of capital arguments were ultimately of little importance in determining the fundamental imperative for policy action in relation to climate. Even so the arguments were revealing in the differing attitudes they uncovered. Nigel Lawson’s polemic against science driven climate policies argued strongly that we should care increasingly less for the futures of our grandchildren or more remote generations, arguing for much higher discount rates, of the order of 10% or more, largely on the grounds that these were closer to the target rates applied in business decision making.
The impact of discounting at such high rates makes damages a 100 years hence worth a very small fraction in terms of today’s values. Unfortunately for this argument, and as we suggest above, the scale of the perceived risk – sometimes stated in worst case scenarios as a forced population reduction of many billions - can also be described as almost infinitely large, and this is clearly the position implicit in what we might describe as the “Paris consensus”.
The Lawson position was, I suspect, based on a profound misunderstanding of how business works, especially in extrapolation of the most superficial approaches to investment appraisal. It may reflect multiple confusions over the way businesses treat investment appraisal, the debt and equity balance, use of real or nominal rates, and the appropriate assumptions about market correlation, which are a major feature of the standard CAPM model of finance. Another interesting corollary of using a high discount rate would, of course, be that it would not be necessary to set aside any significant sums today for nuclear or other decommissioning in 100 years time. Needless to say this is not an approach that is argued very often.
Lawson’s hypothetical rates are so far from the actual rates of return achieved in most business, most of the time, that we must assume one of two things. Either business is incompetent in investment appraisal, or Lawson just does not understand the subject. As he was perhaps one of the less able Chancellors of modern times, and remains someone who clearly fails to get to grips with climate science or the interpretation of statistics, the latter seems more likely.The reality seems to be that, under the right conditions, major projects can be financed at very low real rates of interest. But that is an important issue to which I hope to return. The subject remains important in practical terms, both for choosing investments and making them affordable.
 To give credit to Stern he never proposed CBA as a main driver of policy, and his post-Review thinking on the subject gave much more weight to the catastrophe avoidance arguments.
 In fact this may be an early modern fabrication, or simply an illustration of a category error in a more substantial metaphysical discussion.
 The exceptions being Trump’s USA, and Nicaragua, but the latter on the grounds that the proposals did not go far enough.
 The reality of actions is of course far less clear, but there is progresss.
 An Appeal to Reason. Nigel Lawson. Duckworth Overlook, 2008.
Wednesday, June 28, 2017
DIRECT EXTRACTION OF CO2 FROM THE ATMOSPHERE. IS THIS REALISTIC? IF SO IT COULD BE A GAME CHANGER?
A Swiss company has told the Carbon Brief website that there is a real prospect of reducing the costs of the direct extraction of carbon dioxide from the atmosphere to a point where it will be possible to consider large scale operations that could substantially offset current emissions and even feature in attempts to reduce concentration levels, in the so-called “zero carbon” or “net negative CO2” policies that many people consider are implied in the Paris agreements. If their promises are realistic, then this would be a truly revolutionary development, with profound implications for our approach to climate policy. But there will be a lot of questions to answer on the way.
A Swiss company has opened what is believed to be the world’s first ‘commercial’ plant that sucks carbon dioxide from the atmosphere, a process that could help reduce global warming, it is claimed. The firm, Climeworks, expressed confidence they could bring down the cost from $600 per tonne of the greenhouse gas to $200 in three to five years with a longer term target of $100. This is almost an order of magnitude lower than previous estimates of the cost of direct carbon extraction, widely assumed to be around $1000 per tonne.
This is also one of the two most important candidates for a game changing technology breakthrough that I identified in my 2016 submission to the House of Lords Inquiry, which can be viewed as a separate page on this site. If it proves to be feasible then it may represent a considerable advance on what has hitherto been considered the only feasible route to net negative carbon, the so-called bio-energy with carbon capture and storage (BECCS) approach. Shortcomings of the latter include the limited supply of bio-energy, not least due to land availability constraints, and controversy over whether this really represents a sustainable approach. So direct sequestration, if feasible, is very attractive.
There are clearly still a large number of outstanding questions before we get too excited by this prospect.
Is $200 or $100 per tonne really achievable? And if so is the technology scaleable? And to what scale? If it is scaleable, it seems likely the world could be seeking an expansion of the process well beyond the 1% of current emissions suggested as an ambitious target by Climeworks.
The other big question is how to dispose of the CO2 after its capture. This is a big issue, and a very substantial part of the cost for all carbon capture technologies, including those based on removing the CO2 from fossil fuel combustion. This cost needs to be factored in and is bound to be a fairly substantial element in the total. It does not appear to be included in the Climeworks figures. Moreover the disposal issue, at scale, will raise its own environmental and risk issues.
But if these questions can be answered this could be a very significant technology advance. It is certainly not the magic bullet that solves all problems, but it could have some important consequences for the way we look at climate policies. Why?
First, one of the most terrifying features of the climate change threat is the apparent irreversibility of the processes involved. CO2 emissions are cumulative. If they cannot be removed on any scale, then there is a real risk of a future where the climate science starts to tell us there is no return. At this point priorities would take a dangerous turn towards survival rather than the global idealism, or at least hope, that underpins global agreements. But it is not just that dealing with a very expensive problem is psychologically more attractive than coping with the prospect of unavoidable catastrophe. Ability, in principle at least, to partially reverse out of the worst consequences, puts a finite bound on the costs of making the wrong policy choices. Inter alia it ought to increase the available policy options.
Second, and more importantly, direct sequestration has the potential to change the basis of policy in relation to carbon pricing. I have previously commented on the weakness of traditional cost benefit analysis (CBA) in this context. CBA fails to provide a basis for a carbon price, and the failure is in large measure due to an impossible number of uncertainties (in climate, geographical and economic impact) to which probabilities cannot be assigned from any established base of knowledge. But if we have a clear way of putting a cost on CO2 removal, then we have at least a first approximation to a “true” cost of CO2 emissions. This might inter alia provide a better justification for effective carbon pricing, and even for global adoption of a “common” rate of carbon tax. It could be a much more hard-edged approach than complex negotiations over carbon trading schemes, which, as with the EU Emissions Trading Scheme, have so far failed to deliver adequate carbon prices.
These are obviously early days for direct extraction technologies, and we should avoid premature optimism, but this could be an important part of the geo-engineering landscape to watch.
 One of the reasons BECCS is controversial is that its justification requires careful analysis of the entire chain of processes involved, starting with the cultivation of the bio-crop and including any ecological or carbon related side effects, as well as consideration of the alternative land uses for food production or other purposes.
 Limits to scale might be imposed, for example, by the availability of other input chemicals to the extraction process. But the more serious limitations are likely to be on disposal of the CO2 gas. A preferred route of extraction might be capture of the carbon in a solid and inert form, such as calcium carbonate, if this were possible.
Sunday, June 25, 2017
Tragic events in the UK in the last week, the Grenfell Tower fire, remind us of the dangers of not paying attention to readily identifiable risks, and avoiding action for the sake of relatively trivial cost savings. Although it is an issue on a much much longer fuse, there are many analogies that should apply to the way we approach the threat of climate change. It’s not a simplistic cost benefit analysis. It’s about possible risks to our survival, at least in the numbers and the style to which we are accustomed today. This means a sensible approach to the avoidance of catastrophic risk. It also means understanding the science, in this case some of the dynamics of climate.
Discussions in one of the recent BIEE climate policy seminars, taken with some of the references that I then pursued, touched on a number of general issues that I have sometimes touched on before in this blog, or which deserve repeat at regular intervals. One is the gross inadequacy of conventional approaches to justification of climate policy in terms of a traditional cost benefit analysis, sometimes grasped enthusiastically by second rate economists as if it were a raison d’etre of their trade. Another is the notion of “tipping points”, associated with particular catastrophic risks to climatic systems, and sometimes ridiculed by climate sceptics; these are essentially points where a small marginal change in one factor, eg temperature, can completely change the dynamics of a climate system. A third is the problem of finding a rational approach to risk uncertainty, and a fourth is the importance of irreversibility. And finally I discovered, buried in an under-reported section of an IPCC report, a simple illustration of why we might want to take seriously the aspiration, from the Paris agreement, for a 1.5o C global warming target.
Let’s start with the illustration, which is a chart showing the pattern of a likely relationship between temperature. The vertical axis is estimated long term sea level rise associated with a given increase in global temperature to a new equilibrium.
Climate Change 2013: The Physical Science Basis. Chapter 13. Sea Level Change
The graph shows a step change in the long term sea level that starts as the global temperature rises. The step change occurs as global temperatures reach about 1.5o C above pre-industrial levels, and adds about five metres of sea level. It is perhaps not entirely coincidence that this is the aspirational target from Paris COP21.
What the chart shows is actually a physical phenomenon that is very easy to explain. It is the melting of land ice, in this case the Greenland ice cap. Up to that point sea level rise is slower and due to other factors such as thermal expansion or glacier melt, as well as smaller land ice reductions. Once the ice has melted it will not reform quickly or easily even if temperature stabilises or falls slightly. In other words the change is irreversible. The change also changes the climate dynamics and accelerates global warming through a feedback effect, as water absorbs more heat than reflective ice cover.
This scale of sea rise, which threatens many if not most major cities, such as London and Shanghai, and countries such as Bangla Desh, as well as much of our most productive agricultural land, might be considered an existential threat to human survival, at least with a continuing population of 8 to 10 billion. Even if this probability were considered quite small, an assumption that is by no means obvious, it is one that most people, facing such a risk in their daily lives, would take a great deal of trouble to avoid. As the simple physics of heat tells us, melting is not an easily reversible process. Land ice melting on this scale would be a catastrophe from which there would be no easy escape.
This is also an where a traditional cost benefit analysis to public policy breaks down. It fails for a number of reasons.
First there is no means to measure the scale of what the costs of serious disruptive climate change might look like, in terms of forced mass migration of hundreds of millions of people, resource conflict, and the destruction of capital assets. Integrated assessment models of the type quoted in the Stern Review, however well intentioned, are simply not fit for this purpose. Second, cost benefit analysis is actually a very limited technique, suitable for the analysis of small incremental changes. It does not deal adequately with radical choices between wholly different paths to the future. Third, it takes no account of inequality. Hardships for poor people are valued less than minor inconveniences for the wealthy.
But most important of all, it depends on the ability to quantify everything, including uncertainty. This is acceptable when it is possible to assign a known probability distribution, but in this context, and many others, that is completely impossible.
This is a field where other professions have long had a more realistic approach. Dr David Hare, a past-President of the Institute and Faculty of Actuaries, puts it very well.
“Climate change is primarily a risk management problem – one of the most important goals of climate change policy should be to limit the probability of a very bad outcome to an acceptably small value.”
The task then is not to find an arbitrary value for a carbon tax, although such a tax is a useful measure. It is to make sure, above all, that a safe policy objective is achieved. 1.5o C, far from being idealistic, may even prove to have been a dangerously conservative target.
 I shall not be specific as these seminars meet under the Chatham House Rule and I prefer to minimise the risk of accidentally ascribing an opinion to an identifiable individual.
Monday, June 19, 2017
Stunned by the range and scale of extraordinary and dramatic events in the last few weeks, this blog has remained very quiet and is only now starting to recover. It will remain quiet and slightly less frequent over most of the summer as the author is also working on some substantial papers about low carbon issues.
But it’s a good time to review quickly some recent events, in terms of their possible implications for energy and climate policy. Some of the themes may deserve a fuller treatment in due course. Some reflect on earlier postings.
Trump. The Trump comedy machine trundles on. Monty Python meets House of Cards is one popular characterisation of recent events (and not just with Trump or the US). But, as I commented earlier in relation to the Paris agreement, the damage of US withdrawal can be exaggerated. It will be limited both by growing appreciation within the US of climate issues, and by the increasing extent to which the rest of the world will simply ignore the US in the framing of its own policies.
The Middle East. Probably of more geopolitical significance are the strange diplomatic initiatives in relation to Saudi Arabia and Quatar. At the very least these risk adding fuel to the flames of conflicts that are already very terrible and will pose problems well beyond their own borders. These are very well explored by David Gardner in the FT.
The Saudis have long so mismanaged their energy resources as to have been forced to consider their own austerity programme, and on current prognostications for oil demand and prices their long term prospects must force some very substantial changes, not least in the very wasteful consumption of energy that has characterised much of the Middle East. We have long thought of the region mainly in terms of its role as a low cost intra-marginal oil producer, but consumption growth has been huge, and it deserves to be taken much more seriously in the broader context of how global adjustments and low carbon policies can be developed. We have to hope this will not be hindered by ill-considered diplomatic and military adventures on all sides.
UK. Bank of England forces financial institution stress tests in relation to climate change. This is another sign that widespread assumption of a low carbon future is gaining traction. Part of this is concern with the liabilities of insurance companies, in relation to some of the bigger risks anticipated from climate change, eg coastal flooding. But another of the Bank’s concerns is with the position of funds that have too much invested in companies that are going to lose out heavily if the world turns even more decisively against fossil fuels. Companies most at risk include coal, especially as the prospects for carbon capture appear to recede. Again this is an issue flagged in an early posting on this site.
And the UK election and Brexit. Direct implications for climate policy seem limited. There is no doubting the multiple close correlations and affinities between the fundamentalist free marketeers, the hard right Brexiters, the Trump camp and fossil fuel lobbies in the US, and refusal to accept the implications of climate science. Politicians like Redwood, Lawson, Trump himself, Farage and UKIP, Rees Mogg and Grayling, together with the small band of pro-Brexit economists, all fit the mould, and the correlations have been noted in earlier postings. But with too many internal battles over Brexit, and the relaxation of austerity, any threats to UK climate policy, its 2050 legally binding targets or its commitment to Paris seem unlikely, for a host of reasons.
Where do we go on liberalised markets? Both major parties went into the election on a platform that included the prospect of price controls for the energy companies. This deserves a deeper analysis, perhaps, but surely marks the death knell of the liberalised market approach in the UK. The UK government, and most other European governments, intervene extensively in the energy sector.