Climate Change

-- Risk & reward

     [NOTE: This article was originally written in Chinese in January 2009, and published in the newspaper World Journal on 2/26/2009. I want to thank the World Journal for its generous permission for me to post this updated English version here.]

     President Obama's $787 billion economic stimulus plan is now in full swing. The enormous government spending plan spans several key areas, including tax cuts, social welfare, education, healthcare, housing, scientific research, infrastructure, and energy. It was clear from the beginning, however, that climate change was one of the most important elements in his stimulus plan.

     Aiming to turn the public's concerns over climate change (and the related issue of energy self-reliance) into the driving motor for economic growth, the president's plan will invest heavily in energy-related infrastructure construction, such as smart power grid and renewable energy. It will also invest in other venues capable of reducing greenhouse gas emission, including improving energy efficiency, electric vehicles, or green manufacturing facilities.

     For those concerned with potential undesirable human impacts on the earth's climate, the stimulus package should be exciting news. Climate change, however, is still a controversial subject, entailing numerous uncertainties and risks. It will be necessary to understand these risks to properly understand the associated risks introduced into the stimulus plan, and the economy, by the inclusion of the "climate change" element.

• Government bureaucracy: Greenhouse gases are invisible and odorless, and pose no direct harm to human health. Releasing the gases into the air incurs little, if any, direct costs. As a result, large-scale reduction in greenhouse gas emission is unlikely, unless the government intervenes to regulate the activities. Government bureaucracy, nonetheless, introduces a first layer of risks into the stimulus plan.

• The gap from science to policy: A majority of scientists now agree that human activities and the greenhouse gases they generate were principally responsible for the drastic rise in the earth's surface temperature during the past century. Uncertainties, however, still exist due to several factors such as the natural fluctuations in the earth's climate, the uncertainties in our models of climate change, the uncertainties regarding the impact of human activities, and the errors in data collected. These uncertainties will result in a gap from science to policy, adding another layer of risks.

• Broad scope of influence: Every corner of our modern industrial society, including power plants, industrial factories, transportation, agricultural activities, or buildings, directly or indirectly releases greenhouse gases. The impact of any government policy will be broad in scope and enduring in time, which increases the risk of heightened political confrontation.

• Cost pressure: Businesses need to invest in research, equipments, or services to reduce greenhouse gas emission. With the weak economy, the cost pressure will transform into high political pressure, diminishing the efficacy of the stimulus plan.

• Immature technology: Green tech has made significant progresses in the past decades, leading to successful products such as solar photovoltaic panels, wind turbines, hybrid engines, etc. There is still a long way to go, however, before green tech can upstage petro fuel as our main energy source, and otherwise reduce greenhouse gas emission in other areas. In the 70's, US implemented a cap-and-trade system to reduce the emission of sulfur dioxide that was the source of acid rain. The system successfully stimulated development in new technology, and achieved its goals in less than 50 years. It is unknown, however, whether the domestic experience can be transplanted to the global climate change issue.

• Uncertain market demand: In the past several months, the oil price has fallen from ~$147 to less than $40 a barrel. [UPDATE: The oil has rebounded recently to ~$50 / barrel.] If global economy and oil prices remain depressed, so will the market for credits in greenhouse gas emission reduction (a/k/a carbon credits), delaying the development and implementation of new green tech.

• Reluctance by developing nations to participate: Among the 4 BRIC nations, China has become the world leader in the aggregate amount of greenhouse gas emission, surpassing US recently. The emissions by Brazil, Russia, and India are not too far behind or are increasing rapidly. These 4 nations, however, have been reluctant to limit the greenhouse gas emission of their domestic businesses, for fear of slowing their own domestic economic growth. As a consequence, political pressures have been mounting within US against unilateral reduction in domestic greenhouse gas emission. This political pressure will not disappear in spite of the new government.

• Unintended consequence: Several years ago, the US government encouraged the production of ethanol as a replacement of petro oil. Many farmers therefore sold the corns from their farms for the production of ethanol, which resulted in shortage of corns in the food markets and caused food prices to surge. All the other methods in reducing greenhouse gas emission may result in similar unintended consequences in the complex societal or biological chains.
  

     In light of these risks, and the surging federal deficits, the rate of success of the stimulus package will depend on its ability to attract diverse private investments and international participation. To the private sectors, on the other hand, these risks may represent new demands and new markets. When viewed from the right angle, risk and rewards are often two sides of the same coin.

     For a Chinese version published on the World Journal, please click the link at the end of this paragraph. 欲閱讀在世界日報上發表的中文版, 請按此連結鍵 here.

-- In the context of greenhouse gas emission and climate change

     It is well known that air is a type of "public goods", which normally cost little to use. A public good generally carries the characteristic that everyone can use it without significantly affecting the use by others, and therefore free of costs. (For example, see here.) Water is another "public good" natural resource. In some occasions, lands and soils can be another type of "public good".

     The "public good" nature of air is the fundamental root behind the climate change issues supposedly caused by human activities. Because it costs little to emit greenhouse gases into the air, there is little financial incentive to stop. Unless, that is, people voluntarily choose to stop, or are involuntarily required to stop by government regulations.

     Government regulations, therefore, play an important role in managing the air quality, because they create financial incentives, and thus markets, for people to change behaviors. Availability of financial incentives and markets, on the other hand, is critical in stimulating capital investments and innovations. (Many people have studied this area. See, eg, here.)

     This causal relationship between regulations, markets, and innovations is clearly illustrated by a paper I recently read. The paper was written in 2001 by Taylor, Rubin, & Hounshell of Carnegie Mellon U, and titled "The effect of government actions on technological innovation for SO2 control". The authors analyzed the correlations between the Clean Air Act and innovative activities in the reduction of SO₂ emissions among power utilities. One of the approaches they used was to collect the numbers of patents issued each year in technologies related to the reduction of SO₂ emissions from 1887 to 1997. They discovered that US patents related to SO₂ control technology surged during a 5 year period encompassing the enactment of the 1970 Clean Air Act, rising from under 5 patents issued each year before 1967 to more than 75 patents issued in 1971. And the level of issued patents remained above the 1971 level for the rest of the study period that ended in 1997. (See Fig 4 of the paper here.)

     The authors noted that prior to the Clean Air Act f 1970, when EPA was established, the patenting activities in SO₂ control technologies were nearly non-existent, even though the federal governments had generously granted research funds in the areas. Today, the federal government has been debating whether to directly regulate greenhouse gas emissions (by taxes or caps) or to avoid direct regulations by providing research funding. At lease in terms of patenting activity, the Taylor paper should shed some light on the debate.

-- According to United Nations estimates

     In my previous posting (see here), I estimated that the potential size of the greenhouse gas (GHG) markets could reach the level of US$500 billion to US$8 trillion by year 2030. That estimate was based on the amount of GHG emission reductions needed to stabilize the GHG concentration in the atmosphere (100 billion tons by 2030) and the potential market price of GHG (US$5 - US$80 per ton).

     I just found out, however, that before my posting, the United Nation itself had came up with a direct estimate of the potential amount of investments necessary to avoid the undesirable consequences related to GHG emissions. (Report of the Secretary-General, "Overview of United Nations activities in relation to climate change", 10 January 2008. See here.) Its estimate was: US$15 trillion to US$20 trillion by 2030. Below is the relevant quote from the UN report.

"Global investments in the magnitude of from 15 trillion to 20 trillion United States dollars may be required over the next 20-25 years to place the world on a markedly different and sustainable energy trajectory."

     The UN numbers are far greater than my estimates, although the UN report did not explain how it made the calculations. Assuming my approach is generally correct, on the other hand, the UN number would imply that the market price of GHG could reach US$200 each ton. ($20 trillion / 100 billion ton = $200 per ton) That is ~560% return in ~25 years from the current price of ~$30 per ton, or ~7.8% annually, absent leverage.

[Note: The abbreviation "GHG" represents "Greenhouse Gas".]

     A couple of months ago, I went to a speech on environmental law. One of the speakers commented half-jokingly that just a few years ago environmental lawyers had pretty low popularity ratings. The presence of environmental lawyers in a transaction normally was considered a sign that troubles were brewing ahead. No more, the speaker said with a grin. These days, environmental lawyers are like rock stars, attracting admiring attentions.

     Because of the rising public awareness of the risks associated with the alarming trends in global climate changes, investments in the GHG markets have surged recently, in tandem with the rising popularity of environmental lawyers. It was not too long ago, however, when "green investment" (which includes "GHG investment") was often met with skeptical eyes. The markets then were simply too small and the returns too low. Of course, concerns over global warming and the market-based framework set forth under Kyoto Treaty have changed the calculus. But the question remains whether this segment of the green markets can grow large enough to sustain sufficiently high returns. Other related questions also linger around for investors: Is this market already too crowded? Is it too late to enter? How long can investments continue to generate sufficient returns?

     Answers to these questions likely depend on two key factors: The amount of GHG emissions we will have to (or want to, or be able to) reduce, and the market price of GHG. For example, if we manage to cut 100 billion tons of GHG emissions within the next 50 years, and if the price of a ton of GHG is worth $1 throughout the period (an arbitrary assumption), then we have a potential demand of $100 billion. Our economy would have to invest that much capital within the period to invent new technologies, systems, or policies, or to implement existing technologies, systems, or policies.

     To get a more realistic estimate of the necessary amount of GHG emission cuts, I turned to the report published by the Intergovernmental Panel on Climate Change (IPCC). Recently, the panel published its "Climate Change 2007" final report. The report included estimates of the amount of GHG emissions that we would need to cut within the next century in order to stabilize the amount of atmospheric GHG at a sufficiently low level. According to the report, we need to cut in the order of ~100 billion tons of GHG between 2000 and 2030, and over 2 trillion tons of GHG between 2000 and 2100. (See table below.) Moreover, the panel estimated that the price of GHG could fall within the range of $5-$80 per ton. (Currently, carbon prices in Europe is ~$32. See here.) So, these numbers project the size of the GHG market in the order of ~$500 billion to ~ $8 trillion by 2030, and to grow 10- to 20-fold by the end of the century.

     To put these numbers in perspective, the IPCC report also estimated that energy infrastructure investments could total over $20 trillion by 2030. That means, the GHG market can account for ~3%-40% of total energy infrastructure investments before 2030, and the percentage will likely increase many fold by 2100.

     $500 billion to $8 trillion of demand during the next 30 years is sizable. And the demands will likely surge rapidly before the end of the century, if we manage to pull our acts together and the computer models are correct. These numbers actually already need to be increased today, because the IPCC projections assumed that the growth rate of GHG emission would begin to abate beginning year 2000. Numbers in the IPCC report, however, also indicated that between 2000 and 2004, the annual GHG emission growth rate did not decline at all. The growth rate actually nearly doubled that in the previous decade. As a result, the GHG emission reductions will have to accelerate relative to the IPCC projections in order to reach stabilization as scheduled. That will increase the size of the GHG market.

     Of course, these estimated ranges of GHG market size depend on the accuracy of the extremely complicated computer models. They also assumed that we human beings could achieve the scale of GHG emission reductions projected by these models. At this point, however, the observed climate changes seem to have outpaced most previous computer models. Whether or not we human beings can manage to achieve the projected GHG emission reduction goals, on the other hand, is a big question mark.

     Human efforts or hypes alone will not be enough to achieve the GHG emission reduction goals. We will need to figure out ways to effectively reduce the net GHG emissions, counting emissions through every node along the chain of interactions. That's a monstrously difficult undertaking. We have made significant efforts since Kyoto. For example, last year alone we saw member nations of the Kyoto Treaty reached an agreement to begin negotiating a new protocol to succeed Kyoto; Australia ratified the Kyoto Treaty; and, even US managed to enact a new energy bill. Despite these efforts, global GHG emissions have continued to accelerate in recent years. Whether we human beings can manage to stabilize climate changes remains the greatest uncertainty in estimating the potential size of the GHG markets.

     On a final note, investment funds controlled by governments have grown rapidly in size recently. It has been projected that these funds (called "sovereign wealth funds") can exceed $10 trillion by 2015. (See here.) That's more than the money needed to reach the GHG emission reduction target for year 2030 set by IPCC. Hopefully, managers of these sovereign wealth funds will increase their investments in this sector. That will be a win-win situation for the Earth and humanity!

     Please click the link below for the Chinese version. 請按以下連結鍵閱讀中文版.

     Last weekend at the UN Climate Change Conference in Bali, UN member countries agreed on a road map to hammer out the post-2012 replacement for the Kyoto treaty, after a dramatic last-minute reversal of position of the US delegation. Today, the House passed an energy bill that will increase the fuel efficiency standard for all vehicles by 40% to 35 miles per gallon by 2020. The bill also requires that ethanol use increase 6-fold by 2022. The bill was sent to the White House. (See here & here.)

     During the coming century, our nation's climate policy and energy policy will become more and more entangled and intertwined, simply because fossil fuels, the principal sources of greenhouse gases, happen to be also our principal energy sources. Let's not forget, however, that they are not equivalent to each other.

     As shown in the table, an energy policy must address various issues other than global warming. Meanwhile, a climate policy needs to address factors not associated with fossil energy use. For example, livestock feeding and agricultural activities have been known to account for around 15% of greenhouse gas emissions. Also, the global nature of climate change requires much greater international interactions than energy.

     At this point, almost all factors influencing our energy policy are moving it closer and closer to our climate policy. Energy independence urges development of non-fossil energy sources (although coals, which are abundant domestically, satisfy this requirement). Declining worldwide oil reserves require development of new energy sources (although abundant coals can satisfy this end too). Even China is gradually waking to the reality that it cannot sustain strong economic growth if sea level rises dramatically and flooding or droughts become more severe.

     These factors, nevertheless, may someday move away from their current direction, pulling our energy policy from our climate policy. (For example, if Mid-East stabilizes, or enormous new fossil energy reserves are discovered.) If that happens, oil & other fossil energy prices may remain low, disrupting markets for clean technologies and carbon credits. In that case, climate policies may encounter greater conflicts with energy policies.

     We'll need to be aware of this possibility. And, at the same time, should work to find ways  to reduce the amount of green house gases our farms' manures send to the sky!

     Please click the link below for the Chinese version.