An introduction to the new book ‘Upsetting the Offset: The Political Economy of Carbon Markets’, edited by Steffen Böhm and Sidhartha Dabhi (MayFlyBooks, December 2009), by the authors. The book can be ordered or downloaded free here.

Dr. Steffen Böhm is Reader in Management at Essex Business School, UK. Siddhartha Dabhi is a researcher at Essex Business School, University of Essex, UK.

December 2009 saw world leaders come together in Copenhagen to try to agree on a post-Kyoto deal to save the planet from global warming. But the attempts to hammer out a new deal met with an apparent failure. But was it a failure? Many commentators would argue that the apparent failure can be seen as a welcome breathing space to question the underlying mechanisms that are supposed to help us fight climate change. In this way, Upsetting the Offset is a very timely book, as it critically engages with the political economy of carbon markets, which have emerged as the dominant instrument to mitigate climate change.

This book argues that carbon markets are one of the most ambitious projects of neo-liberal capitalism, in its attempt to create a business opportunity out of what many would label as the most important issue mankind is currently facing: climate change. The underlying ideology of carbon markets is to internalize and reduce the risk of climate change by putting a price tag on carbon emissions. The core assumption is that the power of a self-regulating market will achieve maximum possible reductions of carbon emissions at the lowest possible cost. The book, which comprises 30 chapters written by some of the world’s most renowned critics of carbon markets, shows that this efficient market is a myth. All the evidence collected so far about the actual workings of carbon markets points to the alarming conclusion that carbon markets, instead of reducing carbon emissions, provide perverse incentives for the increase of carbon emissions, while also having detrimental social and environmental impacts on local communities in many so-called developing countries of the Global South.

Part I of the book introduces carbon markets, focusing specifically on the logic of the Clean Development Mechanism (CDM), one of the most prominent carbon markets administered and controlled by the United Nations. The first introductory chapter by Steffen Böhm and Siddhartha Dabhi gives a broad overview of the most recent climate change science and the political steps taken so far towards its mitigation. The main aim of this chapter is to form a premise for why the authors of this book might want to ‘Upset the Offset’ and engage in a critique of carbon markets. The second introductory chapter by Larry Lohmann talks about the formation of carbon markets through the commodification of the atmosphere. In this chapter Lohmann illustrates in detail how carbon emissions are converted into an abstract, quantifiable commodity, thus opening up endless avenues for creative accounting, a huge trading market, and leading to financialization and securitization of a “fictitious commodity”, to use Polanyi’s term.

Part II of the book comprises a range of case studies from Thailand to Chile, from Uruguay to India, presenting rich details of the often negative effects of CDM and voluntary offset projects on local communities in the Global South. The CDM has been packaged as a ‘win-win’ strategy where technology transfer takes place bringing emissions reductions and sustainable development to the South. But on the ground, it turns out that what the rich North pays the poorer South for is continued pollution and fostering inequalities between the masses and the elites. With its rich empirical detail, this section of the book shatters the false  illusions created by carbon market proponents, who have been promising a green capitalism where profit maximization is possible in an environmentally sustainable and socially just way. While tree planting, biomass electricity generation and wind power may sound green and ethical, it turns out that they often are too good to be true.    Part II begins with papers by Melissa Checker, Tamra Gilbertson, Cristián Alarcón and Isaac ‘Asume’ Osuoka, showing how ‘developed’ and ‘developing’ countries and their respective governments, corporations and local communities are interlocked in a complex web of carbon market relations, which, rather than promoting sustainable development, help to increase inequalities between North and South. The next set of chapters – written by Ricardo Carrere, Raquel Nuñez, Rafael Kurter Flores et al. and Steffen Böhm – are aimed at breaking our illusion of considering industrial tree plantations to be real forests that would help us fight climate change. The last set of cases – written by Soumitra Ghosh, Hadida Yasmin, Siddhartha Dabhi, Nishant Mate and Soumya Dutta – come from India, which is one of the largest hosts of CDM and voluntary offset projects. These cases expose the greenwash created through the usual rhetoric of technology transfer, employment generation, emissions reduction and sustainable development.

Having presented the case studies, Part III offers a broader critique of carbon markets. What these seven chapters show is that carbon markets are not merely mechanisms to combat climate change. Instead, they must be seen in relation to the historical development of capitalism. In fact, carbon markets can be seen as the expansion of the market system to new spheres which so far have escaped commodification. This is where a crucial question needs to be asked: can we trust capitalist markets to deal with such a grave and global problem as climate change, given that capitalist production and consumption regimes have created the problem in the first place? The authors of Part III argue that there is now overwhelming evidence that carbon markets will not help us mitigate climate change by commodifying the atmosphere, which should be seen as a common good shared by humanity. Instead, carbon markets will lead to more exploitation, inequalities and perverse speculations and financial bubbles of the kind the world has seen explode in 2008. Therefore, carbon markets should be seen as a dangerous diversion from the need to drastically change lifestyles and economic, social and political structures that will help to free ourselves from the world’s addiction to fossil fuels.

Part IV of the book is a step towards hope. Each paper in this section points to real alternatives to carbon markets, many of which already exist in local communities around the world. If indeed carbon markets often deliver quite perverse outcomes – as many contributions to this book have shown – then what are the alternatives? What can be practically done to mitigate climate change and create a real sustainable, low carbon future? These authors stress that a sustainable future is in our hands. The first two papers by Patrick Bond and Philippe Cullet offer a more ‘political’ answer to carbon markets, suggesting that, rather than managing complex carbon markets, governments in the North need to think about the ‘ecological debt’ they have created and consider climate change from a point of view of justice. The remaining papers  offer a range of very practical insights into how communities already live in sustainable ways. What these contributions seem to be saying is that communities around the world cannot depend on governments or markets to save them from climate change. If something has to be done, then it has to be done by each and every person.

Overall, the book alerts us to the realization that climate change is not just a problem of global warming and rising sea-levels. It is a wider problem of politics, economy, society and culture. It is a problem of a system that believes in relentless economic growth without paying much attention to the ‘externalities’, as the economists call all those social and environmental costs that cannot, or rather must not, be accounted for. One of the key issues that arise from Upsetting the Offset is that governments, corporations and citizens at large need to stop thinking that climate change can be stopped by simply introducing markets and putting a price tag on carbon. There is no evidence that has emerged so far showing that carbon markets actually work in terms of reducing carbon emissions. On the contrary, this book provides plenty of credible evidence that carbon markets are, in fact, a smokescreen and a dangerous diversion, preventing us from focusing on the real issues at hand.

The Financial Times reported some intriguing new McKinsey data this week on carbon mitigation costs across sectors and countries. The data indicate that there are substantial differences in costs, and predictably, that building efficiency, lighting, and HVAC are the low-hanging fruit available at negative cost. The implication is that US companies should look to efficiency measures at home before buying international offsets, though international offsets might be preferable to renewables in the US.

The surprise in the data is that mitigation costs for most efficiency measures in the US appear to be substantially below those in Europe, China, and India. The cost per (metric) tonne of CO2 saved approaches €50 (Euro) in the US for these efficiency measures, while in Europe the saving is about €25 Euro. In India and China, there is a positive cost to these measures. The exception is lighting, for which the cost saving in Europe, China, and India is €60-90/tonne. Even more surprising is McKinsey’s estimate of mitigation costs from cleaner vehicles (hybrids and pure electrics), at negative €79 in the US and about €35 in Europe (i.e. net savings).

The Financial Times does not give the basis for these calculations, and the estimates are projected for 2030. It’s unclear if McKinsey is estimating real resource costs, or the costs as viewed by consumers or manufacturers, taking subsidies and taxes into account. Perhaps McKinsey is factoring in much higher fuel prices and lower battery costs by 2030, but these values are highly speculative. I looked at buying hybrid Prius last year, which cost about $6000 more than the Mazda 6 I finally settled on. I would have to drive about 15,000 miles a year for 10 years, with fuel at $3/gallon, to break even (and that ignores discount rates for future savings). My actual mileage is only around 7,000 miles a year, which is why I don’t feel too bad about not buying a hybrid. It’s also unclear why the savings in the US, with it’s cheap gasoline, are more than double those in high-cost Europe. Perhaps its because Europeans are already driving lightweight high-efficiency diesels.   Another mystery is why renewable power is so much cheaper in China and India compared to Europe and the US. Most of the cost in solar and wind is in manufacturing, which is already dispersed through a complex global supply chain. So those costs should be the same wherever the renewables are installed. Installation and maintenance will rely on local labor, which is much cheaper, of course, in developing countries (but might be expected to rise quite sharply over time).

The availability of free carbon lunches has been discussed before on Climate Inc. Mark Sarro and Jurgen Weiss urged caution regarding the hidden costs of energy efficiency, while I noted that the low-hanging fruit might be locked up or hidden away behind misaligned incentives, inertia, and market barriers. Indeed, he fact that negative cost (i.e. profitable) opportunities to reduce carbon are not being exploited points to the importance of these hurdles. Because these barriers are frequently organizational, behavioral, and institutional, putting a price on carbon is not the best way to move ahead: a price high enough to be effective would be politically infeasible.

To repeat what I said in the earlier post: Most companies have traditionally paid little attention to potential energy savings because nobody was paid to do so. Once companies assign managerial responsibility for the task, measure the savings, and evaluate performance accordingly, they start finding a lot of low-hanging fruit. Many of the barriers are more complex, and require restructuring markets and institutions – California is famous for paying utilities to save energy, not sell it. Utilities are also finding that they can nudge consumers in the right direction with non-price signals, such as comparisons with their neighbor’s bills. The booming field of behavioral economics points to all sorts of low-cost ways of shifting behavior.

Of course, these solutions are not cost free – they involve managerial time, some capital, and transaction costs. Some of the barriers are complex and would require large scale institutional restructuring, requiring government-business collaboration. But one person’s transaction costs are another’s business opportunity (the transaction costs of carbon markets will keep financial firms smiling). The key point here is that there are creative organizational and managerial approaches to unlock the doors to low-cost or even negative-cost carbon reductions. The carbon price is, by itself, an inefficient and ineffective tool.

The headline 2020 emission reduction target has been raised slightly to 20% from 17% (from a 2005, pre-recession baseline, but still only 7 percent below 1990 levels), but most analysts think that this improvement is largely offset by the elimination of regulatory controls on methane emissions from natural gas facilities and other sources. Instead, voluntary efforts to control methane emissions can be used as offsets, which will provide a relatively cheap and plentiful domestic source of offsets, at least till 2020 when regulations are meant to kick in. The overall offset cap remains at 2 billion tons per year, equivalent to 30% of all U.S. GHG emissions,  and the cap on international offsets has been lowered from 50% to 25%.

Methane accounts for around one-third of the human contribution to global warming and, according to Andrew Revkin and Clifford Krauss in the New York Times last week, “some three trillion cubic feet of methane leak into the air every year, with Russia and the United States the leading sources…This amount has the warming power of emissions from over half the coal plants in the United States.” Unless controlled, these emissions could grow rapidly as gas production is expected to soar nearly 50% in the US in the next 20 years, according to the Department of Energy, will thousands of miles of new pipelines being laid. Some recent studies by EPA suggest that emissions from oil wells and other sources might actually be far higher than previously thought. In fact, global atmospheric methane levels have resumed a sharp upward trend in the last couple of years (see graph and discussion of possible reasons). Yet under industry pressure, the EPA has excluded oil and gas well methane emissions from the mandatory GHG reporting requirements that start in 2010.  

The carbon arithmetic here is very troubling, to put it mildly. For compliance purposes, offsets are interchangeable with allowances on the carbon market. It is critical, therefore, that offsets reflect real GHG reductions from the fixed 2005 baseline. If we suddenly discover that methane emissions are much higher than previously thought, and give offsets to companies that reduce them, we are not cutting emissions below the baseline. The case is particularly clear for new wells and gas facilities constructed since 2005. Moreover, because it is relatively cheap to control these emissions, the price of carbon allowances will be low, reducing the incentive for investments in low-carbon technologies and products (see Carbon Markets to Serve the Planet).

The mechanisms for defining offsets have not yet been spelled out in detail in the 800+ pages of the Senate bill. International offsets from sources such as the Clean Development Mechanism (CDM) are generally NOT real reductions from a baseline. This point cannot be emphasized strongly enough. Even in the best circumstances, offsets are reductions below “business as usual”. A new facility that beats some average “performance standard” can claim credits that feed into the offset market, but still generate incremental new emissions compared.

The Kerry-Boxer bill keeps the price collar on the price on carbon, one of the better features of Waxman-Markey, as it reduces the uncertainty that plagues potential investors in low-carbon technologies. Nevertheless, the starting floor price of $11/ton, even with a 5% annual escalator (which is only 2-3% in real terms), is far too low to have any real impact on carbon emissions for at least 15 years. For industries with a very long time horizon, of course, the expectation of a higher price in the future will have some effect.

Perhaps the most important change in Kerry-Boxer is that it retains EPA’s authority to regulate GHG emissions, which was superceded in the Waxman-Markey version. This is critical, because in the absence of an adequate carbon price signal, EPA officials know that they must move more directly to regulate emissions from major sources, particularly automobiles, buildings, and power generation.

In the emerging carbon economy‚ projects that reduce‚ eliminate‚ or sequester carbon emissions will have enormous value. An examination of climate change legislation recently passed by the U.S. House of Representatives¹ indicates how important such projects will be and the many questions that remain about them. Those who participate in the legislative and regulatory processes that will define the amounts and types of eligible projects can gain a competitive advantage by ensuring they capture the full value of such projects.

To date‚ most technology entrepreneurs‚ project developers and investors‚ anticipating a “cap and trade” regulatory system‚ have focused on the number of allowances that the government would issue. This makes sense: the availability of allowances will have an important influence on the severity of the reductions required by “capped entities” and‚ correspondingly‚ on the competitive advantages of non-carbon fuel sources.

But allowances are not the whole story. In fact‚ from the perspective of driving investment decisions and market valuations‚ they may be less influential than carbon offset credits. The price for emitting carbon and the prospects for non-emitting competitors will be heavily influenced by the amount of offsets that can be used for compliance‚ the types of projects eligible to create offsets‚ and whether or not they are located in the U.S.

Carbon offset projects avoid‚ reduce‚ or sequester carbon emissions‚ and generally include activities such as:

• Capture and destruction of methane emissions from landfills
• Sequestration of carbon through forest preservation and expansion
• Reduction in CO2 emissions through energy efficiency in buildings
• Avoidance of methane emissions through management of agricultural manure.²

The influence of offsets on the economic impacts of a federal cap and trade carbon control policy is vividly demonstrated in a recent study by the Congressional Research Service (CRS). It examines the potential costs of the climate legislation passed in June by the U.S. House‚ officially known as the American Clean Energy and Security Act. In its review of seven reports that used computer models to predict the economic impacts of the cap and trade portion of Waxman-Markey‚ the CRS found that the ability to use carbon offsets to achieve compliance is “potentially the key factor in determining the cost” of the bill’s proposed cap and trade program.³

Waxman-Markey sets two important constraints on the use of offsets for compliance with its cap and trade program. One is a limit on the total amount of offsets that can be used for compliance. The other sets a limit on how many of these offsets can be obtained from outside the U.S. These two constraints will be crucial in determining the long-run marginal price of carbon offsets‚ indirectly the long-run price of carbon allowances‚ and the future competitive positions of low-carbon energy sources like wind‚ solar‚ and biomass.

The Total Amount of Offsets Allowed for Compliance

Waxman-Markey allows the federal government to issue five billion tons of allowances beginning in 2012‚ increasing that amount slightly each year until it reaches its high point of 5.05 billion tons by 2015. The limit then drops steadily each year‚ so that for example‚ by 2030‚ total annual allowances would be reduced to 2.9 billion tons.

The number of allowances alone is very likely insufficient to enable “business as usual” emissions‚ even at the outset‚ and these insufficiencies grow larger over time. Obviously‚ marginal industries may choose to comply with these new requirements by simply ceasing operation‚ making compliance relatively easier and less expensive for those that continue to operate. But the vast majority of emitters will seek to find a way to comply. If the supply of allowances is insufficient‚ bidding to purchase an allowance could produce prices that get very high indeed. The most important antidote to this is to expand the supply of compliance options by allowing the use of carbon offsets (certified reductions from sources outside the cap-and-trade system). The environmental effect of purchasing credit for an emissions reduction from an offset project is the same as purchasing an allowance.

Because offset credits and allowances are interchangeable for compliance purposes‚ long-run prices for them will tend to converge. Whenever the long-run marginal cost of an offset project appears likely to yield an offset price that is less (by a significant margin) than the anticipated long-run price of allowances‚ it will make more sense for developers to build‚ and investors to invest in‚ carbon offset projects.⁴

Waxman-Markey would allow for the use of up to two billion tons of offset credits for compliance each year starting in 2012. This means that offsets‚ if they were fully used‚ would expand the compliance options available to capped entities by about 30% in 2012 and by about 67% in 2030. If offset projects are supported by investors and built by developers‚ they will constitute a dramatic expansion of the supply side of the carbon market and will moderate the price of allowances significantly.

One of the studies examined by the CRS suggests the large impact of allowing offsets to be used interchangeably with allowances for compliance. It estimates that if the two billion tons of allowances in Waxman-Markey were disallowed‚ allowance prices in 2030 would be expected to increase from $40 per ton to $138 per ton and that‚ between 2012 and 2050‚ the average annual savings from offsets could be about 70%.⁵

On the other hand‚ offset projects take time to be approved‚ financed‚ and built. The CRS report notes that the seven studies generally agree that it will take time for the supply of international and domestic offsets to start producing credits‚ and that offset limits in the bill are generally not reached until 2025‚ if at all.⁶ This suggests that the price moderating effect of offsets will be quite modest at the outset‚ but increase over time as the price–escalating effects of diminishing allowances take effect.

Types of Offsets Projects Allowed for Compliance

Waxman-Markey sets up a process to determine which types of projects are eligible and which projects actually receive credit. An offset credit would be awarded to project developers for each ton of CO2 equivalent reduced‚ avoided‚ or sequestered after January 1‚ 2009.⁷ Each project would receive credits from the Administrator of the Environmental Protection Agency (EPA) based on an assessment prepared by an independent third party who verifies the quantity of greenhouse gases that would be reduced‚ avoided‚ or sequestered.

Eligible types of offset projects are not defined nor are the criteria on which their performance will be evaluated. Instead‚ Waxman-Markey directs the EPA Administrator to determine the types of projects that are eligible to earn offset credits and the criteria for obtaining certification of project performance. It seems likely that the version of climate legislation signed into law will leave substantial discretion to the EPA Administrator to conduct rule-makings and make determinations to clarify eligible project types and performance evaluation criteria.

International Versus Domestic Offsets

The cost of offset projects varies widely from one type of project to another. Moreover‚ the cost of similar types of projects can vary widely‚ depending on whether they are located in the U.S. or abroad. Experience with the use of offsets under the Kyoto Protocol has shown that offsets available in less-developed countries can be considerably less expensive than those produced domestically. Thus‚ it is widely assumed that allowing compliance using offsets from projects in other countries will tend to lower the price of allowances and the overall cost of compliance.

Waxman-Markey allows covered entities to achieve compliance each year by using up to one billion tons of domestic offsets and one billion tons of international offsets. Further‚ if the supply of domestic offsets is below 0.9 billion tons‚ the remainder can be made up with international offsets‚ up to an additional 0.5 billion tons.⁸ The EPA Administrator is allowed to issue offset credits for projects in other countries and to exchange U.S. credits for credits issued by an international body established pursuant to the U.N. Framework on Climate Change or the Kyoto Protocol.⁹

The CRS report notes that‚ of the seven reports it examined‚ three modeled scenarios in which international offsets could not be used for compliance. Those three studies predict that if international offsets cannot be used for compliance‚ by 2030 the price of carbon allowances would increase dramatically‚ ranging from a low of 65% in one study to a high of 180% in another.¹⁰

Conclusion

The volume of carbon offset projects deemed eligible for compliance with emission requirements under federal cap and trade legislation will substantially influence the cost compliance for capped entities. A large supply of approved offset projects will bring down the price of carbon allowances‚ and make the overall cost of compliance lower than it would be otherwise. A large supply of international offsets available to be used for compliance will further reduce the cost of allowances and the overall cost of compliance.

At the same time‚ wind‚ solar‚ biomass‚ and other low carbon-emitting sources of energy are likely to see their competitive advantages over carbon-emitting sources of energy vary according to the supply and price of qualifying carbon offsets‚ and the supply of eligible international offsets allowed by the legislation will determine the degree to which investors choose to invest in domestic carbon-reducing technologies and projects.

Technology entrepreneurs‚ project developers‚ and investors may find their competitive positions in the new carbon economy heavily influenced by federal policies on carbon offsets. The degree to which this will be the case will be determined‚ not only as a result of the legislative debates now underway‚ but also even after legislation is enacted. Federal agencies will have to write the rules on eligible projects‚ performance evaluation‚ and verification requirements. Clean energy companies and offset project developers would do well to create a chorus of vibrant and influential voices throughout this process.

[Note from David Levy, Climate Inc. editor: I will soon post an update that describes the proposed changes to offset rules in the US Senate Kerry-Boxer version of cap-and-trade]

¹ The American Clean Energy and Security Act‚ H. 2454‚ June 26‚ 2009

² For an example of offset project categories approved in one cap and trade program in the U.S.‚ see the categories eligible for compliance with the Regional Greenhouse Gas Initiative at http://www.rggi.org/offsets/categories.

³ Larry Parker and Brent D. Yacobucci‚ “Climate Change: Costs and Benefits of the Cap-and-Trade Provisions of H.R. 2454‚” Congressional Research Office (Washington‚ DC: September 14‚ 2009): ii.

⁴ This is not to say that prevailing (i.e. short-run) prices for allowances and offsets will be identical. The certainty of compliance obtained by purchasing an allowance will always tend to give it a short-term advantage over the uncertainty of future production and compliance inherent in an offset project. Buyers will want to obtain a discount on the purchase price of offset credits that reflects this risk difference. This short-run price advantage of allowances may be countered by the ability to buy project offset credits under a long-term contract and obtain a hedge against future volatility in allowance prices.

⁵ Congressional Budget Office‚ “The Use of Offsets to Reduce Greenhouse Gases” (August 3‚ 2009); Economic and Policy Brief prepared by Natalie Tawil.

⁶ CRS‚ ibid. p. 46

⁷ At the EPA Administrator’s discretion‚ offset credits may be awarded to projects started after January 1‚ 2001 and to offset projects for which credits were issued by another regulatory or voluntary program‚ provided that the program’s evaluation standards are at least as rigorous as those used by the proposed federal program [See ACESA‚ Section 740 (a)].

⁸ Under Waxman–Markey‚ after 2017 international offsets are discounted by 20%; that is‚ five international offsets are required to offset four tons of emissions.

⁹ While the bill doesn’t stipulate the type of international projects that would be eligible for offset credits‚ it does establish guidelines regarding international offsets from reduced deforestation.

¹⁰ The three reports are (1) EPA/IGEM: “Data Annex” available on the EPA Web site‚ here. (2) EIA/NEMS: EIA‚ Energy Market and Economic Impacts of H.R. 2454‚ the American Clean Energy and Security Act of 2009‚ (August 2009); and (3) NBCC/CRA: CRA International‚ Impact on the Economy of the American Clean Energy and Security Act of 2009 (H.R. 2454) (May 2009).

The need to address climate change is going to transform entire industries, our infrastructure, and our lifestyles. But will this transformation be driven by wise policy, oil depletion, or a real climate crisis? Will it be a benign process that creates new jobs and technologies and leaves our societal structures intact, or will it cause violent economic and social disruption that threatens the fabric of democratic societies?

This week’s global release of the climate change docudrama The Age of Stupid has Pete Postlethwaite, apparently still alive and well in 2055, playing the custodian of an immense Noah’s ark of Earth’s cultural artifacts as climate change ravages the earth. Apocalyptic visions of a future beset by high cost oil and climate change are not new, of course. M. King Hubbert predicted in 1956 that oil production would peak in the United States between 1965 and 1970, and Colin Campbell has brought mainstream credibility to the concept of peak oil through papers and 2004 book The Coming Oil Crisis. James Howard Kunstler’s 2005 “The Long Emergency” provides a compellingly gruesome account of the collapse of civilization.

Just last week I heard Christopher Steiner, author of $20 per Gallon: How the Inevitable Rising Cost of Gas Will Change Our Lives for the Better, interviewed on WBUR,  my local NPR station. Steiner, a writer for Forbes magazine, trained as a civil engineer at the University of Illinois, before graduating from the Medill School of Journalism at Northwestern University. His book is premised on the “peak oil” hypothesis, that global oil production will soon start to decline as existing fields deplete and new discoveries fail to keep up. Combined with exploding demand in China, India, Brazil, and other parts of the developing world, fuel prices could rocket towards $20 a gallon for gasoline. His book examines what the world would look like at various price points along the way. Though highly speculative, it’s an interesting thought experiment and a challenge for long-term corporate strategic planning.

Steiner’s conclusions are provocatively shocking. At $8 per gallon, commercial airlines become extinct, replaced by high-speed rail, teleconferencing, and the rebirth of oceanic ship travel, only now its nuclear-powered. When prices rise further, suburbs, exurbs, and their concomitant SUVs and McMansions disappear as people flee energy intense lifestyles and move back to cities to enjoy apartments, trams, subways, biking and walking. Walmart’s business model is dead, because it’s premised on people driving the freeways to huge box stores outside major cities. Plastics derived from petrochemicals become too expensive for consumer goods. And on the supply side, value chains stretching around the world become untenable, leading to drastic restructuring of world trade, production, and sourcing.    

For investors already battered by the current recession, the message seems to be that it will soon be time to go to cash. Indeed, if civilization is really about to collapse, then perhaps even government backed cash and bonds are not safe, and a copy of The Complete Worst-Case Scenario Survival Handbook might be a better investment. While most of the apocalyptic books and movies try to sweeten their message with a modicum of hope, what they lack is nuance.

For business and policymakers who understand the need for a radical low-carbon transition (still by no means the consensus view), a key question is: What will drive this transition? Will it be oil running out pushing fuel prices to stratospheric levels? Will it be a sudden manifestation of climate change that precipitates dramatic governmental economic intervention reminiscent of wartime? Or will wise government policy be able to steer a safe course through the treacherous shoals and avoid the more cataclysmic effects of climate change, resource depletion, or economic depression? It’s important to distinguish the various scenarios, because they have very different implications.

1. Oil Depletion Drives Fuel Prices

This scenario, described by Campbell, Kunstler, and Steiner, points to oil depletion and soaring fuel prices to drive a transition to a low-carbon economy. Oil prices are certainly one of the most powerful drivers of consumer behavior and business investment in low-carbon technologies. As oil prices surged past $140 a barrel in 2008 we saw a dramatic shift in demand toward smaller cars and hybrids and a surge in interest in clean energy from traditional industry and venture capital. Funds that track clean energy such as QCLN, based on the CleanEdge index, and Invesco Powershares’ ETF PBW, joined the bandwagon. Although oil prices have plummeted since the onset of the financial crisis, a  Financial Times article last week predicted a renewed demand crunch by 2014, despite massive new offshore oil finds in near Brazil, Ghana, and Sierra Leone.

One way to understand $140 a barrel oil is in terms of the equivalent carbon price. Burning of a barrel of oil leads to an emission of about 0.4 tons of CO2, so from current prices of around $70 per barrel it would take a carbon price of $175 per ton. The work by McKinsey has estimated (see earlier post Whacking the MAC) that carbon prices of $100/ton CO2e could make a range of abatement technologies viable to reduce US GHG emissions by about 3.5 Gigatons a year by 2030, a reduction of about 1/3 from the business as usual case.  So an oil price of $140 per barrel would send a very powerful price signal to industry and consumers.

Yet there are reasons to doubt the desirability and efficacy of this path. First, oil prices of $140 per barrel produced gasoline prices in the $4-4.50 per gallon range in the US, high enough to shock and anger American consumers, but still far below the $6-9 a gallon Europeans have been paying for a while. Yet as a frequent visitor to Europe, I’m always struck that the roads are choked with ever increasing traffic, even if the cars are smaller and more than half are diesels. Fuel prices alone are not going to revolutionize our use of energy. They are far too volatile to be strong, reliable signals for business investment, and the industry response time at the scale needed is far too slow.

Second, oil prices are increasingly irrelevant for the power sector, which accounts for about 1/3 of GHG emissions in the US, and around 25% worldwide. Liquid oil-based fuels are important for transportation, but the world generates electric power mostly from coal, gas, nuclear power, and a sliver of renewables. There is enough cheap coal for fifty years at least, and nuclear power is expensive but stable in price. Natural gas prices initially jumped along with oil, but vast new discoveries off of Australia and elsewhere, together with the development of unconventional shale gas, will help keep prices reasonable.

Third, high oil prices are likely to be self limiting due to fuel substitution effects. Compressed or liquid natural gas can quite easily replace gasoline in cars and buses and costs the equivalent of about $2-3 a gallon. At oil prices over $60 a barrel, vast reserves of tar sands and bituminous oil shale become commercially viable, if environmentally hazardous. At prices over $100 a barrel, coal-to-oil and biofuels look attractive.

Finally, oil prices that stay above $100 for long are likely to trigger another global recession as money drains out of the US, Europe, Japan, and China. Global oil consumption is about 30 billion barrels a year, so a $100 price increase transfers $3 trillion a year out of consumers’ pockets to exporting countries. The current recession, which was exacerbated by the run-up in commodity prices in 2008, has caused the carbon price and interest in clean energy to slump again. It’s also caused a significant fall in emissions. The International Energy Agency (IEA) projects in a New York Times report that global GHG emissions will fall by 2.6% in 2009, while US emissions, which fell 3.8% percent in 2008, are likely to fall a further 6% in 2009. While good news for the climate, a massive recession is hardly a long term solution for the planet; the fall in emissions could even lead to complacency. Moreover, an oil boom-bust cycle is not only painful but unlikely to generate the sustained investment and enthusiasm needed for a transition to a low carbon economy.

2. Climate Shocks Drive Societal Response

If high oil prices are not going to shift us into a low-carbon economy anytime soon, then perhaps we’ll have to wait for climate change to shock us into action with floods, drought, and the other horsemen of the climate apocalypse portrayed in the movie The Age of Stupid. It’s unclear exactly how bad things have to get before countries are willing to collaborate on real action rather than argue about protectionism or who-goes-first. For anyone who follows the science, the debate is over. Perhaps the best we can hope for is a substantial but non-catastrophic wake-up alarm, a climate Pearl Harbor, such as a big chunk of Greenland ice suddenly breaking off (OK, bigger than the last chunk!). Groups like the Apollo Alliance have called for mobilization of vision and resources comparable to the Apollo program of the 1960s, but the financial crisis has demonstrated that it takes an imminent crisis to spur action on the trillion dollar scale.

Unfortunately, if we wait till the effects of climate change reach crisis levels, the governmental response is likely to be draconian and authoritarian. After Pearl Harbor, governments took over control of factories and ordered production lines switched from consumer to military output. If climate change really does result in massive food shortages and migration, governments are likely to intervene directly in the supply of basic goods and services, and the military and security apparatus of states will be stretched to the limits. International resource conflicts seem unavoidable. While it’s true that some businesses can prosper in times of war and crisis from juicy governmental contracts and monopolistic conditions, this is not a very appealing scenario for the majority of citizens or businesses.

3. Science and Economic Analysis Drives Precautionary Climate Action

If we cannot rely on oil-driven market mechanisms and don’t want to risk waiting for the impacts of climate change to reach crisis proportions, then we have to act on the best scientific evidence and economic analysis that we can – and from the IPCC assessments to the Stern report, it’s clear that aggressive action is needed soon. A strong policy framework for cutting emissions at least 50% by mid-century is needed if there is to be a reasonable prospect of a manageable and orderly transition to a low-carbon economy.  Yet today, as 100 heads of state gather in New York for a UN climate summit, prospects for a meaningful agreement in Copenhagen look dim. Let’s hope this is the age of wisdom.

Managing crises in complex systems

Just when the world was beginning to wake up to the climate change crisis, with a flood of new evidence on the accelerating meltdown of glaciers and polar ice caps, the financial crisis struck. Paul Gilding has termed this convergence of twin crises “The Great Disruption.” At first glance, the twin meltdowns, financial and climatic, appear to be very different problems requiring very different responses. The financial crisis presents as a relatively short-term crisis that resulted from a combination of housing and financial asset bubbles, poor regulation, excessive leverage, and distorted incentives. The climate crisis, by contrast, is driven by the seemingly inexorable rise in human emissions of greenhouse gases, a longer-term problem with a more defined physical structure. The financial crisis calls for fiscal and monetary policy responses combined with new financial regulation. The climate crisis is spawning a wave of regulatory and market responses, from caps on emissions to subsidies for low-carbon energy.

Despite their apparent differences, however, the climate and financial crises are both manifestations of a common problem – the difficulty in predicting and controlling complex dynamic systems riddled with feedback loops, time lags, and non-linear relationships. Though it’s tempting to point the finger of blame (and there is plenty of blame to go around), both systems are susceptible to fundamental, structural problems of governance. Most notably, we rarely recognize that we are careening over a cliff until we are well past the precipice. Moreover, once we recognize that we are spiraling down in a vicious circle, recovery is far from easy.

Complex systems, such as the climate and the economy, have many interconnected parts that interact in intricate and sometimes poorly understood ways (for a primer on complexity, download my book chapter here). They tend to be unstable and unpredictable, though they also exhibit patterned, cyclical behavior. The current recession, while more severe than most since the 1930s, is following an oft repeated trajectory of boom and bust, of overshoot and collapse in asset prices. In a similar way, but on a much longer time scale, the earth’s climate has cycled from ice ages to relatively warm inter-glacials about every one-hundred thousand years. The search for historical parallels can be useful due to this regularity. As Mark Twain famously said, history does not repeat itself, but it rhymes. Systems move in familiar patterns, but never exactly retrace the same path. A host of complex non-linear interactions mean that small differences in starting conditions can lead to very different outcomes. Though hurricanes take familiar tracks in the North Atlantic, we can never be quite sure how strong one might grow or what city it might hit. The current recession could turn out to be a brief dip or herald the onset of second major depression. Occasionally, complex systems can exhibit dramatic collapse, a result of self-reinforcing feedback loops that transform a minor event into a systemic crisis. We are used to the “normal” business cycle where output, investment, employment, asset prices, and confidence interact to create growth or recession dynamics. In the current recession, however, the sudden recognition that vast pools of complex derivatives based on risky mortgage and credit card debt might be worthless led to panic, frozen credit markets, and bank insolvencies. In a similar way, many scientists fear that human emissions of greenhouse gases could lead to a runaway warming effect due to several mechanisms. For example, polar regions tend to warm more rapidly, leading to loss of polar ice and more absorption of solar radiation. Moreover, warming is likely to lead to faster release of carbon dioxide from forests and vegetation. The vast Russian and Canadian tundra regions are thawing, while recent studies demonstrate that the Amazon will become significantly drier, accelerating the shrinking of the rain forest.

In the June McKinsey Quarterly, Michele Zanini reminds us that the severity of these unpredictable disasters, from earthquakes to stock market crashes, actually follows a predictable power law; there is a clear statistical relationship between the frequency and magnitude of the collapse. The so-called butterfly effect is not always at work; sometimes small events may cascade into a major storm, but more typically self-balancing feedback loops help to restabilize the system. Hurricanes dissipate thermal energy, the fuel for storms. Recessions lower interest rates and prices, stimulating investment and consumption. Occasionally, however, the changes that cascade through a system can push it past a tipping point and lock it into a new “phase state”, with a markedly different set of patterns of cycles. As Keynes famously argued, the economy was stuck in a deflationary cycle in the Great Depression and would not naturally bounce back as wages and prices fell. In a similar way, the climate can transition into ice ages lasting tens of thousands of years, in which ice sheets miles thick covered the British Isles and large portions of North America, or hot periods such as the Jurassic era, which lasted millions of years.

It is, then, not surprising that complex dynamic systems are inherently difficult to manage. Controlling the economy has been likened to attempting to steer a car by looking in the rear-view mirror. We can only see where we have been, not where we are heading. And the mirror is often foggy. Data are available after a time lag and may be distorted or offer conflicting interpretations. While the warning signs might seem obvious with hindsight, distinguishing the signal of a financial crisis from the noise of usual variability is difficult in the early stages. Moreover, the recognition of crisis conditions necessitating extraordinary policy measures is a time-consuming social and political process. Nick Kristoff has argued that evolution has predisposed us to worry about immediate tangible threats from tigers and snakes rather than longer term concerns based on analysis and calculation. As a result, prescient prophets of doom are destined to be ignored and we prefer, instead, to assume that what worked (or appeared to work) yesterday will continue to work tomorrow. There are also social and competitive pressures for this. We exhibit herd behavior in markets and crowds, relaxed and optimistic if others are, but vulnerable to panic contagion. As Citigroup chief executive Chuck Prince famously said in mid-2007: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Facing up to the climate crisis is much harder than recognizing the financial crisis. It is unfolding on a time scale of decades rather than months. Unlike the economy, where unemployment, bankruptcies and foreclosures provide more tangible and immediate evidence, the human imprint on the climate is hard to discern for the casual observer. Changes in carbon dioxide levels are invisible, the melting polar ice sheets and tundra are far away, and the oceans are, for now, soaking up much of the excess heat (though we may have reached nature’s overdraft limit).

Even for climate scientists, sophisticated statistical analysis is needed to demonstrate the human impact of greenhouse gases on global temperatures, and we are only just beginning to discern evidence of a link between hurricane intensity and climate change. Moreover, this is our first climate crisis as a sentient civilization. We have experience and institutions to help measure and deal with hurricanes and financial crises, but these are sorely lacking on the climate front.

We do, of course, attempt to peer into the future for both climate and the economy using modeling techniques, but the picture is generally even foggier than that in the rear view mirror. Models are, by definition, simple representations of a far more complex reality. They attempt to capture the major elements of a system and can perform quite well for short-term forecasting under relatively stable conditions. Economic forecasts hold up in reasonable fashion over several months or quarters, as long as there are no sudden shifts in consumer or investor sentiment. Weather forecasts, which rely on very well defined physical relationships between humidity, temperature, air pressure, and other factors, can be quite accurate for three or four days into the future, a bit better than a guess for up to ten days, but have little utility beyond that.

Weather forecasting illustrates an interesting paradox of complex systems; in principle, the weather is a deterministic system based on the well-known physics of atmospheric interactions, so that from a given set of starting conditions, the system ought to unfold in a predictable way. Yet even the most sophisticated weather models that use powerful supercomputers cannot capture the precise initial conditions at every point on earth; they usually work with a spatial resolution of several kilometers and don’t even have accurate data for all these “grid boxes”. Small errors in initial conditions are amplified across the millions of calculations that simulate the dynamic interaction of these atmospheric boxes every few minutes. For climate forecasting, the problems are similar, though different in scale. We are more interested in the average temperature and rainfall in fifty years time at a regional level than whether it will be cold and raining in Boston next Tuesday. But over a timescale of decades, the climate will exhibit more structural shifts with uncertain feedback effects; we don’t know how rapidly polar ice will melt, how fast rainforests will shrink, what might happen to cloud cover, or whether giant ocean currents like the Gulf Stream might slow or even shut down.

Even once the existence of a crisis is widely recognized, the steps required to address it are far from clear and simple. The economy and the climate have huge inertia and respond slowly and somewhat unpredictably to intervention, with the potential for unwelcome side effects. Action on the financial crisis was delayed while debates played out over fiscal versus monetary intervention, and bank nationalization versus recapitalization. Paul Krugman and Niall Ferguson have been recently feuding over the potential impact of large governmental deficits on inflation and interest rates; while Krugman supports aggressive intervention, for Ferguson and the deficit hawks, large scale government deficits will spook the bond markets, raise interest rates, and choke off any recovery. In any event, available policy options are only partial, limited tools; the government does not directly control business investment or consumer confidence. Large parts of the “gray” financial markets, such as hedge funds, non-bank finance, and credit default swaps issued by insurance companies lie beyond the reach of existing regulatory structures.

In a similar way, action on climate has been delayed while various parties argue over the best course of action – cap-and-trade versus carbon taxes versus direct traditional command and control regulation; nuclear power versus renewable energy. Mitigation policies can have unwanted side effects; raising vehicle fuel efficiency lowers the cost of fuel per mile, and so might encourage more driving. Electric vehicles might be charged on coal-intensive power in the US mid-West. Valuable carbon credits help to make air conditioning plants in China appear more profitable, accelerating production of these power hungry appliances. Policy tools tend to use indirect levers, such as the carbon price, which is likely to so low in the US as to have little effect on corporate or consumer behavior (see: Carbon Markets to Serve the Planet). Large sources of emissions lie mostly beyond the reach of current policy; emissions from developing countries, deforestation, international air travel and sea shipping have been out of bounds, till now at least. Moreover, carbon is only one piece of the climate system; we lack the technical tools to directly address other elements, such as melting ice caps, thawing tundra, or ocean currents.

Arguments about how to tackle crises are partly technical, reflecting different understandings of the workings of complex systems. But these differences are also deeply political, reflecting how we think the crisis, and proposals for intervention and change, will affect us in our particular geographic and economic location. It’s easy to claim that “we are all in the same boat”, but the truth is that some of us are in luxury yachts and some are in leaky dinghies. Bankers holding bad loans and homeowners facing foreclosure might want very different forms of government assistance; meanwhile, the majority of the tax-paying and still-employed public are wary of large scale public bail-outs. On climate change, the fiercest proponents of action on climate change are the low-lying countries likely to be swamped by rising sea levels, while the countries who strongly oppose action possess substantial coal and oil reserves. Rich industrialized countries might consider it reasonable to pay 1-2% of GDP to cut their emissions, but developing countries want access to cheap fossil fuels to drive their own industrial transformations.

Managing through a crisis in a complex dynamic system is clearly no easy task. To adapt the steering metaphor, the apt image might be steering a car with fogged up windows, using a greasy steering wheel that’s only loosely coupled to just one of the wheels. Oh, and there are four people in the car arguing about how we got here, where we are heading, and which way to turn the wheel.

A managerial and behavioral lens on low-cost carbon reductions

I’m writing this response to Jürgen Weiss and Mark Sarro’s excellent guest contribution while looking out of my antiquated and rusting steel casement windows in Brookline, Mass. These single pane windows, which date to the1951 construction of the house, are wintertime energy hogs – they are drafty, provide no insulation, and get covered in icy condensation. Why haven’t we replaced them? I teach in a business school and am outspoken on climate change, so the decision to replace the windows ought to be easy -  with my business school suit on, I should see the financial benefits, and with my environmentalist hat, I would feel good about reducing emissions.

But the math does not look so good when I run some numbers. Oil heat costs us around $2000 a year, and new windows might save up to $400 a year (though we have huge south-facing windows, which help keep the house comfortable in winter, at least when the sun shines, and insulated blinds for night-time). Yet it would cost around $20,000 to replace the windows with energy efficient ones. The 2% return on investment is a little better than money market funds are paying right now, but wouldn’t be attractive to an average investor (let alone a hedge fund!) It represents a 50 year payback, while most businesses look for 3-5 year payback. Even if we had the $20,000 lying around, who knows how long we’ll be in the house, or whether new windows would add much to the sale price. And this is a big expense, so my wife would have to be onboard. Ironically, my low-tech energy management system (the blinds!) helps lower the bills and reduces the incentive to invest in new windows.

The point of this embarrassing personal saga is to reinforce Jurgen and Mark’s argument that we need to be cautious of negative-cost carbon abatement. The good news is that about one-third of needed emissions reductions appear to have positive ROI, according to the McKinsey Marginal Abatement Cost (MAC). The bad news is that about one-third of needed emissions reductions appear to have positive ROI – yet the necessary investments are not happening. The costs may be higher than engineering estimates suggest and there are a host of market, institutional, and psychological barriers (and McKinsey themselves now puts more stress on these hurdles). The same logic applies to emission reductions that the curve suggests will occur with a carbon price of, say, $50 a ton – in reality, it might take a much higher carbon price to overcome these hurdles and secure the reductions.

Jurgen and Mark frame the problem in classic economic terms of scarcity: There Is No Such Thing As A Free Lunch. If there were free MAC lunches lying around, it is axiomatic for economists that someone would already have eaten them. My own Harvard Business School training in organization and management leads to a different perspective, however. There may well be free lunches available, but they are locked up or hidden away behind misaligned incentives, inertia, and market barriers. This business school perspective leads to a more optimistic conclusion than the economists’ dismal view.

Most companies, for example, have traditionally paid little attention to potential energy savings because nobody was paid to do so. Once companies assign managerial responsibility for the task, measure the savings, and evaluate performance accordingly, they start finding a lot of low-hanging fruit (see, for example, work by the Pew Center and The Climate Group (download large pdf file). Many of the barriers are more complex, and require restructuring markets and institutions – California is famous for paying utilities to save energy, not sell it. Utilities are also finding that they can nudge consumers in the right direction with non-price signals, such as comparisons with their neighbor’s bills. The booming field of behavioral economics points to all sorts of low-cost ways of shifting behavior. There are also a host of start up companies trying to exploit the potential savings and overcome market barriers by providing customers with turnkey efficiency projects packaged with financing, and then generating a revenue stream out of the lower energy bills.

Of course, these solutions are not cost free – they involve managerial time, some capital, and transaction costs. Some of the barriers are complex and would require large scale institutional restructuring, requiring government-business collaboration. But one person’s transaction costs are another’s business opportunity (the transaction costs of carbon markets will keep financial firms smiling). The key point here is that there are creative organizational and managerial approaches to unlock the doors to low-cost or even negative-cost carbon reductions. The carbon price is, by itself, an inefficient and ineffective tool – the price would have to be at a politically infeasible level to achieve the desired goal. But we don’t have to rely just on the carbon price or on command and control; a multi-pronged attack is needed.

A guest contribution by Mark Sarro and Jurgen Weiss, Watermark Economics, LLC

Jürgen Weiss and Mark Sarro are the co-founders of Watermark Economics, a consulting firm specializing in international and regional climate economics, finance and policy with an emphasis on mathematical and economic modeling, forecasting methodologies, policy analysis, strategy and risk management.

Of the dizzying array of topics crammed into the 1,428-page Waxman-Markey bill which passed the House in June 2009 by the slimmest of margins (219-212), energy efficiency is the very first topic.  By comparison, the bill doesn’t even mention cap-and-trade (for which it is most widely known) until six sections and 678 pages later.

The fact that energy efficiency comes first in the bill makes a lot of sense.  Least-cost climate change mitigation relies on the successful implementation of a range of energy conservation measures.  The potential for low or no-cost investments in conservation and energy efficiency is substantial.  Investments such as commercial and residential building energy efficiency upgrades and increases in transportation fuel efficiency can generate cost savings well in excess of the costs to implement them.

But it also makes sense that most people only flipped through that section of the bill on their way to the cap-and-trade part, because, as a practical matter, the potential for low or no-cost investment in conservation and energy efficiency has never seemed to translate into reality.  Instead, a confluence of market, financial, and institutional hurdles has yielded a persistent pattern of non-investment in cost-effective conservation and efficiency.  The key to unlocking the potential of conservation and energy efficiency is in overcoming these hurdles.  Unless we do, most of the available abatement potential will continue to go unrealized, even with the relatively high carbon price path in the Waxman-Markey bill.

ALL YOU CAN EAT

At a May climate change conference in London and in a follow-on op/ed piece in the Times of London, U.S. Energy Secretary Steven Chu said, “The quickest and easiest way to reduce our carbon footprint is through energy efficiency.  Energy efficiency is not just low-hanging fruit; it is fruit that is lying on the ground.”  Of course, he is right.  Efficiency investments create immediate savings and reduce the need for more expensive, longer-term options to reduce greenhouse gases.

As a matter of dollars and time, increased energy efficiency is the least-cost and most expedient option for reducing carbon emissions, since many of efficiency measures (e.g., transitioning to LED lighting, updating electronic devices and appliances, better building insulation, etc.) are immediately available and far less costly than supply-side options, like getting new renewable power generation and cleaner traditional plants onto the grid.

In a cap-and-trade carbon market, companies can choose to pay the allowance price for the right to emit a ton of carbon, or they can try to emit less carbon themselves and incur an abatement cost. The ability to substitute between abatement and emissions makes abatement costs an important determinant of the ultimate cost of carbon emissions reductions. Estimates of the marginal abatement cost (MAC) for carbon show many energy efficiency investments as NPV-positive, meaning they yield net economic gains even without taking into account climate-related benefits.

The most celebrated MAC curve is the McKinsey curve.  It shows the economy-wide potential for realizing reductions in carbon emissions from various activities and lists their respective abatement costs.  Sequencing each abatement option from lowest to highest cost generates a curve of what McKinsey estimates is the increasing marginal cost of potential avoided emissions.

Just last week (7/29/09), McKinsey released its latest installment of the curve as part (on p. 11) of a 165-page report titled “Unlocking energy efficiency in the U.S. economy.”  Reading from left to right, the curve still shows potential emissions reductions in order of increasing cost, where the height of each bar shows the average annual abatement costs in dollars per million BTU.  But the curve has now been redesigned.  It no longer shows the “negative cost” efficiency options (i.e., net cost savings) below the horizontal axis.  Instead, it shows a dashed line at the average cost of a new power plant ($14/MMBTU).  According to McKinsey’s math, all of the efficiency options along the curve below that line are NPV-positive.

The allure of the McKinsey MAC curve is that about one-third of the potential emissions reductions can be realized at negative cost (i.e., a net savings) right away, with existing technologies. This is the fruit lying on the ground in Secretary Chu’s comments, essentially an all-you-can-eat buffet of conservation and energy efficiency measures.  But it assumes the economy is efficient and agile enough to respond to price and profit signals.

The new McKinsey report received great fanfare for its ultimate conclusion that the U.S. can both sharply reduce emissions and realize substantial net cost savings.  According to the report, implementing all of the NPV-positive options would reduce U.S. CO₂e emissions by 1.2 billion tons, or 17% of emissions in 2005, at a net savings of $700 billion.  It says an investment of $520 billion in energy efficiency would produce $1.2 trillion in savings on energy bills through 2020.  This happy result means efficiency gains alone would be sufficient to meet the 2020 emissions target under the Waxman-Markey bill, plus a healthy return.

McKinsey admits that assumption is clearly optimistic.  Actually, it is entirely unrealistic.  The New York Times reports the required $520 billion investment is 4 to 5 times more than the nation currently spends on energy efficiency.  But why?  If there are such obviously valuable abatement options out there, why aren’t we exercising them?  Why aren’t efficient capital markets funding them, even without hundreds of pages and billions of dollars of energy efficiency incentives in the Waxman-Markey bill and stimulus package?  Why is there so much ripe and ready fruit just lying on the ground?

If the negative cost options on the MAC curve look too good to be true, it’s because they are.

NO FREE LUNCHES

Scarcity is the most fundamental principle of economics, the genesis of all economic problems.  Every freshman student of economics learns, on the first day of the first semester, that economics is the study of how scarce resources are allocated to satisfy unlimited wants.  In practice, economic scarcity simply means you have to give to get.  Or, as University of Chicago economist and Nobel laureate Milton Friedman put it, “there’s no such thing as a free lunch.”  But if Friedman is right, is Chu (also a Nobel laureate, in physics) wrong?  Fruit lying on the ground sure sounds like a free lunch.  And if Chu is wrong, then McKinsey is very wrong, because its vaunted  MAC curve suggests we actually get paid to eat.

But alas, we can’t, because even what look like no-cost or low-cost conservation and energy efficiency options on the surface actually involve several significant market, financial, and institutional barriers which are ignored in casual commentary and most estimates of abatement costs and likely future carbon costs.  As a result, public discourse and analyses of the least-cost path and price of emissions reductions seriously overstate the likely efficiency gains and understate the likely cost of carbon in a future world where many NPV-positive efficiency options will sit rotting on the ground.

These barriers are ignored because they are frequently difficult to quantify or predict precisely.  Since we mostly observe conservation and energy efficiency options not being used, there is no objective historical basis on which to forecast their future use or relative costs.  Likewise, the likely future use and cost of abatement options depend on a dizzying array of mutual interactions with policy, technological, and market unknowns.

THE HIGHEST HURDLES

The new McKinsey report acknowledges “significant and persistent barriers” to actually achieving its estimated net cost savings.  The first step toward appropriately accounting for these hurdles is to identify and understand them.  They are easier to identify than they are to model, but they are impossible to model if they remain unidentified.  Here, we outline only the highest hurdles to overcome and we suggest some possible approaches for doing so:

Inelastic energy demand

One very simple explanation is inertia (or inelasticity, in economic terms) in the way energy decisions are made on the demand side.  Economic theory says as energy prices increase, the quantity of energy demanded will decrease, all else equal.  But empirical evidence over long periods of time shows energy use changes less than proportionately to changes in price (i.e., a 1% price change results in less than a 1% change in energy use).  According to one study, the price elasticity of commercial energy demand ranges regionally from just -0.15 to -0.30 (i.e., when price changes, quantity changes by only a third as much or less) and has not changed significantly over a 20-year period.  This is because energy is a relative necessity with only a limited degree of substitutability, especially in the short-run.  Also, energy remains a small share of expenditure, especially relative to its critical importance, and overall energy intensity has been decreasing.  The U.S. DOE reports a 10% drop in its energy intensity index over a 20-year period.

To the extent energy demand is responsive to efficiency measures, the news still isn’t all good.  Rebound effects may offset potential efficiency gains.  Energy efficiency makes energy cheaper to use, so we use more, thus offsetting some of the efficiency gains.  A recent study showed rebound effects may be significant, potentially accounting for half of all future global carbon and energy savings.  It estimated global rebound effects in response to the International Energy Agency’s (IEA) efficiency recommendations may be 31% by 2020 and 52% by 2030.

Capital market imperfections

Widely-discussed hurdles to conservation and energy efficiency investments are the relatively large upfront costs and relatively long break-even periods for such investments.  While the resulting efficiency improvements result in energy bill savings, many of which are NPV-positive under conservative discount rate assumptions, the payback periods are relatively long, many in the 10-20 year range.  This payback period is longer than typical home ownership or the average life of many businesses.  So far, families and business have been reluctant (at best) to commit large sums of money upfront in efficiency investments, even if they are expected to pay back over the duration of ownership.

Different financing approaches are thus needed to encourage serious efficiency investments.  Most promising are approaches which require no upfront investment and tie the financing to the building itself rather than to the owner.  Some financing models already exist, such as on-bill financing by utilities, pay-as-you-save approaches, and property tax financing by communities (clean energy municipal financing and outright utility ownership.  But none has yet been widely used.

Information Barriers

Conservation and energy efficiency investments suffer from information barriers at both ends of the issue: information about the investment setting (e.g., a home or commercial building) and the various options to upgrade its energy infrastructure is sparse, complex and often biased.

There is very little information about the energy performance characteristics of most structures.  Energy audits, while increasingly common and free of charge by local utilities, are typically unsophisticated, based on outdated models, performed by marginally skilled “professionals”, and are not embedded in a system that easily allows for comparisons of structures.  Information about potential solutions is often limited to “partisan” advice by equipment manufacturers, installers or industry associations interested in promoting a particular approach.  As a result, there is significant uncertainty about how much of an improvement proposed efficiency measures actually would yield and whether promises made actually translate into real energy and cost savings.

Technological uncertainty

Sometimes it just makes sense to wait things out, especially in changing circumstances.  The landscape for energy efficiency certainly qualifies.

This year’s $800 billion stimulus package put on the table $43 billion in new money for energy investments.  It extended production and investment tax credits for renewable energy investments and added a new incentive, Treasury grants in lieu of tax credits for the increasing number of investors with no profits against which to take a credit.  But the on-again, off-again nature of tax incentives for renewable investments and increasingly intense competition for dollars and dominance among alternative technologies (geothermal, solar, wind, etc.) have made it difficult for renewables to gain more traction more quickly.

The stimulus package also offers freebies for energy efficiency upgrades.  It extends home energy efficiency tax credits which had expired 2007.  (Tough luck if you replaced all the windows in your house in 2008!)  But efficiency upgrades cost very real money, typically upfront, and pay off relatively slowly over long periods of time.  It is questionable whether the tax credits are sufficient to make the dollars flow.  For example, the new 30% tax credit for energy-efficient doors and windows triples the old 10% tax credit.  But it won’t amount to anywhere near a 30% credit in most cases because it is capped at just $1,500.  Solar water heaters, geothermal heat pumps and wind energy systems get a true 30% credit:  30% with no cap through 2016.  But they require large cash outlays and are not well-understood by most homeowners or contractors.

Even with sufficient financial resources and incentives in place, it still may be rational to wait on big efficiency investments.  After all, the fruit lying on the ground tomorrow might be tastier than what is lying there today.  In a fluid environment, it is challenging to figure out exactly when to invest in efficiency upgrades.  Investing in today’s technologies may make it impossible or more costly to take advantage of better, lower-cost technologies in the future.  Investing frequently is costly and can be risky, but waiting too long also increases cost.  So energy efficiency investments become a game of optimal waiting based on the perceived gap between current and new technologies and the opportunity cost of investing now.

JUMPING THE HURDLES

We think the most important observation for policy-makers to understand right now is that simply introducing a carbon cost via a Waxman-Markey style cap-and-trade program will not be adequate to realize the potential for substantial low-cost or negative-cost efficiency gains.  But finding a way to unlock the potential value of energy efficiency is critically important or we will literally pay the price.  Even assuming available efficiency gains are realized, a new report (8/4/09) just released by the EIA (likely an optimistic source) projects a carbon price of $65/ton in 2030 under the Waxman-Markey bill.  Without the reduced energy demand from projected conservation and efficiency investments, power prices and carbon prices will be substantially higher.

We are also skeptical of giving money to utilities in the form of free allowances to spend on efficiency.  The evidence that utilities know how, and are willing, to spend that money wisely is scant at best.  Utilities have little incentive to make the right energy efficiency investment decisions because their fixed cost recovery depends on the volume of electricity they sell.  In fact, increased sales (exactly the opposite of conservation and energy efficiency) results in an over-recovery of costs which goes straight to a utility’s bottom line until its next rate case.  Doling-out free allowances to utilities does not change their economic incentives.  So we greatly prefer auctioning emissions allowances and returning the revenue directly to ratepayers or, better yet, to taxpayers, and letting them decide for themselves which energy efficiency investments make economic sense.

Simply put, it will take a lot more than a market-based carbon price and a handout of free allowances to utilities to unlock the potential of conservation and energy efficiency investments.  It will take some serious innovation, a great deal of risk-taking and capital, and a coordinated effort by policy-makers, investors, and entrepreneurs to jump the significant institutional and legal hurdles currently in the way.  Until then, it will continue to be a real stretch to bend over the hurdles in an effort to reach all the elusive fruit lying on the ground.

David Levy raises many questions in his post Carbon Markets to Serve the Planet, on Krugman’s defence defence of cap-and-trade. I want to pick up on two here, and then add another into the pot which seems to me crucial to whether carbon markets can help in the fight against climate change.

First, a central premise in David’s intervention is that carbon markets could encourage speculation which will produce carbon price volatility. It is clearly the case that this would undermine the ability of such markets to help achieve carbon emission reductions in a predictable way, since investors and manufacturers rely on a stable and increasing carbon price to give them the signals to direct investment.

But let’s look at the main cap-and-trade market in existence, the EU Emissions Trading System. The two figures below give carbon prices in the EU ETS. The first one goes from December 2004 (just before the official start of the system) to April 2007. It shows the prices for the Phase I (2005-7) allowances and the Phase II (2008-2012) allowances. These are forward prices – precisely those prices on the derivative markets that make people squeamish about speculation. The second one shows just Phase II allowances but goes up to January 2009. These are also forward prices.

Two major episodes of volatility can be seen in these graphs. One is the collapse of the Phase I price in April 2006 (the blue line on the left). The other is the steep decline from July 2008. My point here is that neither of these have anything to do with speculation. In the former case, it was because new information came out from the European Commission, which showed that companies had been over-allocated with allowances, causing the price to crash to virtually zero. This might cause us to worry about the regulatory capacity of governing institutions, but not to prevent speculation. The forward price for the Phase II allowances, after a little panic, recovered and was pretty stable throughout the period before the Phase II period started (January 2008).

The second decline followed the onset of recession and the decline in oil prices (since January 09, it has recovered somewhat, again along with oil prices). Here, the point is that because the main demand for allowances is among electricity producers, as demand for electricity fell, two things happened. First, anticipated demand for allowances also fell, and their prices fell accordingly. But second, demand for natural gas fell, since natural gas is the swing producer in European electricity supply. And gas prices correlate strongly with oil prices, since they are often produced together, thus putting further downward pressure on electricity prices and thus carbon prices.

So it is hard to find evidence that speculation is a huge problem in those carbon markets which already exist. One or two of the smaller short-term spikes (e.g. the one in June 2005) were possibly attributable to speculation, but there isn’t systematic and wide fluctuations in prices which would suggest there is volatility produced by widespread speculation. In fact, the prices overall look relatively stable. To be sure, they are young markets, but they are nevertheless the sort of derivative markets – with forwards, options, swaps, and the like – which current worries about finance emphasise as the reason why we should be wary of finance-driven solutions to climate change.

David raises a second question about price – that it is too low. This is clearly another question, and it is indeed clear that the prices being envisaged in the Waxman-Markey bill are way too low. Again, a comparison with the EU ETS is instructive. As to a price cap, in Phase II the EU ETS has an official price cap (the fine you would pay per tonne of CO₂ for non-compliance) of €100 (around US$140). As the figures above show, carbon prices have never gone above €30 (US$43), way below the fine price. The EU envisages prices rising considerably again in Phase III (2012-2020). Again, two things are worth noting here.

The first is that EU officials deliberately decided to aim for a low-ish price in the first period, to get the system up and working, rather than aim too high too quickly and risk the credibility of the system if huge number of firms were not able to meet their obligations. American officials and policy-makers are presumably making a similar judgement. Of course the converse risk is that the targets may not be ratcheted up later, but the experience of the EU isn’t too bad on that front either.

The second leads me to what is probably the biggest regulatory dilemma for carbon market design, which David doesn’t mention. This is the question of offsets, which are crucial to whether cap-and-trade has a chance of delivering emissions reductions. Waxman-Markey allows companies to use offsets (see sections 731-743), but doesn’t specify a limit to their use. In the EU ETS, offsets are the de facto principal cost containment strategy in the EU ETS, not the fine price. In most member countries, there are limits as to how much of a company’s obligation can be met by purchasing offsets.

Much of the carbon market industry argues forcefully that maximum access to offsets is required, both for regulated firms to contain costs, and to sustain interest in carbon markets by investors. But there are two questions (at least) here. On the one hand, the regulation of the carbon offset market – what types of offsets to allow, what percentage of firms’ obligations can be dealt with by offsetting, how to measure additionality, and so on – is much more problematic than for cap-and-trade markets, since they involve stages and processes which are much more prone to flexible accounting if not outright scams. There have been huge numbers of exposés of carbon offset projects, both of the UN’s Clean Development Mechanism and the voluntary carbon market, well-publicised in particular by Carbon Trade Watch.

Perhaps these can be addressed with good political campaigning to close loopholes. But there is a deeper problem, which is that if you allow offsets the cap is no longer a fixed cap. This is a more basic question, and here it is even clearer than with cap and trade that we are in a ‘Faustian bargain’, and this is perhaps the core of Krugman’s problem. Even though he is critical of many of the dodgy practices of financiers, he is so precisely in order to recuperate the ‘good’ side of finance.

As I see it, the kernel of the problem of dealing with climate change within capitalist society is this. Capitalism needs growth in order to keep going. Historically, business, or specific sectors, has worked with other forces (unions, nationalists, social movements) to provide legitimacy and a broader appeal for ways of managing the economy that suit business interests. With other environmental problems, you could deal with them by isolating specific parts of business and limiting their activities, assuming that growth would go on elsewhere; with climate change this is not possible, however. Energy is simply too central to the whole of capitalist development. To sustain any project for decarbonisation, it is unimaginable to do so without gaining the support of wide sectors of business.

This is the basic brilliance of cap-and-trade. Economists will tell us it is all about efficiency, but in practice it is all about (a) parcelling up the climate so as to concentrate the benefits of climate change action on particular economic groups (financiers and clean energy), and (b) as a consequence building a political coalition that can sustain climate policy in the face of the rustbelt and SUV onslaught. No other policy can do that. Famous NASA climate scientist James Hansen came out in favour of carbon taxes recently, and organisations like Carbon Trade Watch opposing carbon markets supported his claim. But a carbon tax is no more certain to create a shift to decarbonisation, certainly not at the speed Hansen along with many others now argue is necessary. To believe so requires extraordinary belief in neoclassical economic principles – principally concerning how much demand for energy responds to price changes (what economists call price-elasticity). We know these principles don’t function in most energy markets, where demand is in fact rather insensitive to price changes. At least with cap and trade, there is a cap. But more importantly, carbon taxes create no winners, and will thus get massacred, as the Canadian Liberals recently experienced in their 2008 election campaign.

David raises the point that most of the policies that will help us get to decarbonisation may well be good old-fashioned ‘command and control’. We do indeed need to mandate levels of renewable energy use, housing standards for low-carbon futures, city planning that eliminates sprawl and favours transit and bikes over cars, and so on. Most of these will be achieved through such command and control policies. And most outcomes they would achieve could not be done simply via carbon markets.  But the political point here is that cap and trade could get buy-in from powerful actors. They may then see the opportunities in investing in rail, wind, solar, fuel cells, etc., given increasing carbon prices. But they will have realised their goals of money making in carbon markets (even if, as David says, the rest of us have to hold our noses), letting us get on with the business of other policies which either work on their own, or more likely, work in tandem with carbon markets.

Some critics of carbon markets suggest that it is a distraction from the ‘real’ action which is needed. This may be true. But the question is: Whose attention gets deflected? Does cap and trade deflect the attention of policymakers from command and control, or does it rather deflect the attention of the anti-climate change nutters from the command and control policies that actually deliver results?

This summer the Union of Concerned Scientists published Climate 2030: A Blueprint for a Clean Energy Economy. The UCS plan is designed to reduce US greenhouse gas (GHG) emissions by 26% below 2005 levels by 2020, and 56% by 2030, putting the country on target for an 80% reduction by 2050. These are the kind of aggressive targets that are needed from industrialized countries if global warming is to be held roughly at the 2 degrees Celsius ceiling.

UCS clearly understands that the political economy of climate is more important than the science in spurring action. Businesspeople, policymakers, and consumers need to be convinced that they can prosper in a low-carbon future. This report certainly makes that case. It states that:

The nation achieves these deep cuts in carbon emissions while saving consumers and businesses $465 billion annually by 2030. The Blueprint also builds $1.7 trillion in net cumulative savings between 2010 and 2030. Blueprint policies stimulate significant consumer, business, and government investment in new technologies and measures by 2030. The resulting savings on energy bills from reductions in electricity and fuel use more than offset the costs of these additional investments. The result is net annual savings for households, vehicle owners, businesses, and industries of $255 billion by 2030. Under the Blueprint, every region of the country stands to save billions. Households and businesses—even in coal-dependent regions—will share in these savings.

The report uses a version of the Department of Energy’s National Energy Modeling system to project changes in energy use, emissions, and energy costs. The model was used to forecast the impact of a cap-and-trade system combined with regulatory mechanisms and R&D funding to promote efficiency, renewables, low-carbon transportation, and green growth. The model shows higher carbon prices than envisioned in W-M, due to the tighter cap and fewer offsets: $18 per ton of CO2 in 2011, rising to $34 in 2020, and to $70 in 2030 (in 2006 dollars). Most of the GHG reductions come from the power sector, though the report does not say how much comes from the carbon price and how much from other measures.

The UCS Blueprint is based on commercially available, rather than breakthrough technologies. It’s meant to be realistic and conservative, so that it can withstand critique. They even included $8 billion in government-related costs to administer and implement policies. The demonstration of savings is quite compelling – by 2030, for example, the model shows consumers saving about $900 annually per household in energy and transportation costs. Although most of the emission reductions come from the power sector, nearly half of the financial savings come from transportation – more efficient cars and more public transportation:

The targets are substantially tougher than Waxman-Markey, which aims for 17% GHG reduction by 2020. The UCS model still shows the economy growing by 81% between 2005 and 2030, only slightly less than the 84% it would grow in the baseline case without new climate policies (a number that does not take into account the negative economic impacts of climate change on agriculture, tourism, etc.). There is little overall impact on employment. It should be stressed that by construction, these models always show a hit to GDP from raising the price of fuels, because they assume – as economists love to do – that we are already in a blissful state of perfect allocation of resources, so any disturbance must hurt GDP. The model also does not fully account for growth and productivity stimulated by new investments in clean energy.

Despite the limitations of economic modeling, this is a carefully crafted and well executed study – and it has some great graphics and charts. Importantly, it knows what is a cost and what is a benefit, which is surprisingly muddled in many reports. Although the report touts new clean energy investment as a ‘good thing’, generating jobs and reducing emissions, it does recognize that investment is a cost to society, channeling resources that could have been put to another use (I made this point regarding employment in another study – see: Clean Energy – How Many Clean Jobs?).  Energy savings translate into lower costs for consumers and businesses, and do reflect a real economic benefit to society. Of course, they also reduce revenues for companies selling fossil fuels and carbon intense products, from power to conventional cars. What these economic models cannot tell us is which companies and countries will be the long-term winners and losers from a carbon constrained economy.