BLUFFERS’ GUIDE TO COST OF CAPITAL.

Shortly before lockdown in 2020 I was asked to provide an introduction to this subject - discounting, net present value, and cost of capital - for an Oxford Martin School seminar. It’s a vitally important subject for policy making on the major infrastructure investments that will be needed in our climate mitigation strategies, and that was a primary interest for that particular audience.

Unfortunately it’s also a subject that enjoys a very limited degree of consensus among economists, especially in relation to questions of social time preference, which bring in major ethical issues. 

Equally unfortunate is the disconnect between most people’s intuitive understanding of risk and the concept of risk that underpins the dominant CAPM model in modern finance theory.

I don’t pretend to have definitive answers on many of these questions, but many colleagues have found this brief description or “bluffer’s guide” quite helpful, and I finally decided to make it a blog post

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A tourist’s guide to the landscape of finance theory, investment choices, NPV and IRR, and other cost of capital issues

 

Why it matters ?

Summary of the CAPM model.

Multiple fallacies and pitfalls.

Context is vital.

And the time value of CO₂ ?

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WHY DO WE WORRY ABOUT RISK, RATES OF RETURN AND COST OF CAPITAL?

Multiple contexts for RoR and CoC. And do we expect consistency?

 

Financial sector – fund management. Portfolio theory. Selecting portfolio of investments (balancing risk and return).

 

Basis for valuing an asset/ business. Future revenue and cost stream discounted at an appropriate cost of capital [usually defined by the “(market correlated) risk” attached to type and sector of business, eg consumer goods/capital/utility].

 

Valuing future liabilities (eg pensions and life insurance) to determine how much to hold in financial assets– [vide pensions crisis]. Analogous to funds required to be set aside as provision for decommissioning costs.

 

Investment appraisal. Decisions by a company on (selection of or between) investment projects.  Analysis of revenue stream discounted at the company’s cost of capital to a net present value (NPV). Can dramatically impact choice between technologies.

 

Regulation of utility prices. The “allowed rate of return” on a regulated asset base (RAB). Beta value of about 0.5 for utility businesses with low market-correlated risk. 

 

Public policy choices. What is the social “time preference rate”? [presumes applicability of cost benefit analysis in order to generate stream of costs/ benefits over time.] Can this reconcile with markets?

 

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BASIC MATHEMATICAL/ARITHMETICAL TOOLS

 

Compound interest calculations and actuarial annuity tables.

 

Calculation of net present value (NPV) for a given cost of capital/ discount rate.

 

Calculation of internal rate of return (IRR) for a given stream of costs and revenues. [NB there is not necessarily a unique solution for IRR**.]

 

The Capital Asset Pricing Model, “CAPM”, for risk adjustment of the cost of capital.

 

** eg the net revenue stream: -50, +10 for 20 years, then -150. IRR is either 0 or 14.8% ???

 

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CAPITAL ASSET PRICING MODEL
(which derives from portfolio theory)

 

E(r_i) = R_f + b_i (E(r_m) – R_f)

 

where

 

E(r_i) = return required on financial asset i

 

R_f = risk-free rate of return

 

b_I = beta value for financial asset i

 

E(r_m) = average return on the capital market

E(r_m) – R_f is usually known as the equity premium. The beta value is the sensitivity/ correlation of the individual stock i with the overall market. The risk-free rate is usually taken as the rate on government bonds.

 

 

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WEIGHTED AVERAGE COST OF CAPITAL

 

Modigliani-Miller Theorem. The overall WACC should be independent of the ratio of debt to equity financing.

 

The higher the debt ratio, the more financial (market correlated) risk attaches to the residual equity component and hence the cost of equity capital.

 

Tax interferes with this simple message, since debt interest is tax deductible. This tends to favour debt financing.

 

The main implication is that when businesses talk about cost of capital or expected return it is important to be crystal clear about what this means, WACC or equity component.

 

Also we always need to be clear as to whether we are analysing any problem in real or nominal terms.

 

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ASSUMPTIONS THAT LIE BEHIND THE CAPM MODEL

 

We should ignore project-specific risk. This is because investors can in principle diversify away from specific risks. Of course individual managers may have very different perspectives (both directions). (For most people this is a counter-intuitive concept of what we mean by risk, and accounts for a great deal of misunderstanding in relation to how “risk” should affect cost of capital.)

 

We can measure or assume a “risk-free” rate – typically the return on government bonds. This is a non-trivial exercise but is relatively uncontroversial.

 

We can measure the overall “equity premium”. This is more controversial, and depends (mainly) on interpretation of long term historical data.

 

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QUALIFICATIONS TO CAPM IN CONTEXT OF RISK

 

CAPM is focused entirely on “market correlated” risk – an investor perspective.

 

Managers and other stakeholders may have very different attitudes to project specific risk – eg either excessive aversion or complete indifference.

 

[Managers may avoid high return projects with some project specific risk if employment is at risk. Or they may promote dubious projects if the risks are long term and past their event horizon – eg retirement.] 

 

For most people their intuitive concept of risk is mostly project –specific or competitive, on which subjects CAPM says nothing per se.

 

The market correlation of a particular investment opportunity may have a very different  “profile” from that of the company and the sector as a whole.

 

For a big project, the risks and cost of capital may differ markedly for different parts of the project, eg construction versus long term operation as utility asset.

 

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WHEN SPECIFIC RISK IMPACTS COST OF CAPITAL

 

CAPM was largely about the market correlation of “equity” earnings in financial markets.

 

But financial markets also need to deal with debt, about future payments that are denominated as fixed and not market related; in this instance lenders need to discount the possibility that the debt will not be honoured. This can have market and non-market components.

 

So a promised payment of £100, with a 5% probability of default, is only worth £95 (or less because of risk aversion); conversely the borrower has to promise to pay £100 rather than £95. For a twelve month loan this would be equivalent to a 5% increase in cost of capital.

 

Hence the importance of credit ratings, eg wrt sovereign debt. They affect both ability to borrow and its cost. If risk of default is high, projects/ borrowing becomes non-financeable at any cost of capital. [cf basket case economies].

 

The corresponding core issue in the context of infrastructure investment is regulatory and policy certainty. For high capital cost projects, this will have a massive impact on affordability.

 

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INVESTMENT APPRAISAL PROBLEMS AND FALLACIES

 

Widespread appraisal optimism. Promoters of projects will often tend to overstate benefits/ revenues and underestimate costs.

 

The sensible solution in this context is not to impose a high “hurdle rate”. This confuses risk with the time value of money. The answer is to address directly the validity of the revenue stream estimates.

 

High hurdle rates or “payback time” approaches produce “short-termism” outcomes.

 

Comparing IRR for choice between different projects will normally give very similar answers to NPV, but can go badly wrong if there is back-end loading of significant costs, eg decommissioning.

 

Theoretically the right approach is NPV, using realistic estimates and assuming the right values for cost of capital

 

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SO WHERE ARE WE IN THE REAL WORLD?

 

It used to be assumed risk free cost of capital was c.1.0-3.0% real, based on observed return on government bonds inflation adjusted, … and the equity premium was about 3% real (very long term analysis).

 

Utility returns (on regulated asset base), with a company beta of c 0.5, typically around 5%, but

 

… currently the risk-free cost of capital is close to zero, or even negative. (What does this mean? And will it hold?)

 

Global glut of capital, so real cost of capital ought to be assumed to be extremely low, especially for infrastructure projects with little or no market correlated risk, or “essential” low carbon “must do” projects.

 

Some evidence that projects really can be financeable with very low real terms cost of capital, of order of 1-2 % pa. This depends on clever financial structures to meet actual financial market preferences, segmenting risks, and contractual or other guarantees against regulatory/project specific risk.

 

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IMPLICATIONS TO TAKE FROM THIS BRIEF TOUR

 

We should use very low CoC for policy choice purposes (essentially the Stern position), and this is broadly consistent with a Stern/ social time preference approach to climate policies.

 

It is possible to reconcile this with financial market measures of cost of capital, at least in broad terms and on favourable assumptions.

 

But achieving a low cost of capital also requires taking out project specific risks that are outside control of investor. Hence need for some combination of regulatory/ policy certainty and contractual commitment.

 

Real world factors make it hard for many of the agents to achieve low CoC. eg domestic consumers, market distortions, poor legal/regulatory framework, countries with sovereign debt risk, financial market issues etc.

 

Always be aware of context eg market situation, political framework etc. And define terms: real or nominal, equity or WACC, pre/post tax.

 

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WHAT ABOUT THE TIME VALUE OF CO₂ EMISSIONS?

 

This has all been about the time value of money. What about the time value of CO₂? Emissions also have a time value. 

 

Because CO₂ is cumulative, emissions now do more harm than emissions in 10 years time. (ie 10 years extra harm).  [ ≈ c 2% pa.]

 

Confirmed by some IA models but rarely reported.

 

An issue quite separate from cost of capital.

 

Ought to have an equivalent impact on policy.

 

Favours early emissions payoff projects, eg known technology rather than “wait and see”.

 

 

 

 

ELECTRICITY TARIFF REFORM. SHIFTING THE BURDEN FROM ELECTRICITY TO GAS IS A START

 

Plans to shift green surcharges from household electricity bills to gas bills are an overdue and welcome reform. With the necessity to shift consumption away from gas to low carbon power, taxing electricity but not gas has been perverse. In particular it conflicts with policies to shift residential heating to electricity-based systems, especially heat pumps. It was one of several key recommendation of the 2019 report, on network tariffs for a low carbon future, that I prepared for Energy Systems Catapult. So it’s satisfying to see the proposed change.

However this shift is probably not enough on its own to provide a clear incentive for consumers to switch from gas to electric systems, including heat pumps, even if the present surge in gas prices is sustained. A more fundamental recasting of the structure of electricity tariffs will be essential, notably a significant change towards recovering far less of the fixed costs of network infrastructure through the kWh charge. This is a profound change, and may require additional measures to prevent the regressive effects of a larger burden on lower income households. But it can be done in ways that are consistent with equality or levelling up agendas.

The flaw in current tariffs

The incremental costs of supplying energy are the right basis for any price and tariff comparisons that consumers make when choosing a heating system. Costs should ideally include all environmental costs and these may be expressed for example as a carbon price. Energy costs are however only a part of the story for the tariffs faced by consumers. For residential consumers, up to 50% of total costs reside in the fixed costs of the networks, concentrated in the local distribution networks. The marginal cost of accommodating extra throughput is, at least in uncongested networks, very low. But the fixed cost still needs to be recovered. How best to do it poses some difficult questions in terms of reconciling considerations of equity and income distribution, on the one hand, and the efficient allocation of economic resources on the other.

Current UK practice for smaller retail consumers is simply to average most fixed costs over all units of energy sold. This seems fair, and prima facie results in those who consume most (and might broadly also be those with higher incomes) paying the most towards the fixed costs. However it distorts the economic message, that the actual marginal or incremental cost is much lower. This leads to at least two major problems.

1.       It exaggerates the incentive for individual consumers to instal their own forms of power generation, even if these incur high resource or environmental costs, simply in order to avoid network charges. There is no saving in overall fixed cost and, while individual consumers with own generation may benefit, a larger share of fixed public network costs is then picked up by others. Total societal costs increase. Incidentally, this also tends to benefit the wealthier households who are more likely to instal their own generation.

 2.       Policies for a low carbon economy rest on persuading consumers to use large amounts of extra electricity for heating (eg with heat pumps). The high unit kWh rates that result from the current practice of spreading the fixed costs over all kWh then become a very serious obstacle, particularly when the consumer choice is between electricity and gas. This is reinforced by the matter of high per household capital costs for retrofitting heat pumps.

 

For household consumer, a higher fixed charge in the tariff, and a lower unit energy charge, transforms the choice between using the low carbon solution (electric heat pumps) and traditional fossil fuels (gas or oil).  I examined this in my 2019 report, but it is worth recalculating in the light of recent price trends. Assuming 10,000 kWh per annum consumption, a coefficient of performance (COP) of 3 for heat pumps, and 90% efficiency for modern condensing boilers (both slightly optimistic), the message is clear.

 

Economics of Heat Pump vs Gas [Energy Cost Only]	elec tariff p/kwh	Elec useful heat p/kWh	Gas tariff p/kWh	Gas useful heat p/kWh	Heat pump saving £ pa
Current tariffs[1]	14.50	4.83	3.86	4.29	-54
Current tariffs and + 1p/kwh CO2 tax on gas[2]	14.50	4.83	4.86	5.40	57
Reform tariffs + CO2 tax.[3]	7.50	2.50	4.86	5.40	290
Reform tariffs + CO2 tax + permanent high gas price[4]	7.50	2.50	8.00	8.89	638

 

With current tariffs, heat pumps struggle to be competitive with gas even on running costs. A 1p per kWh carbon tax on gas, or its equivalent, helps to shift the balance (to a small advantage for heat pumps). Tariff reform has a much larger impact (2.5 times), and this is of course hugely reinforced if we assume permanently higher gas prices. This takes us at least part of the way to compensating households for the higher capital costs of heat pumps.

Disadvantages to poorer consumers

We noted above that some wealthier consumers benefit from current tariffs through the arguably excessive implicit subsidies to own generation. Other beneficiaries include second home owners with very low annual consumptions. However the regressive impact of a necessary tariff reform cannot be ignored. But there are many different options available.

One is to change the basis for applying standing charges to consumers. One proposal put forward has been to collect contribution to fixed costs through tariffs based on property values, akin to traditional approaches in water based on rateable value, or property tax band.

Another is to limit the application of the lower tariff rate to consumption for heating, but not for other purposes. Modern technology makes separate metering, as well as the detection of any metering fraud, a very plausible option.

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The conclusion must be that tariff reform will be an essential component of any national strategy for the decarbonisation of the heat sector.

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[1] Average kWh rate for UK, and recent variable rate British Gas tariff for gas.

[2] Set at 1.0 p/kWh as first approximation to likely impact of transferring environmental cost burden to gas. I used a higher number in the original report

[3] Assumed future average wholesale power cost of 7.5p/kWh

[4] Assumed winter gas price of 170 to 210 p/therm, deduced from recent reports

ELECTRIC VEHICLES FOR AFRICA. PIPE DREAM OR NECESSITY?

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A recent FT article argued the importance of electric vehicles in Africa, as an essential component of a global strategy to limit emissions and combat climate change. A predictable response from readers was that this was wholly impractical on the grounds of both affordability and the current inadequacy of African power systems. Healthy scepticism is fine but it should not obscure the fact that it is in an African and global interest to leapfrog to an electricity based transport technology. Electric vehicles can be part of the solution for Africa’s power systems, not just another problem.

Vome Aghoghovbia-Gafaar writes[1] on “Why Sub-Saharan Africa’s teeming cities need electric vehicles.” The response from FT readers was sceptical, making the seemingly obvious points that Africans will not be able to afford expensive Teslas, that even developed countries are struggling with the infrastructure electric vehicles (EVs) require, that Africa largely lacks adequate power supplies, and that better mass transit systems are perhaps a more immediate transport priority for Africa’s mega-cities like Lagos or Dar-es-Salaam.

Healthy scepticism is fine, but there is a wider case for EVs in Africa, and it builds on the almost universal imperative to move rapidly towards low carbon sources of electricity as a substitute for fossil fuel use. The big issues for this target in Africa are first the absence of affordable electricity, and second the unsustainability of clean economic development without it.

The global imperative is that unless we can achieve a transformation of the power sector in Africa, which enables both economic development and a switch to low carbon fuel sources, then the chances of meeting global emissions and climate targets are very low indeed. That reality should condition our judgements on the realism of prospects for overcoming the undoubted obstacles

From my experience the biggest single barrier to resolve the first issue – affordability – is likely to be the very high component of fixed cost, which especially in poor communities has to be spread over a small number of kWh. The only way to get the unit cost down is by much higher volumes, but these are often hard to achieve.

Africa has some of the highest unit costs and prices for power in the world, as well as many of the poorest people. This combination makes it particularly difficult to build the volumes, and the economies of scale, which are ultimately the only ways of bringing these costs down.

For rural electrification, involving some of the poorest communities, the World Bank has estimated kWh costs could be brought down to about 22c per kWh with the achievement of reasonable load volumes and a 40% load factor. Neither of these conditions is easily met, however. Moreover much of Africa is well endowed with solar power, but the management, even of small systems with intermittent energy, is problematic in the absence of storage or back-up. And similar issues can be expected in urban systems.

Electric vehicles help with both problems. It is intrinsically a large load, and with a high percentage of EV batteries connected to the grid when the vehicle is not in use, eg in the evening, this creates significant opportunities to improve load factor, substantially reducing the unit costs to other productive uses of electricity, and to cooking. The latter in particular offers a big environmental benefit. Electricity can substitute for firewood or charcoal, whose continued use has disastrous consequences for deforestation as well as a large carbon footprint. The scale of emissions from these unsustainable sources is comparable to that of diesel used as a transport fuel.

As an idealised solution, therefore, promotion of electric vehicles in Africa can provide a classic synergy in terms of reducing emissions, providing clean energy and assisting economic development. In itself it reduces harmful emissions, a global CO₂ benefit, as well as localised city pollution. The key to the economics is that if the vehicles and their batteries are already there, some of the essential but very expensive storage requirement of renewable power systems is already in place.

The additional load permits more effective management of renewable systems and much higher load factors. Both these gains would have a big impact in reducing unit costs, and this in itself could create a virtuous circle of more affordable power, more productive use of that power, higher incomes and improved affordability, feeding back into further economies of scale, cheaper power, and less polluted cities.

Measuring the benefits

In an earlier post[2], I discussed the benefits of eliminating traditional and unsustainable use of firewood or charcoal for domestic cooking. The potential reduction in CO2 emissions is huge. Charcoal use is widespread in the developing world and its elimination for a billion people (a conservative estimate of potential) could reduce global emissions by as much as 700 million tonnes or about 3 % of the total. The nature of the emissions externality is that the benefit accrues to the global community as a whole, not just to Africa. But the scale, with any reasonable valuation of carbon, is huge

The contribution from eliminating oil dependent road transport in Africa could be of a similar order of magnitude, with a similar global benefit.

How realistic is all this?

As electric vehicles take an increasing market share, some of the barriers are likely to fade away. Scale economies will bring down manufacturing costs and prices to consumers, along with a new generation of vehicles made in China or India, probably with more basic specifications but significantly lower costs. Electric vehicles combined with electric cooking could, as suggested above, mitigate the technical and economic problems in developing the power sector

The biggest barrier remains the quantum leap required of African power sectors, partly in terms of governance but even more in terms of the sheer amount of capital required. Help from development aid budgets will be a necessity. But, as I have suggested above, failure in this task should not be considered an option. The global economic cost of climate catastrophe, or the cost of expensive carbon extraction from the atmosphere (which we shall almost certainly be forced to adopt) could make African electrification a bargain form of carbon reduction for wealthier nations.

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References

Is sub-Saharan Africa ready for the electric vehicle revolution? | World Economic Forum (weforum.org)

John Rhys on Energy, Climate and Carbon: FINANCIAL SUPPORT FOR ENVIRONMENTALLY SOUND POLICIES IN POORER COUNTRIES MAKES SENSE FOR EVERYONE. THE CASE OF FIREWOOD, CHARCOAL AND DEFORESTATION. (co2economics.blogspot.com)

Energy and Transport in Africa and South Asia. Katherine A. Collett, Maximus Byamukama, Constance Crozier, Malcolm McCulloch February 2020

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[1] FT.  1 February 2021

[2] Reference and link at bottom of post.

GLOBAL BRITAIN. IS COP 26 THE GREAT OPPORTUNITY?

 

It ought to be, but our government is hamstrung by its own ideologies, its recent history, and our decision to cut adrift from Europe.

The next climate summit COP 26 is so important for our collective future that we should all hope for  a resounding success. The question will be whether the UK is up to the task of delivering on the promise, and achieving worthwhile agreements and commitments. A lot depends on the ability of the summit host to persuade and cajole. Alok Sharma, the Business Secretary has been charged to work full time on preparations for COP 26, and, encouragingly, is quoted as recognising that “the biggest challenge of our time is climate change and we need to work together to deliver a cleaner, greener world”.

On the positive side, the UK does bring some strengths. Tony Blair gave the UK a genuine world first in the 2008 Climate Change Act, targeting an 80% reduction (from 1990 levels) in emissions, the first time such a national target had been introduced into law. The UK is able to claim significant reductions in its own emissions, even if these largely reflect the special circumstances of its gas for coal transformation of the power sector and the off-shoring of emissions that resulted from the Thatcherite de-industrialisation of the 1980s and 1990s. And it has important strengths both in policy formation and in science, both vital for the future.

And growing environmental awareness provides an auspicious international backdrop for climate action. 2020 saw some of the highest global temperatures on record, alarming heat and record wildfires in the Arctic, and record tropical storms in the Atlantic. Even if these and the Australian bush fires are not all directly attributable to global warming, and other factors are indeed often at work, the impact on the public consciousness has been huge.

Even the covid pandemic plays into the wider Green agenda that our failure to protect our global environment has been a huge mistake, with the indications of connections between declining wildlife habitat and the probability of viruses jumping the species barrier.

Finally 2020 has seen the stunning electoral defeat of arch science denier and fossil fuel promoter Donald Trump. Covid-19 has proved not to be a hoax, and so has climate science. The biggest single obstacle to international progress, the intransigence of the USA on climate issues, has softened even if not wholly removed, at least for now.

But this is also where the credibility problems of the current UK government begin. It is not helped by its poor and embarrassing record in appeasing the disgraced Trump, partly in its desperation to find international, and particularly US, support for Brexit.  “… this opportunity is dependent upon Mr Trump’s presidency. Without him the US would be offering no support for Brexit and would be seeking to frustrate it.” (Rees-Mogg, 2018)

The bigger problem is that the Tory party has over a long period been the home of the most vocal climate sceptics – Lawson, Redwood and many others. Moreover “climate hoax” claims,  and more muted efforts to reject or ignore the implications of climate science, are strongly associated with the tendency to theological belief in Brexit (with Lawson fronting the Brexit campaign), an observation I made in this blog in 2016, and which many others, including The Economist, have made subsequently.

Nor is the Tory ideological commitment to low public spending and a small state easy to sustain in the face of the kind of crisis provoked by climate change (or by covid-19 for that matter). Action to reduce emissions, to promote electric vehicles and alternative heat provision, and to mitigate the effects of climate change, are all going to require huge infrastructure spending, policy interventions, and financial commitment by governments everywhere.

But the more interesting challenges for British commitment to climate goals will come in relation to its ambitions for international trade, and its fragile trading relationship with Europe. In July 2020, the EU launched a consultation on proposals for a border carbon adjustment mechanism, effectively a carbon tax imposed on imports from countries deemed to have less rigorous emissions policies than the EU. This provoked predictable outrage from Trump and much of corporate America, but the concept will also have longer lasting and more subtle effects on trade. There are powerful arguments for this kind of tax, to allow a “level playing field” in trade, and to prevent carbon and jobs “leakage” to countries that refuse to cooperate with low carbon goals.

It is very likely that a such a carbon tax, applied at borders, would impact initially only on highly energy intensive sectors such as steel, aluminium and cement. My own view is that pushing it down to other sectors may prove much more difficult in terms of measuring carbon content, with complexities that may make current issues with “rules of origin” look comparatively simple. But the effect on trade negotiations is likely to be more subtle, with pressures to imitate and endorse EU climate targets.

The consequence is that for the UK to operate successfully as the host of COP 26, this initiative is likely to push it closer to the EU position on convergence of trade policy and climate objectives. This is almost certainly in the UK’s short, medium and long term interest anyway, but may be a hard pill to swallow in the aftermath of the bitter divisions, internal and external, of the last four years. Even if the USA, under Biden, adopts a much more progressive position, major players, such as India, Brazil and others, will be much more resistant. The Brexiter reliance, at least in terms of political rhetoric, on new friends and trading partners, will make effective international  influence more difficult. But that of course is just one more negative consequence of leaving the world’s largest free trading block in the first place. A climate coalition with Europe remains the UK’s best policy.

SAVING THE PLANET DOES NOT NECESSARILY COST THE EARTH

Beware Fake News  on the economic and other choices we have to make.

There are longstanding debates about the economic costs of moving the world away from its addiction to the fossil fuels that are the prime source of the greenhouse gases causing temperature and climate change. There will be renewed attention to the challenges as the world slowly emerges from the covid-19 pandemic.

There are many elements to this discussion, from estimates of aggregate cost to macro-economic issues of reviving economies through Green investment. Some are discussed in a forthcoming article in the Oxford Review of Economic Policy.[1]   Will COVID-19 fiscal recovery packages accelerate or retard progress on climate change?

However, the propaganda battle has also begun, and so have the invented stories. On 7^th May the Financial Times commissioned an exchange of views between Christina Figueres, a former leader of the UN climate secretariat, and Benjamin Zycher of the American Enterprise Institute. Can we tackle both climate change and Covid-19 recovery?

Taxes at $30 for a gallon of petrol? Really?

Zycher, after a fairly conventional if disputable assertion of essential connections between economic growth and energy consumption, claimed that the Intergovernmental Panel on Climate Change (IPCC) advocates carbon taxes for 2030 with a midrange equivalent to $30 per gallon of petrol.

I have always been a natural enthusiast for Twyman’s principle, also attributed to the distinguished statistician, the late Andrew Ehrenburg. The “principle” is that any “interesting” statistic is probably wrong. In other words, if a number looks wrong, then quite likely it is wrong. This one was specially “interesting”; my own familiarity with energy statistics, and energy costs and prices, indicated an order of magnitude error.

If it looks wrong, there’s a good chance it is wrong!

Quite apart from the numbers, the attribution of this statement to the IPCC was intrinsically improbable, as the IPCC does not take policy positions. Its function is to report and summarise the literature of thousands of scientific and other publications, including economic modelling. It tells policymakers what we know and don’t know about the risks related to climate change (a bit like the role of the UK’s SAGE in the current pandemic). Its processes are carefully controlled by national governments, and it emphatically does not “do” policy recommendations, or advocacy.

I decided to do a quick check.  Much of the polemic was based on the supposed extremism, and implied naivety or hostility to humanity, of environmental campaigners, exemplified by “$30 per gallon”. It seemed quite important to understand how the author had come to this number. If the alleged advocacy was not correct, it seemed to be a particularly egregious example of dishonest reporting and misinformation.

First this meant chasing up the citation[2], given as Chapter 2 of the IPCC Special Report: Global Warming of 1.5 ºC. That report also has a Summary for Policymakers. Inspection of that summary did not reveal any mention of carbon taxes or carbon prices. If IPCC were really engaging in advocacy, it is in a summary for policymakers that one would expect to find it. It was not there.

I turned to Chapter 2, which appeared to be where Zycher had extracted his dubious statistic. The chapter consists largely of a technical summary of modelling methods, and hundreds of modelling outputs, all heavily qualified as to assumptions, meaning and interpretation. It does discuss the theoretical impact of carbon prices, but the relevant section, around page 78 of Chapter 2 emphasises the “real world distinction … between implementable and notional [model] carbon prices …” and that any “price … estimated in modelling studies needs to be compared with what is feasible”.

Turning to climate policy discussions, some proposals for more aggressive carbon pricing do indeed favour CO2 prices (or taxes) higher than today’s, typically of $100-200 per tonne. The same section of the IPPC report does identify evidence in support.  “Literature has identified a range of factors … that support [social cost] SCC values above $100.”  But for petrol that would be around 90 cents per gallon, an amount almost lost in the noise, not Zycher’s hysteria-inducing 30 dollars. Focusing on petrol prices in an electric future seems inappropriate but is presumably intended to link back to an everyday price with which most people are familiar.

If anything, environmental campaigners might be concerned that carbon taxes, even at the quite aggressive level suggested above, have so little impact on pump prices to consumers. An amount of 90 cents (or pence) a gallon is less than European governments already levy in tax, and within the range of the normal fluctuations in fuel prices in recent years. It is widely assumed among energy economists that taxing petrol is not a particularly effective instrument for promoting low carbon transport, and that more of the solution lies with electric (or hydrogen) vehicles. A more common financial concern is that governments will be reluctant to face the loss of the fuel tax revenues that stem from petrol and diesel.

Setting up straw men is, I am afraid, a standard tactic for this camp in the climate debate and the wider culture wars. This was a prime example.

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[1] Will COVID-19 fiscal recovery packages accelerate or retard progress on climate change? Cameron Hepburn, Brian O’Callaghan, Nicholas Stern, Joseph Stiglitz and Dimitri Zenghelis. Forthcoming in the Oxford Review of Economic Policy 36(S1).

[2] Chapter 2: Mitigation pathways compatible with 1.5°C in the context of sustainable development. https://report.ipcc.ch/sr15/pdf/sr15_chapter2.pdf .