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”.

 

 

 

 

CRYPTOS THREATEN SUSTAINABILITY. BITCOIN AS AN EASY TARGET FOR COP26?

 

Crypto-currencies are not just the latest speculative bubble.  Bitcoin (and others) may be virtual commodities but they have big real-world impacts, and are a threat to our attempts to contain climate change. Stopping their contribution to CO₂ intensive emissions must surely be the simplest of credibility tests for international agreement in the forthcoming international climate negotiations, COP 26. 

Alarm over the carbon footprint of bitcoin is the latest illustration of the convergence of climate change issues with a widening range of social and economic issues. We are witnessing a collision between two of the most disruptive themes in today’s global economy - sustainability and the cryptocurrency explosion.

Cryptocurrencies were already a controversial subject, promoted by libertarians as an alternative to national currencies, a currency that would be outside the control of governments or “inflation promoting” central banks, and a means to improve on existing payments systems. They are however also seen as potentially damaging innovations, whose main application may prove to be, at best, facilitation of criminal activity, tax evasion and money laundering, and whose main product has no real function or value other than as a vehicle for speculative investment. At worst they may simply be an elaborate Ponzi scheme.

What is bitcoin, and could it replace other currencies?

The Cambridge University Judge Business School (JBS) provides useful summary descriptions[1]. Bitcoin is a virtual currency whose proponents believe it could represent the future for payments systems of all kinds – the future of money. The three main functions of money are to act as a unit of account, a medium of exchange and a store of value. Bitcoin’s price volatility militates against its future either as a unit of account – the unit in which most transactions are priced and value is measured, or a medium of exchange. As a store of value it has been compared to gold, in having a limited supply, with the potential to become more and more valuable as bitcoin use increases. This third function is, at least theoretically, a more credible possibility. After all gold has a price that is disconnected from its use in jewellery and its value in industrial applications.

However these ambitions for bitcoin seem to hinge, inter alia, on its ability to see off the competition from thousands of other crypto currencies, many of which can also promote themselves as payment systems. These include dogecoin (dog e-coin, or doggy coin?), originally a joke currency that now has holdings worth up to a nominal $ 80 billion.

Mainstream economic commentators and financial authorities have been almost universally sceptical or even scathing. The European Central Bank has compared the rise in crypto prices in recent months to “tulip mania” and the South Sea Bubble of the 1600s and 1700s.

The joke-coin makes a mockery of the idea that crypto investing should be considered a serious pursuit. Its very existence undermines the notion that bitcoin derives value from its scarcity. While bitcoin’s total supply will eventually be capped at 21m, as written into its original source code, there is no limit to the number of copycat cryptocurrencies that compete with it — there are now almost 10,000, and dogecoin itself has no hard supply cap. [Jemima Kelly, FT, 11 May 2021]

None of this will deter the bitcoin evangelists, and it is certainly true that many people will have made a great deal of money out of the gyrations in the bitcoin price. However early entrants often make money out of Ponzi schemes of all kinds, and one worry for financial stability is the destabilising effect of an eventual crash, possibly bankrupting thousands of smaller, later investors and speculators. The collapse of financial pyramid schemes in Albania in 1997 brought the country to the brink of civil war.

Bitcoin’s Extraordinary Energy Consumption

Mining bitcoin is intrinsically a highly decentralised and indeed largely anonymous activity, so direct measurement of its energy consumption is not possible. The Judge Business School have attempted to research the carbon footprint of bitcoin, highlighted by the recent pronouncements from Tesla’s Elon Musk. This reflects the huge amount of computing power absorbed in searching or “mining” new bitcoins, and its impact on fossil use in electricity generation. The numbers, and even more importantly the growth, are extraordinary.

In April 2018 some 17 million bitcoin had been mined[2], and the JBS estimate that the annualised rate of electricity consumption at that time was 36.4 TWh. In May 2021 the number of bitcoin had grown to 18.6 million, but JBS estimate the annualised rate of electricity consumption had grown to 148 TWh, an amount larger than that of a medium sized country such as Sweden or Argentina This 2021 level of power consumption, resulting in more generation from the most polluting coal-fired power stations, could be close to 150 million tonnes of CO₂. The JBS consumption estimates from which this number is derived are central estimates and JBS suggest much much higher upper estimate bounds.

Other sources offer equally alarming estimates. One estimate by Chinese academics[3] published in the scientific journal Nature Communications in April found that, without policy intervention, bitcoin in China alone would generate 130m metric tonnes of CO₂ emissions by 2024.

The implication of the JBS trend growth, or of this alarming estimate for China, is that we could easily see bitcoin mining exceed 1% of global CO₂ emissions in a few years. This may sound small but global GHG is an aggregation of individually small issues. Aviation, for example, to which far more attention is paid, accounts for only about 2.5 % of CO₂.

This accelerating rate of energy use is intrinsic to the bitcoin process as mining becomes increasingly difficult. Inefficiency is a necessary consequence of its security requirement. Higher energy use is also encouraged by a rising bitcoin price, and by the fact that much of bitcoin mining takes place in jurisdictions with high coal based power and where electricity is subsidised or seriously under-priced. The increasing “inefficiency” of bitcoin mining implied by these numbers is not remediable; it is intrinsic to the bitcoin design, and indeed to that of other cryptocurrencies.

The Carbon Footprint and Implications for the Global Climate Challenge

The carbon footprint of bitcoin, and other similar cryptocurrencies depends on how the electricity is generated. Crypto promoters attempt to argue that this is or can be from renewable resources and therefore that the carbon footprint should not be an issue. This is a nonsense argument. Low or zero running cost renewables will always be used in power systems before fossil plant is brought into play, so any additional power demand will normally result in extra production from the generating plant at the margin. In almost all geographies this will be fossil plant for the next few decades, and all the extra CO₂ emissions attributable to bitcoin will reduce the available carbon budget.

Two particular concentrations of bitcoin mining have been in highly fossil dependent Iran, where illegal use of subsidised power for crypto mining is believed to resulted in major city blackouts, and China, which relies very largely on coal generation.  The current growth of mining in China is of increasing concern to the Chinese authorities on environmental grounds, and the FT reported[4] that the government of Inner Mongolia, which is particularly reliant on coal generation, has come under particular pressure to crack down on bitcoin mining.

Implications for COP 26 and Global Agreement

The clearest possible priority in the global effort to reduce GHG emissions is to seize, with urgency, the “low hanging fruit”; these are the easy measures which have little or no real economic or social cost and deliver immediate savings. Since CO2 in the atmosphere is cumulative we know that immediate emissions prevented are more valuable than the same saving in 20 years time.

Stopping or severely discouraging emissions attributable to crypto currencies falls in this category. There is little or no real cost in economic terms, and perhaps economic and social positives if the world has one fewer set of Ponzi schemes and speculative bubbles. Reduced subsidies to fossil fuel is one of the instruments to discourage mining, and will also help reduce emissions and fund low carbon alternatives. No major physical investments or disruptive lifestyle changes are required to dispense with cryptos, and the carbon saving is immediate and substantial.

It does however need concerted international agreement. What better simple “win” with which to start COP 26 negotiations than a general agreement to apply measures which will discourage any use  of cryptocurrencies dependent on high energy input[5].

The Chinese approach of criminalising bitcoin mining may not be universally acceptable, although most countries have plenty of laws and regulations prohibiting the release of other dangerous substances.  Bitcoin was designed to “escape” any such central control from authoritarian regimes or central banks, and mining is highly decentralised. However there are plenty of other effective measures that governments can take to minimise the attractions of crypto currencies. These include wide restrictions on the use of cryptos as a means of payment (Turkey, Morocco, and India), and controls over the holding of bitcoin by pension funds or other regulated investment vehicles.

For COP 26 a declaration of intent to eliminate the crypto emissions threat might be a small step, but a useful one that sends a powerful message..

 

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[1] https://cbeci.org/  “Bitcoin is a software protocol and peer-to-peer (P2P) network that enables the digital transfer of value across borders without relying on trusted intermediaries. … an open and permissionless system: anyone can participate in the network, as well as send, store, and receive payments. Bitcoin has its own cryptocurrency called bitcoin (BTC), as the universal unit of value within the network. New bitcoins are issued … through a process called mining.“ It is a virtual currency, and the Bitcoin protocol specifies that a maximum of 21 million bitcoins will ever be created. Of this 21 million, it is estimated 17 million have been create to date, of which some 4 million have simply been “lost”. It is intrinsic to this virtual currency that, once lost, they can never be found.

 

[2] https://www.statista.com/statistics/247280/number-of-bitcoins-in-circulation/

[3] Policy assessments for the carbon emission flows and sustainability of Bitcoin blockchain operation in China.  Jiang, S., Li, Y., Lu, Q. et al. Nature Communications, April 2021.

[4] Chinese province sets up hotline to report suspected crypto miners. [FT. 20 May 2021]

 

[5] Not all such currencies do. Restrictions on bitcoin, and likely subsequent collapse of the bitcoin bubble, would however send a significant warning to future cryptos, even those with much lower energy implications.

 

FINANCIAL SUPPORT FOR ENVIRONMENTALLY SOUND POLICIES IN POORER COUNTRIES MAKES SENSE FOR EVERYONE. THE CASE OF FIREWOOD, CHARCOAL AND DEFORESTATION.

 You tube presentation on this subject available at https://youtu.be/d81oGZzQaQ0

And it’s not just a matter of ethics or moral responsibility.


There is now near universal acceptance that human responsibility for greenhouse gas emissions constitutes possibly the greatest possible economic “externality” of all time, as activities which carry little cost for individual actors will have wider and global consequences that range from the very costly to the potentially catastrophic. Carbon emissions in one place (eg the USA, the UK, or any other country) have a global impact on climate, but, for a variety of reasons, there is currently no consistent or universal way to reflect the resulting climate costs back into individual and national choices and decision making on fuel burning[1]. 

This commentary will deal with one particular example, that of the use of firewood for cooking in rural societies, and the potential for substitution with rural renewable energy (RRE), to illustrate a wider set of principles that need both to be understood and to govern our discourse, particularly in relation to the value of energy sector development aid. Put simply the massive market failure that sits behind climate change should make such support a matter of vital self-interest for the providers of aid in the global community as well as an important resource for the recipients. Ultimately there can even be a financial pay-off.

Firewood is not always carbon neutral

Women carrying firewood| Photo source: Face2FaceAfrica.com

Wood burning is sometimes classed as use of a “biofuel” and regarded as nearly carbon neutral. This may be so, for example, with wood pellet[2] burning at Drax power stations in the UK.  But this neutrality assumes the wood is being harvested in a sustainable way. When the collection of the wood results in deforestation, as is currently the case on a large scale in many parts of the developing world, this biofuel is by no means a sustainable resource. Charcoal or wood burning reduces the carbon store of the forest, and adds substantial incremental CO₂ to the atmosphere; this is in addition to any other damaging consequences that it can and often does pose for a local and regional environment (soil degradation, habitat loss, and flooding risk).

The global or “planetary” benefit of enabling rural communities to reduce firewood consumption


Cost benefit analysis has a number of limitations in relation to assessing climate policy questions, not least being the conceptual and ethical difficulty of comparisons across low and high income economies, and a lack of consensus on even an approximate valuation of carbon emissions. This is compounded by the complexity of estimating both actual firewood or charcoal consumption, on the one hand, and multiple additional environmental consequences, on the other. However, it is possible to at least demonstrate the scale of some of the benefits compared to the costs, and in this instance the exercise provides a powerful message.

The first step is to estimate typical use. The World LP Gas Association estimates that cooking with wood requires typical per capita wood consumption of around 400 kg annually, and that this could be substituted by 36 kg of LPG; this is equivalent to about 500 kWh of electricity. Other sources confirm that this level of wood use for cooking is a very credible estimate. The very large weight difference compared to LPG reflects the much lower energy density of wood compared to LPG, the moisture content of wood, the “heat loss” inefficiency of wood burning, and its lack of controllability.

Assuming a 50% carbon content for the wood, the associated per capita CO₂ emissions[3] will amount to about 730 kg. On the basis of the equivalence assumed above, 1.0 kWh of renewable electricity can substitute for 0.8 kg of wood and hence eliminate 1.47 kg of CO2 emissions.  Bringing electric cooking to 10 million people would on this analysis reduce CO₂ emissions by over 7 million tonnes a year.

Putting a value on carbon emission reduction

Deforestation in the Amazon. The Weather Channel.

The environmental or climate related cost of emissions, or the value of emissions reduction, is the next element in the calculation. Levels of carbon tax, or carbon prices within “cap and trade” regimes, where they exist, have so far failed to provide market valuations of carbon emissions that provide a realistic reflection of the human and environmental cost associated with climate impacts.[4]  More realistic numbers are presented in some Committee on Climate Change scenarios, usually based on estimates of the prices necessary to induce sufficient low carbon investments to achieve targets, ranging up to $ 100 per tonne or more.

Arguably more realistic estimates also stem from the increasing recognition that globally we shall have to move to a “net zero” world and that this, if achievable at all, will very probably require direct removal of carbon from the atmosphere, an extremely expensive operation. Estimates of the current cost of this operation have been put at around $600 per tonne, although some experts claim this might conceivably be reduced to about $ 200 or less.  If this view of the future is adopted, a conservative estimate of the “true” cost of current emissions might be as high as $ 200 per tonne.  Inevitably this cost burden would have to fall disproportionately on countries most able to pay.

These numbers suggest that, if we take the cost of direct extraction as being between $100 and $ 200 per tonne, then every kWh of electricity used in RRE cooking will ultimately result in the global community having to spend between 14 c and 28 c less on removing carbon from the atmosphere, similar to the kWh retail tariff rate in many developed economies. We compare this with estimates of the unit cost of delivered electricity under RRE schemes, for which the World Bank’s ESMAP estimates that the unit cost could fall to $ 0.22/kWh, or 22 c, by 2030.

Of course, the real world is much more complex than this simple comparison suggests. The marginal cost of low load factor cooking load may be significantly higher than our projected average or unit cost of 22 c/kWh. Much of the benefit could be achieved, possibly more cheaply, with LPG[5]. Other economic, social and local infrastructure issues  will be relevant. RRE is only sustainable with a wider range of uses. And the difficulties inherent in implementing successful RRE programmes should not be understated. On the other hand there are multiple benefits that accrue from RRE in terms of economic development, income generation, health, and the local environment, which have not been enumerated above. And there is evidence that RRE households will themselves be able to pay on tariffs that cover most if not all of the total cost. Firewood collection is not free, not least in terms of the time of women[6] and families who may do most of it; nor is charcoal. So electric cooking can provide a win-win both for global environment and for immediate benefit to RRE communities.

Taking a long term and global perspective

This analysis demonstrates that development aid in the energy sector can, ultimately, come close to paying for itself even from a “selfish” donor perspective, and make a major immediate contribution to reducing carbon emissions. In practice aid funds will usually need to provide only a part of the capital finance and very little of the ongoing costs of RRE. Reducing wood burning and deforestation should be a huge priority, as one of the lower cost ways of meeting global targets and avoiding environmental degradation.
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Further comments from readers

One important additional fact is that the rapidly growing use of charcoal amplifies the problem, as it results in even more emissions and deforestation than firewood. This is in large part a result of urbanisation, where firewood is no longer an option for households.

Brian has also pointed out that it is far cheaper to look at green carbon sinks (e.g. planting trees) or avoiding emissions in the first place (i.e. more renewables quicker). so the economic tradeoff for a green investor isn't as simple as direct air capture vs eliminating firewood.

The counter, though, is that almost all the alternatives are supply limited in one way or another - green carbon sinks are constrained by the availability of land for example. If those constraints are reached then the marginal cost of CO2 removal becomes the most expensive direct extraction technology. It is of course far cheaper to replace firewood with electric cooking, or even more so for charcoal, and that is the key point. Unfortunately that seems unlikely to be enough on its own.

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[1] The Clean Development Mechanism, defined in the 2007 Kyoto protocol, has been one such scheme, created with the intention of providing wealthier but high carbon economies with a means to reduce emissions by supporting low carbon initiatives outside their own borders, particularly where this would be more cost-effective.

[2] Drax uses imported wood pellets from sustainable sources, although this claim is sometimes disputed.

[3] 1.0 tonnes of carbon translates to 3.67 tonnes of CO₂

[4] The EU emissions price is currently around 25-30 euros per tonne, after many years languishing in single figures, according to Sandbag data

[5] If this were so then LPG might be considered as a “second best” option, for a transitional period, if it were demonstrably capable of more rapid deployment.

[6] One of the notorious weaknesses of cost benefit analysis is that it struggles with non-monetised or only partially monetised activities and economies. This is often particularly relevant to matters affecting the role of women in certain societies..

NORWAY’S DISINVESTMENT IN OIL, THE GREEN PARADOX, AND A WEAKNESS OF POLICY TOWARDS GLOBAL CLIMATE RISKS

This commentary was provoked by recent reports that Norway’s sovereign wealth fund is to sell off its investments in companies that explore for oil and natural gas. This has been welcomed by some environmentalists campaigning for disinvestment from the hydrocarbon-based economy. In fact the Norwegian move is not really a signal of environmental virtue or ethical investing, and is best interpreted simply as a prudent rebalancing of their investment portfolio, a point made forcefully by Nick Butler in a recent FT article (18 March 2019). Butler regrets that this disinvestment is not balanced by “positive” investment in low carbon alternatives.

Butler goes on to claim, again correctly, that environmentalists may also be disappointed because, as he says, the evidence is that the oil companies are anticipating a continuing demand for their product, with few forecasts anticipating a peak before the mid-2030s. If these forecasts are correct and we are unable to prevent continuing growth in production and consumption, then it is bad news for hopes that the ambitious aspirations of the Paris agreement can be met, and that global warming can be limited to the 1.5^o C. This is regarded by many climate scientists as the upper limit consistent with avoiding the most dangerous environmental and climate outcomes.

There are however some related factors that should concern us in relation to oil industry incentives for investment. One is the so-called Green Paradox[1]. This argues, very logically, that if fossil fuel producers perceive that they face increasingly hostile restrictions on output, and gradually increasing carbon taxes, then they have a strong incentive to accelerate production and accelerate the depletion of their reserves. Implicitly the same argument would apply to many of the main sources of demand for oil, where the product depends on oil consumption either in the production stage

And yet that is more or less exactly the future carbon scenario that is most often presented in policy forums, that of a gradually increasing carbon tax. Needless to say, there is little evidence yet of the sort of collapsing investment that would seriously reduce supplies, nor of the much higher oil prices that could result, at least temporarily, from serious disincentives to production. The oil price seems to be stuck somewhere around the $60/ bbl mark, near the bottom of the $60 - $120 “credible range” recognised by many industry analysts.

In consequence it should be no surprise that production and consumption continue to rise. A rational policy to reverse this, and to overcome the Green Paradox, would be to recognise that, if anything, immediate near-term emissions, given that CO2 is cumulative, do more damage per tonne than future emissions[2] and have a significantly higher social cost. Rational policy towards climate should therefore include a policy for a price/tax on emissions that starts high rather than climbs gradually. This would make fossil fuel extraction and investment less profitable, and also provide an additional non-distorting incentive for low carbon investment of all kinds, an objective that many of us share.

Of course, it will be argued that this may have redistributive consequences, but green taxes offer their own answer in this respect. Revenues from taxing emissions offset the need for other taxes, or can be used for redistributive agendas.

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From an economic analysis perspective, the Green/ Sinn Paradox may not seem very surprising. It simply represents a potential consequence of policies that are poorly thought out (at least from a climate perspective). There are of course other factors that lead some oil rich states to favour accelerated exploitation, notably the desire for an immediate boost to the domestic economy, even at the expense of longer term considerations. But the Sinn paradox provides an additional incentive.

The source of the disconnection, between the science led climate imperative and the current economics of fossil fuel industries, is explored in more depth on another page: CUMULATIVE CARBON. HAS THE ECONOMICS LOST CONTACT WITH THE PHYSICS?

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[1] aka the Sinn paradox, it was first discussed by Hans Werner Sinn.

[2] See link above.

BREXIT, HITACHI AND CLIMATE CHANGE. SERIOUS LESSONS TO BE LEARNED.

Michael Mackenzie wrote in yesterday’s FT (18 January) that Brexit was weighing heavily on on investment confidence in the UK.

“… one opinion has held sway among professional custodians of money for some time: steer clear of the UK.” Investors are increasingly wary of investing money in the UK economy, partly because of the dangers associated with a disorderly exit from the EU, partly because a UK not in the EU is a far less attractive proposition, and partly because of continuing chaos and uncertainty in government.

This is clearly one of the factors behind Hitachi’s decision to pause construction on the Wylfa nuclear power station in Anglesey. But another is the sheer difficulty and complexity of putting together private sector financing for massive energy projects. “Foreign companies are increasingly leery of British infrastructure projects”, according to Nick Butler, also writing in the FT. And this problem transcends Brexit, although it is certainly amplified by it.

According to FT reports (17 January) “People involved in the Wylfa project said a lack of firm financing commitments made it impossible for Hitachi to keep pumping in its own cash.” Hitachi intimated that their involvement could only continue if the project were kept off their balance sheet, limited further investment was required and there was a prospect of adequate profit. FT reporting commented that “… to meet these criteria is likely to require a significant change in the UK government’s approach to financing nuclear power.”

This is a huge blow to the government’s plans for early decarbonisation of the power sector, and hence for its contribution to internationally agreed targets for combatting climate change. It is widely argued that the costs of other renewable sources such as solar energy or offshore wind are falling sufficiently rapidly that this should not be a concern, and that these technologies are already more than competitive with nuclear power.

However, the government has also effectively killed off the Swansea Bay tidal lagoon project, a renewables energy project with the potential to overcome some of the objections to wind and solar power, that it was insufficiently predictable to provide a complete answer to the issue of supply security and reliability. Once again there is a strong suspicion that the government was unwilling to support financing arrangements that would have given this project a sufficiently low cost of capital to make it viable.

In spite of nuclear travails, it remains difficult to envisage a low carbon future without some elements of nuclear power.  “It’s difficult to see a low-carbon energy system in the future which has no new nuclear,” says George Day, the head of policy and regulation at the government-funded Energy Systems Catapult.[1]  Moreover the government has previously killed off prospects for early adoption of carbon capture and storage (CCS), another prime candidate for non-intermittent baseload power generation.

In my view there are a number of clear lessons to be learned from this debacle.

First, it is clear that almost any form of long life generation investment in the power sector represents infrastructure that will only be created when investors have a very clear policy and regulatory commitment from government. In many instances, as with the feed-in tariffs to support renewables, this will often amount to essentially a long term government guarantee. The arguments are explored more fully on another page on this site, but it is currently very difficult to point to any form of generation investment that is not supported either by long term tariff arrangements or explicit guarantees.

Second, there is clear evidence that the government’s insistence on private sector finance, and keeping the government’s involvement “off the books”, runs the danger of raising the cost of capital and also of performance failure. The Hitachi debacle may be another illustration of the weaknesses and very high capital costs exposed both in the private finance initiative and the blunders associated with the public private partnership for upgrading the London underground [2]. The risks include an impact both on cost – these are all extremely capital intensive projects, and hence on affordability. But, if not delivered, they also imperil the other energy trilemma objectives of security and sustainability.

Third, from a public policy perspective, we are reminded once again that projects that may well be essential to address fundamental concerns such as greenhouse gas emissions (GHG) and climate change, will almost always appear as “uneconomic” when there is no means for them to capture the value of full human cost of greenhouse gas emissions. Current carbon prices are nowhere near the level required, either to match the future damage those emissions will cause, or the likely cost of capturing carbon from the atmosphere, something that will almost certainly be required to meet temperature targets such as 1.5^o C. Contrary to some conventional assumptions, an even higher value attaches to reducing current CO2 emissions compared to those in twenty years time. (Again this issue is explored in more detail on another page.)

Fourth, it seems impossible to escape the pernicious consequences of the Brexit traincrash, even though the energy sector might be seen as one of the least affected, at least directly, by question marks over future trade with Europe.  

Fifth and finally, and this is a challenge for my own involvement in the Oxford Martin School programme concerned with renewables, we need to focus more attention on defining, and if possible increasing, the extent to which we can meet future requirements from a combination of intermittent or variable output sources combined with storage and the management of consumer loads. Not least this could help to mitigate the failure to bring forward either carbon capture or nuclear investment in sufficiently timely fashion.

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[1]Energy Systems Catapult is part of a network of world-leading centres set up by the government to transform the UK’s capability for innovation in specific sectors and help drive future economic growth. Its aim is, by taking an independent, whole energy systems view, to work with stakeholders across the energy sector (consumers, industry, academia and government) to identify innovation priorities, gaps in the market and overcome barriers to accelerating the decarbonisation of the energy system at least cost.

Catapult modelling has tended to support both nuclear power, including smaller modular nuclear technology, and carbon capture.

[2] The Blunders of our Governments, Ivor Crewe and Anthony King. 2013. Its treatment of the London underground fiasco, and the very high cost of capital incurred, is particularly scathing.