Caixin
Apr 24, 2021 09:30 AM

Weekend Long Read: The Economics of China’s Carbon Neutrality Pledge (Part I)

The Chinese government has pledged to achieve carbon peak by 2030 and carbon neutrality, i.e., net-zero carbon emissions, by 2060. Across the Pacific, the Biden administration has brought the U.S. back to the Paris Agreement. Meanwhile, the 27-member European Union has committed to increase emission cuts before 2030 and achieve carbon neutrality by 2050. Achieving carbon neutrality requires not only coordinated efforts by government bodies and nongovernmental institutions but also close collaboration among nations. What kind of obstacles and challenges will confront humanity on the road to carbon neutrality? What new opportunities may emerge? How will carbon neutrality impact the global economy and society?

To answer these questions, CICC Research and the CICC Global Institute collaborated to compile our latest report: Economics of Carbon Neutrality: Macro and Sector Analysis under New Constraints.

The report systematically analyzes the pathways for China to achieve carbon peak and carbon neutrality, as well as their broader implications. The research into carbon neutrality differs from our usual market research in two critical aspects: 1) carbon neutrality encompasses a wide range of fields, covering economics, science and social studies; and 2) carbon neutrality is an unprecedented challenge for public policy, which will undoubtedly play a pivotal role.

From cost-benefit to cost-effectiveness

Carbon emissions can be reduced in two ways: 1) electrification of economic activities, such as industrial production, transportation and home heating; and 2) switching from traditional fuels for electricity generation to alternative energy sources (e.g., renewable energy and nuclear energy), or adopting carbon capture and storage technologies to reduce carbon emissions from fossil fuel consumption. However, these solutions face a critical problem: clean energy is more expensive than fossil fuels and requires new infrastructure, while the increased cost is detrimental to economic growth.

Cost-benefit analysis was an early approach to studies of the economic implications of climate change and policy responses. This approach compares the long-term benefits and short-term costs of emission cuts, and offers policy proposals based on the analysis. However, the monetary evaluation of long-term impacts from climate change is highly uncertain and often underestimates the benefit of emission control measures, resulting in insufficient public policies.

In most cases, economic analysis only captures economic activities that involve market transactions and economic effects that can be measured in monetary terms. However, impacts from climate change, such as rising sea levels, ocean acidification and ecological imbalances, often extend far beyond the scope of traditional economic analysis, or simply cannot be measured in monetary terms. Moreover, emission reduction incurs costs at present but delivers benefits in the future. Most people, including public policymakers, focus on the near-term costs and impacts on the economy, but neglect the interests of future generations.

With the increasing focus on climate change around the world, the necessity to address the problem has become a global consensus. Instead of arguing whether we should take action to control carbon emissions, discussions now focus more on how to effectively achieve policy targets at the lowest cost. Hence, the research method has changed from cost-benefit analysis to cost-effectiveness analysis, i.e., comparison of the costs of different means to attain a pre-determined policy goal, to find the most effective solution with specific action plans.

Defining China’s peak emission

When we analyze China’s emission reduction targets, a critical issue is to estimate the peak emission volume in 2030. A high emission peak means the country would face relatively less pressure to curb carbon emissions from 2021 to 2030, but may have to work hard over 2031–2060 to reduce net emissions to zero as promised. The opposite would be true if the emission peak is low. Most studies on this issue derive the peak emission target from China’s actual carbon emission in 2005 and the Chinese government’s pledge to reduce the country’s carbon intensity (carbon emission per unit of GDP) by at least 65% over 2005–2030. However, the 2005 emission data from different sources are inconsistent with each other. Fortunately, the data inconsistency has narrowed over time and become insignificant in recent years. Based on China’s carbon emission data for 2017, we derive the peak emission volume from the country’s actual carbon intensity reduction and the government’s pledge to cut carbon intensity by 65% over 2005–2030. Our calculation indicates that China’s peak net carbon emission in 2030 should be 10.8 billion tons.

How to interpret the 10.8-billion-ton peak emission volume? China’s aggregate peak emission volume is much higher than the EU’s 4.1 billion tons and the U.S.’ 6.1 billion tons. Moreover, the duration from China’s emission peak to carbon neutrality is shorter than the EU’s and the U.S.’. Both point to the need to significantly reduce China’s carbon emissions after the peak. While a relatively high emission peak seems to suggest that China does not have to substantially cut carbon emissions over 2021–2030, an examination of the per capita emission volume reveals a different picture. We estimate China’s per capita peak emission volume at 7.4 tons in 2030, well below peak volumes in the U.S. (19.6 tons) and the EU (9.9 tons). As the low per capita peak emission leaves little upside for carbon emissions over 2021–2030, we believe China will have to strictly curb emissions in this period. Since both aggregate and per capita perspectives are essential to a complete picture of emission control, we believe China will need to work hard to significantly reduce carbon emissions both before and after the peak in 2030.

What carbon prices can and cannot do

Effects of global endeavors to address climate change have been rather limited and far from ideal. This poses a puzzling question: Why has climate change failed to stimulate innovations in emission reduction when population aging has led to the development of machines to replace humans? In our view, a key factor to explain the paradox is the so-called “negative externality”: Economic activities that emit carbon dioxide benefit individuals, but their consequences, such as air pollution and climate change, harm human beings as a whole. Under such a negative externality, prices of goods and services in the free market are inconsistent with the public interest. For example, market prices of fossil fuels are too low and their consumption volumes are too high.

Economic activities involve many types of externalities. Most externalities, such as financial risks and soil contamination, are limited to certain areas. However, climate change is global — it affects every nation and all people around the world. The ongoing endeavor to contain Covid-19 is comparable to emission control. Vaccination against Covid-19 shows a positive global externality as it not only protects individuals but also helps stop virus transmission. Global herd immunity could be achieved when each country vaccinates 70% to 80% of its population. If governments fail to collaborate on vaccination, even 100% vaccination in a single country is unlikely to end the pandemic, as its continued spread in other countries may cause the virus to mutate and render existing vaccines ineffective.

However, there is a key difference between the endeavor to address climate change and the battle against Covid-19. Pandemic containment measures usually deliver clear and instant results, but the effects of the endeavor to address climate change are barely predictable as they may be decades or even centuries in the future. As the negative externality impacts the whole world and lasts into the future, the private sector has hardly any motivation to participate in the endeavor to address climate change. Meanwhile, the effects of the free market’s adjustment mechanism are very limited. As such, correction of the negative externality holds the key to carbon neutrality.

To correct the negative externality, intervention from public policies is essential. A key concept here is carbon pricing, which measures the social cost of carbon emissions. By requiring carbon emitters to pay for their emissions, carbon pricing turns the social cost of carbon emissions into emitters’ costs, urging them to reduce energy consumption and switch from fossil fuels to clean and renewable energy. Discussions about and implementation of carbon pricing policies involve two related but different issues: the form of pricing and the proper price level.

In theory, carbon prices should be based on the social cost of carbon emissions. To determine a proper carbon price, we need to discount the future climate damage caused by carbon emissions to derive its current cost. However, it is quite difficult to forecast the effect of climate change decades in the future. The choice of a proper discount rate may also cause disputes as it involves a trade-off between the interests of the current generation and those of our descendants. For example, the Obama administration preferred a 3% discount rate, which implies the U.S. is willing to pay $0.22 at present to avoid each dollar of loss due to climate change five decades from now, or less than $0.05 at present to avoid each dollar of loss 100 years in the future.

Nicholas Stern, a distinguished professor at the London School of Economics and the former chief economist of the World Bank, estimated carbon prices in his report on climate change in 2006, a masterpiece that has received worldwide attention. The discount rate adopted by Professor Stern in his report is lower than the rate adopted by the 2018 Nobel Prize laureate William Nordhaus, which implies that professor Stern gives a greater weight to the interests of future generations. The carbon price derived with professor Stern’s discount rate is about $266 per ton, well above estimates made by professor Nordhaus ($37 per ton), the Obama administration ($42 per ton), and the Trump administration (less than $10 per ton). Significant differences between these estimates clearly illustrate their uncertainty and subjectivity.

How to implement carbon pricing

Carbon pricing can be implemented in two forms: a carbon tax and a carbon trading price. A carbon tax is a carbon price imposed directly by the government in areas where market-based carbon prices are lacking. A carbon trading price is the price of emission permits traded in a market established under a total emission cap set by the government (i.e., the “cap-and-trade” system). Both a carbon tax and a carbon trading price have pros and cons. Advantages of a carbon tax include high transparency and price predictability, which helps economic entities formulate long-term plans. However, a carbon tax is not directly or stably related to the emission control target, so the volume of emission reduction cannot be easily predicted under the carbon tax framework. The cost of levying a carbon tax is low as it can leverage the existing taxation system, although the introduction of a new tax could face objections from the public.

Under the carbon trading framework, policymakers need to design new trading mechanisms and set a cap on the total volume of emissions permitted. As such, the volume of emission reduction is more predictable. However, a carbon trading price is less predictable as it is affected by multiple factors, such as economic cycles and technological advancement. For example, carbon trading prices could decline due to falling demand for carbon emissions in an economic recession, but could rise due to growing demand in an economic boom. The main problem for carbon trading is inelastic supply, which means demand-side shocks would result in price fluctuations. This may lead to excessive price volatility and significantly disrupt the business plans of companies and other economic entities.

Both a carbon tax and a carbon trading price are valuable tools for the correction of externalities. They are compatible with each other and can both be effective in a well-designed framework. The main difficulty for policymakers lies in the determination of an appropriate tax rate and an effective cap on emission permits. An excessively low tax rate and an extremely high emissions cap are unable to impose an adequate constraint on carbon emissions or provide sufficient incentives for emission cuts. On the other hand, the economy would face significant adverse impacts if the tax rate is too high or the emission cap is too low. As discussed above, the fundamental problem still lies in the significant uncertainties in setting an appropriate price for each ton of carbon emissions.

As policymakers have set targets for carbon neutrality, the key question at present is how to effectively achieve this goal at a low cost rather than assessing the long-term damage caused by climate change. How can we set a proper carbon price under the cost-effectiveness framework? When economic entities choose between fossil fuels and clean energy, they usually base their decisions on cost comparison. The carbon price that makes the cost of clean energy equal to that of fossil energy is termed a “switching price” or “parity price.” When describing the path to carbon neutrality, the International Energy Agency adopted the concept of switching prices instead of traditional carbon prices. Another example of a switching price is the so-called “green premium,” a new concept proposed by Bill Gates in his recent book “How to Avoid a Climate Disaster.”

Long 1

Green premium: a more practical tool for analysis

The green premium is defined as the difference in cost between clean (zero carbon emission) energy and fossil energy for a certain economic activity. A negative green premium indicates that the cost of fossil energy is higher than that of clean energy — an incentive to switch to clean energy and reduce carbon emissions. The green premium and carbon pricing are compatible with and related to each other. However, the green premium has three distinct advantages over carbon pricing as an analytical tool.

1) The green premium concept is broader than carbon pricing. The scope of carbon pricing, such as a carbon tax and a carbon trading price, is too narrow to fully correct the negative externality of carbon emissions that impact the whole world and last into the future. This compels regulators to intervene by issuing public policies with broader coverage. In contrast, the green premium provides a more comprehensive framework that encompasses not only carbon pricing but also a range of alternative tools. Apart from a carbon tax and carbon trading, we may also lower the green premium by increasing public expenditure on technologies and innovations, formulating green standards for various industries and products, and constructing new infrastructure to reduce the cost of clean energy consumption.

Long 2

2) The green premium focuses on the present, while carbon pricing involves the assessment of future uncertainties. To determine a proper carbon price, we have to discount the future climate damage caused by carbon emissions and climate change to derive its current cost. In contrast, the green premium calculates the difference between the current costs of clean energy and fossil fuels, and extrapolates from these results possible future trends. As policymakers have already set long-term targets for emission peak and carbon neutrality, the green premium is a more practical tool for analysis.

3) Carbon prices are a uniform concept, but green premiums are highly structural and vary significantly across industries due to differences in technologies, business models and public policies. Calculating green premiums in different industries helps policymakers to assess policy feasibility in different areas. Based on a few assumptions about new technologies, new business models and the threshold of economies of scale, the green premium may also help us identify milestones and key indicators in the implementation of emission control policies.

A key innovation we make in this report is the application of the green premium concept in the context of China. Our in-depth industry knowledge has enabled us to estimate green premiums in various sectors, and incorporate them as key inputs into our analysis of the roadmap for emission reduction. They also serve as a fundamental link to combine top-down macro analysis with bottom-up microanalysis to form a comprehensive and systematic analytical framework for carbon neutrality.

Our sector teams assessed green premiums in eight industries with high carbon emissions. Under current conditions, we estimate the green premium at 141% in the transportation industry (excluding by passenger vehicles) and 138% in the construction material industry (e.g., cement and glass). In other words, the cost of using clean and renewable energy in these industries is one to two times higher than the cost of fossil energy. The green premium remains positive at 3% to 17% in industries with relatively mature technologies, such as papermaking, nonferrous metals, steel, power and passenger vehicles. These figures suggest that market prices are unable to provide sufficient incentives for a switch to clean energy in the eight industries, which collectively account for as much as 88% of total carbon emissions in China.

We calculated each of the eight industries’ proportions in total carbon emissions and used them as weights to derive the current weighted average green premium for these industries. The result (about 35%) implies a 377 yuan per ton parity carbon price, i.e., the price that can reduce the green premium to zero. Despite conceptual differences discussed above, the parity price is within the range of estimates ($37 to $266 per ton) found in global research literature. Based on available data, we also calculated the eight industries’ historical weighted average green premium since 2015 to compile the “CICC Green Premium Index.” The index shows that the switching price for clean energy has declined remarkably in recent years despite significant differences between industries.

Long 3

We can lower the green premium by reducing the cost of clean energy and/or raising the cost of fossil energy. However, relying solely on the second option could cause severe adverse impacts on the economy, as it may require a sharp increase in the cost of fossil energy. In our view, the optimal solution is to reduce the cost of clean energy or energy consumption per unit of GDP, which calls for technological advances and innovations in social governance. We believe this would be a positive supply shock to the economy and may create new opportunities.

It is worth noting that the green premium is not stationary: it declines along with prices of clean energy, but rises when prices of fossil energy fall due to declining demand. If current clean energy prices drop below current fossil energy prices, the result is not necessarily conducive to carbon neutrality. We should keep track of changes in the green premium to analyze their implications. Ultimately, we still need direct or indirect intervention from public policies to set a floor for fossil energy prices and carbon prices. While carbon prices measure the social cost of carbon emissions, the green premium gauges incentives for the private sector to switch to clean energy. We believe both are effective tools for analysis and policy implementation, so they should be compatible with and complementary to each other.

Technological advances and social governance

The 2018 Nobel Prize in Economics was shared by William D. Nordhaus “for integrating climate change into long-run macroeconomic analysis” and Paul M. Romer “for integrating technological innovations into long-run macroeconomic analysis.” Although the sharing of the prize might be a coincidence, we believe the two Nobel laureates’ research fields are indeed linked to each other, as technological advancement is crucial to the endeavor to address climate change. Moreover, technological advancement also shows externalities — individuals bear research and development (R&D) costs and risks, while the whole society benefits from R&D accomplishments. That is why private sector R&D spending is too low to generate enough social benefits.

Given the negative externality of carbon emissions and the positive externality of technological advances, intervention from public policies is essential to both emission control and technological development. Over the past few years, the power industry has been the primary contributor to the sharp decline in China’s overall green premium. However, green premiums remain high in a few industries, and existing technologies are unlikely to significantly reduce the cost of using clean energy in these industries in the foreseeable future. Only major innovations and technological breakthroughs can effectively reduce green premiums in these sectors. For example, only expensive carbon capture technologies can effectively reduce emissions in a number of manufacturing industries, such as cement and chemicals, as electricity consumption is not the main source of carbon emissions in these industries.

The green premium is already negative for power producers. Attributes of clean energy production and application are similar to those of the manufacturing industry. A good example is economies of scale: growing production volumes and user numbers reduce unit cost and improve project feasibility for wind energy, solar energy and electric vehicles. The Chinese government’s support and subsidies for the photovoltaic (PV) industry effectively boosted development of the industry in its infancy. As the PV industry grows, it begins to benefit from economies of scale and technological advances, and no longer needs favorable policies or subsidies to support its business viability. This is a typical example of successful technological advances supported by public investment.

Innovations are important for not only natural science and technology but also social governance. The green premium’s relation to emission reduction is not always linear due to people’s habits, customs and path dependence. Carbon pricing may adversely affect the economy in the near term as the emission control target may require rather high carbon prices. Meanwhile, technological R&D faces many uncertainties. To address these problems, we need social governance reforms and administrative intervention from public policies, as they can help push for emission cuts and energy conservation (e.g., a healthier lifestyle) on the demand side. For example, campaigns against wasting food may help free up some farmland for soil remediation, carbon sink or bioenergy production.

In some sectors, rules and regulations are more effective tools than price-based guidance to push for emission cuts and carbon neutrality. The introduction of new products and technologies in these sectors may involve a steep learning curve, while economies of scale could take a long while to develop. To overcome these problems and uncertainties, policymakers should rely more on rules and regulations, such as industrial and product standards, better urban planning, and improved land management. Building new infrastructure, such as charging stations and more convenient public transportation systems, may also facilitate the switch to clean energy. In addition, development of the digital economy may play an important role as well. The application of big data, for instance, may help magnify benefits from clean energy and reduce their costs. In particular, big data may help make wind energy and solar energy more predictable by improving management efficiency on the demand side and matching demand with supply more effectively.

Peng Wensheng (SAC Reg. No.: S0080520060001; SFC CE Ref: ARI892) is CICC's chief economist and head of the research department, as well as the executive dean of the CICC Global Institute. The report, published on April 9, 2021, was originally titled “Economics of carbon neutrality: Some thoughts on entailed transformations”

Contact editor Michael Bellart (michaelbellart@caixin.com)

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