The Big Picture

Mind the Gap: Commitment vs. Action on Climate Change

State Street Senior Investment Advisor Ramu Thiagarajan asserts that transitioning to a low carbon economy is not easy and will only work if capital is directed to fund renewables by financial markets based on proper risk assessment.

December 2021

COP26 ended with high hopes and commitments from global leaders promising swift action to spare the world from the catastrophic consequences of climate change.

But how do we get there - especially when daunting gaps remain between climate ambition and results? And are there readily available tools today that are able to address the existential threat of our time?

The gap between commitment and action boils down, primarily, to replacing fossil fuel energy with renewable energy. This is not a trivial exercise, and it can only be achieved by creating the right incentives and information structures to unleash capital flows to green solutions.

Fossil fuel-based energy is still cheaper compared to renewables particularly if one takes into consideration the cost of investment and storage of renewables. But the cost gap is narrowing thanks to dramatic advances in technology.

Renewables Supply and Demand

Understanding where we need to go, however, is the first step to getting there. And on that score, one needs to look at the market for renewables and how we could foster both greater demand and supply.

Start with demand. Creating demand for renewables can be achieved by a pragmatic  carbon pricing framework. Carbon emissions are a global public goods problem requiring a Pigouvian carbon tax to internalize the environmental externality. In theory, carbon tax should be set to the social cost of carbon (SCC) to deter emissions and limit the negative externality.

Estimates of SCC vary widely depending on assumptions used. Recent studies of the Climate Impact Lab show such costs to be as high as $378 per ton relative to the current assumption of $52. Which is why coordinated international carbon pricing is so essential, and unfortunately an important item world leaders fell short of agreeing to at COP26 (meaning carbon prices will continue to be maintained locally for now).

But even if global leaders decide on a mechanism to price carbon, this will not be enough. Increasing the supply of renewables will be critical. That amounts to making renewables more affordable and, to achieve that, government funding will need to play a key role as private funding cannot fill the investment gap, even with the right incentives.

Fossil fuel-based energy is still cheaper compared to renewables particularly if one takes into consideration the cost of investment and storage of renewables. But the cost gap is narrowing thanks to dramatic advances in technology.

Making renewable energy more affordable and consistent with profit-maximizing firm corporate goals, however, will require significant investment in technology. This is where government funding can play a critical role.

According to the International Renewal Energy Group, for the world to be on course for less than 2 degrees Celsius warming, there needs to be at least $500 billion of annual investment in each of the three forms of renewables till 2050. In 2019, the investment in renewables was $250 billion while oil and gas firms invested twice as much in fossil-fuel extraction, according to the International Energy Agency.

Markets need to make capital flow organically to help improve the supply of renewables and this can only be accomplished with good, consistent information for price discovery.

Chickens, Eggs, and the Invisible Hand

Reducing the cost of renewables means addressing two important externalities. First, innovation externality. This suggests that financial gains from innovation to reduce carbon emissions cannot be fully captured by the innovator.

For example, if there is an environmentally desirable way of manufacturing cement, this technology is best shared broadly to help bridge the global commitment/reality gap. This externality can deter innovation but can be offset by policies that subsidize and support innovation. A recent example of this is government funding of shared research for fighting COVID-19, which can serve as a good model for managing innovation externality.

Second, the network externality—a paradox commonly known as the chicken and the egg problem. For example, without more charging stations, electric vehicles may not proliferate; but it may not be convenient to expand charging stations without more electric vehicles. But this problem can be addressed by government funding in the form of prudent subsidies. In this example, that would mean building charging stations to encourage electric vehicle use.

Thus, technological improvements and pragmatic government funding go hand-in-hand in making renewables cheaper.

But funding cannot come only from the government. And this is where we come back to the invisible hand of the market. Markets need to make capital flow organically to help improve the supply of renewables and this can only be accomplished with good, consistent information for price discovery. The risk premium associated with funding renewables cannot be assessed with noisy information. So, a fabric of consistent information is key to making the invisible hand of markets work and pricing these risks appropriately.

At COP26, the establishment of the International Sustainability Standards Board (ISSB) is among the most significant developments so far.

In other words, what gets measured, gets managed. As noted by Anne Simpson of CalPERS in the Financial Times, “Climate risks are not overseen by auditors, not standardized, not verified or produced in a timely manner.” Consistent disclosure standards from carbon footprints to climate risk management are important in each of the 11 broad categories outlined by the Task Force on Climate-related Financial Disclosures (TCFD) so that financial markets can price these risks more efficiently.

According to the TCFD, only 7 percent of the big firms provide disaster scenario analysis but such scenarios are not consistent across these firms. Without a consistent information structure, the invisible hand of the markets can spectacularly fail in helping bridge the gap between goals and accomplishments. Market failure in pricing these risks can result in sudden write-downs such as that of BP when it slashed $17.5 billion off its balance sheet in a recognition of loss of value of drilling assets as the world pursues COP goals.

At COP26, the establishment of the International Sustainability Standards Board (ISSB) is among the most significant developments so far. A working draft of climate related disclosures has already been produced and investors could have global reporting standards for climate risk disclosure to help them price the risks associated with funding renewables.

In summary, while there’s much work to do to make our level of climate action commensurate with that of our ambition, it can be achieved with the tools at hand.

And that’s good news. By creating the right incentives, we can reorient powerful market forces that, once unleashed, will help ensure the transition to renewable energy. When it comes to climate change talk vs. action, critical mass is the ingredient that will allow us to mind the gap.