May 01, 2021 09:30 AM

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

This is the second of a two-part article on the economics behind China’s pledge to achieve carbon neutrality by 2060. Read part 1 here.

Green finance: correct versus incorrect perceptions

To understand the financial sector’s role in emission reduction and carbon neutrality, we should analyze its relationship with the real economy by examining two cases: First, financial business results from activities in the real economy, and the financial system effectively transforms savings into investment as long as sufficient information is available. In this case, development of the financial industry follows the steps of the real economy. Second, when the real economy is unable to allocate resources efficiently, the financial industry helps remedy market failures in certain areas. A good example is the development of inclusive finance. In other words, development of the financial industry leads the way for the real economy.

We believe green finance can contribute to emission control and carbon neutrality in both cases discussed above. In the first case, the green premium has fallen below zero, so entities in the real economy have financial incentives to switch to green energy. Therefore, the financial sector’s role is to provide financing for green projects. In the second case, the financial sector directly helps lower the green premium. Although current financing data for green projects cover both cases, we believe the second case, in which the financial sector leads the way for the real economy, is perhaps more important from the perspective of public policies.

Specifically, we believe the financial sector can play an important role in emission control and carbon neutrality by reducing the cost of financing, improving the availability of financing, and creating new trading markets. The government may intervene directly by providing favorable financing conditions, such as subsidies on loan interest rates, or specifying the scope of industries eligible for loans. Development financial institutions may play key roles in the initial financing for green projects. In addition, financial instruments may help balance investors’ perception of risks in green and “brown” projects. The financial industry may also create new types of trading products to improve the availability of financing for green projects.

To effectively reduce carbon emissions, it is important to first determine key sectors to be supported by green finance and main financial instruments to be employed. We estimate that the green premium is only 17% in the power industry, which accounts for more than 40% of total carbon emissions. Our estimate takes into account amortization of fixed costs over asset life cycles. If we consider only variable costs, the green premium in the power industry should have already become negative, which means the variable cost of clean energy is lower than that of fossil energy. Given the power industry’s enormous proportion of total emissions and the high financial feasibility of going green in this sector, we believe green finance should prioritize support to the power industry and electrification in other sectors.

Given the highly predictable risk-return profile of the projects we discussed above, we believe credit loans, bonds and other fixed-income instruments should be the primary means of financing for them. While this type of green finance can be roughly categorized as the financial support we discussed in the first case above, we believe the second case also applies here. In other words, financial institutions may help directly lower the green premium and encourage participation from the private sector by improving the availability of financing or reducing the cost of capital for initial investment in a project. This is especially important for low-carbon projects that require high initial investment. As the green energy sector is essentially a manufacturing industry while China is a manufacturing giant, we believe the green energy sector should have strong economies of scale and spillover effects in China. Therefore, green finance may help boost the Chinese economy as a whole, in our view.

Green premiums are high in some industries, such as aviation, construction materials and certain chemicals, due largely to limitations of existing technologies. For example, carbon capture technology is still the only solution to emission problems in some industries. Technological innovations and breakthroughs are critical to these industries, but they need time and funding. A key part of the financial support for these industries is public investment in fundamental research, including fiscal expenditure and financing from development financial institutions. On the other hand, an efficient capital market, notably the equity market, can also facilitate high-risk, high-return innovations and accelerate resource reallocation to more important areas.

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While the amount of green credit and green bonds has been growing rapidly in recent years, the environmental, social and governance (ESG) criteria for investment have become another trending topic. The total amount of ESG investment has exceeded $40 trillion globally. However, a number of studies on this subject revealed that the average return from ESG investment is actually no lower than traditional, unrestricted investment, and interest rates of green loans and bonds are not lower than ordinary products. These findings suggest that taking social and environmental responsibilities is actually not in conflict with personal interests in investment activities, which appears rather counterintuitive. We propose below three possible explanations for this anomaly, and each of them has different policy implications.

1) Financial business reflects activities in the real economy. ESG investment and traditional investment deliver the same returns because externalities of carbon emissions have already been corrected in the real economy. Although this explanation is partially justifiable, we think it is incomplete, to say the least.

2) Not all industries supported by green finance are really green, as the criteria for green companies/industries are not clear enough. Evaluating a company’s nonfinancial performance is not only a technical issue but also a social and ethical challenge that requires a proper set of indicators to gauge the company’s social and environmental performance, as well as a complete system of baseline references and standards. At present, we still lack widely accepted standards on critical issues, such as the composition of ESG criteria and the extent to which we can trust the ESG data from companies. We believe this is a critical problem for the development of green finance. Therefore, a pressing issue for policymakers is to set up an elaborate system for the formulation and assessment of green standards, which we believe should be the foundation and key infrastructure for green finance.

3) Financial institutions and investors hold positive views on the outlook of green projects, which lower their demand for risk premiums. Optimism about new, green assets enhances the appeal of financial instruments, as they usually serve as tools for investment in new assets. On the other hand, existing assets are also an important part of our analysis as the financial industry suffers from path dependence as well. We believe existing assets related to traditional energy face value impairments amid the green economic transformation. This affects the financial industry as corporate borrowings related to such existing assets are listed as financial assets in the balance sheet of financial institutions.

The balance between existing and incremental assets is critical to the financial industry as it affects not only the industry’s support for the green economy but also the stability of the financial system. We believe this is essentially a public policy issue that calls for action by the central bank and other regulators. Financial institutions should be required to fully disclose risks of “brown” projects and assets in good time, and more stringent standards should be imposed on capital- and liquidity-coverage ratios of these assets. Regulators should discourage financial institutions from supporting investment in high-emission assets, and hence facilitate investment in green projects. On the other hand, effective mechanisms to deal with risk exposures in brown assets help maintain financial stability amid the green transformation.

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International cooperation and competition

International collaboration is essential in our battle against climate change due to the global externality of this crisis. A critical issue is how to strike a balance between equality and efficiency. In theory, emission reduction efficiency would be the highest if we impose a uniform carbon price around the world and prioritize emission cuts in low-cost sectors regardless of their locations. If we adopt these measures, the volume of emission cuts would be higher in developing countries, as carbon prices are less affordable to low-income consumers in these economies. The consequent losses in developing countries could, in theory, be covered by transfer payments from developed economies.

However, balancing equality and efficiency is a rather tricky task in reality. Thorny problems for low-income countries include emission reduction’s significant marginal impacts on consumption, the low possibility of fiscal transfer payments between nations, and the greater urgency of poverty relief than climate problems in the near term. In fact, developed economies are responsible for most carbon emissions since the Industrial Revolution, while developing countries actually suffer from insufficient energy supply — a key manifestation of fundamental problems such as poverty and inequality in development. On the other hand, low-income countries should not follow the same development path adopted by advanced economies in the past, because that would create huge demand for resources, especially energy, which is clearly unsustainable from a global perspective.

To better understand international cooperation and competition on climate change, we need to examine price differentials in two key areas and their significant implications.

1) Given the income gap between developed and developing economies, the volume of emission reduction in developing countries is more elastic to carbon prices. In other words, the same carbon price would lead to higher emission cuts in developing countries. This implies carbon prices should be lower in developing countries than in developed economies. However, the differential in carbon prices may lead to “carbon leakage”, i.e., the relocation of high-emission industries to developing countries. To solve this problem, a number of developed economies are discussing a “carbon border tax.” However, setting a proper tax rate is a complex issue involving significant uncertainties. If mishandled, the tax could be easily turned into a tool for trade protectionism.

2) Interest rates are higher in developing economies than in developed countries. A high discount rate means a low current value of the future benefits from climate improvements. In emerging markets, a high interest rate also means high returns from investment in sectors unrelated to climate change, which makes it necessary to strike a balance between investments in emission control and in other areas. Moreover, a high interest rate provides the financial industry with additional space in which it can play its role, which leads to capital flows from high-income economies into low-income ones. To solve these international problems in green finance, we need bilateral and multilateral cooperation to remedy market failures. Meanwhile, development financial institutions may help reduce project risks and attract investment from the private sector.

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International cooperation and competition to address climate change will no doubt significantly impact the existing global governance system, in our view. A key challenge for the international community is how to build a more binding mechanism than the Paris Agreement for emission control. Substantial changes in the international arena call for revamping of the governance structure of international trade and financial systems established after the Second World War, including the World Trade Organization, the International Monetary Fund and the World Bank. As China is a large economy, carbon neutrality in China is an important part of the global endeavor to address climate problems. Moreover, China should play a key role in the establishment of a new international governance system. A possible step in this direction is the country’s cooperation with economies covered by the Belt and Road Initiative.

Although China is at a disadvantage in fossil energy due to limitations in its natural resource endowments, the country’s superior strength in manufacturing and the digital economy gives it a potential competitive edge in clean energy. We believe that international peer pressure will compel all countries to adopt similar strategies to address climate change, and emission reduction will become a prevailing trend. Although this could be a challenge for China, we believe the country has a first-mover advantage in emission control and carbon neutrality.

Stagflation or new opportunity

The endeavor to address climate change and achieve carbon neutrality is, in essence, transformation of development models and economic structures through relative price changes. All measures to reduce carbon emissions, including carbon tax, carbon trading price, administrative regulation and green finance, take effect by raising fossil energy prices and lowering clean energy prices. Under the new growth model, clean energy will serve as the foundation for healthy life and sustainable development of the human civilization. However, relative price change is a supply shock that causes friction in the economy’s transition from the old equilibrium to the new equilibrium.

Effects of carbon pricing are similar to impacts from falling oil supply: Production cost rises on the supply side, while real income falls on the demand side. From a macroeconomic perspective, these are characteristics of stagflation. How strong is the pressure of stagflation? Our computable general equilibrium model shows whether China can achieve carbon neutrality by 2060 hinges on technological advancement, which is an expensive proposition. A rising carbon price could serve as an incentive for technological development, but it may undermine GDP growth and drive up other prices. Our sector studies reveal that reducing the current green premium to zero would raise costs significantly in manufacturing industries such as chemicals and construction materials.

Our structural analysis shows that certain economic activities, technologies and even industries may be replaced by new models amid the transformation to achieve carbon neutrality. Traditional energy industries, notably the coal industry, may face severe adverse impacts. Therefore, we expect employment to decline in infrastructure, manufacturing and service sectors related to traditional energy. On the other hand, we believe employment will rise in clean/renewable energy industries and related sectors. Given China’s size, we expect the transformation’s impacts to vary across different regions of the country due to their different natural resource endowments for fossil fuels. We expect severe negative impacts in provinces and regions that produce high volumes of fossil energy. Most of these regions are economically underdeveloped. Meanwhile, prices of traditional energy may rise for some time amid the transformation to achieve carbon neutrality. We believe this will hurt low-income groups more severely than mid- to high-income groups. To address these problems in structural adjustment and income distribution, we will need effective public policies, notably fiscal policies.

From a more fundamental perspective, carbon neutrality imposes on the economy a single, quantitative constraint that affects all aspects of economic activity but cannot be priced in the free market. This is an unprecedented challenge to public policies and the market economy. Policymakers are confronted with a multitude of problems that they have never encountered before: How to remedy the absence of market mechanisms and avoid excessive government intervention at the same time under rigid constraints? How to balance short-term and local interests with the long-term and overall interests of the whole society? It remains highly uncertain how carbon neutrality will affect the economy and society, but we believe the most fundamental impact will probably be on mainstream thoughts and ideas. How to analyze these complex issues?

Looking ahead, we envision three possible scenarios: 1) efforts to achieve carbon neutrality are unsuccessful or fail to meet the target in time, and global climate change causes severe damage to humanity; 2) carbon neutrality is achieved mainly by raising the cost of energy consumption, so the world economy suffers from protracted stagflation; and 3) carbon neutrality is achieved thanks to technological advances and innovations in social governance under effective public policies and international cooperation. As a result, the world switches to a new development pattern and people enjoy better, healthier lives.

All three scenarios pose challenges to neoclassical economics, which has dominated economic studies over the past four decades. As the spillover impacts from climate change have long-term global implications, we doubt whether externality is an adequate supplement to basic assumptions of neoclassical economics, i.e., complete information, certainty and perfect competition. How to explain carbon emission’s transformation from a single, quantitative indicator into a uniform constraint on global economic and social development? How will interactions between public policies, social governance mechanisms and market mechanisms evolve amid the endeavor to achieve carbon neutrality? Perhaps only time can tell. We believe the journey to carbon neutrality will lead to more profound thoughts about differences between the real market economy and the ideal market economy in neoclassical economics.

Neoclassical economics’ deviation from reality calls for close reexamination of this school of economic thought and points to the necessity of returning to classical economics. Classical economists, such as Adam Smith and David Ricardo, realized that human activities are subject to natural constraints, and emphasized analysis from the perspective of political economics, including social, ethical and cultural studies. The global endeavor to address climate change compels economists to carefully reevaluate the role of nature in their analytical framework. In addition to labor and productive capital, we should also take into account natural capital such as water, air, forests, oceans and biodiversity. As natural capital cannot be priced in free markets, effective public policies and social governance are essential. Meanwhile, we believe people will attach greater importance to equality in the equality-efficiency trade-off.

The road to carbon neutrality is a long learning curve for everyone. While we have tried our best to analyze carbon neutrality in this report, we are well aware that mistakes and omissions might be unavoidable. We will keep a close watch on China’s progress toward carbon neutrality, and update our analysis and assessment when necessary.

Peng Wensheng (SAC Reg. No.: S0080520060001; SFC CE Ref: ARI892) is CICC's chief economist and head of its 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”

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