The New Geopolitics of Energy
Editor’s Note: This essay draws on a keynote address, offering an economic perspective on current climate trends and policy recommendations, delivered to G-20 foreign ministers and central bank governors gathered in Venice in July 2021.
The world is witnessing an alarming outbreak of weather disasters—giant wildfires, deadly heat waves, powerful hurricanes, and 1,000-year floods. There can be little doubt that this is only the beginning of the grim toll that climate change will take in the years ahead. Today, the central question is whether our political systems can catch up with the geophysical realities that threaten our lives and livelihoods. As world leaders struggle to design and adopt policies that can slow the pace of warming and mitigate its consequences, the United Nations Climate Change Conference in Glasgow, Scotland, this November will be an important test.
How do we evaluate the success of past climate policies? The best indicator is carbon intensity, which is a measure of carbon dioxide emissions divided by global real GDP. Figure 1 displays the levels of carbon intensity between 1990 and 2019. There are small fluctuations in the annual changes, but the trend is basically a straight line showing a decline of 1.8 percent per year.
Why is this important? The central goal of climate policies is to bend the emission curve downward. Yet even with all of the international agreements of the last three decades—the UN Framework Convention on Climate Change of 1992, the Kyoto Protocol of 1997, the Copenhagen accord of 2009, and the Paris climate accord of 2015, along with 25 conferences of the parties—over the same period the rate of decarbonization has remained unchanged.
Why has there been so little progress? To begin with, the price of carbon dioxide emissions across the world is essentially zero, so there is no real market incentive to decarbonize. Second, our economies suffer from inadequate investment in low-carbon technologies because of misaligned innovation incentives. Finally, the entire structure of international policy is hampered by the syndrome of free-riding. Countries rely on others to act, a tendency that undermines the strength of climate agreements. Given these three problems, it cannot be a surprise that the world has made so little headway in slowing climate change.
Climate policy today must address all of these failures. A successful strategy must include three mutually reinforcing components: universal carbon pricing, robust government support for low-carbon technologies, and a new architecture for international climate agreements. Every pillar is necessary if the world is to stand a chance of meeting its climate objectives.
The internationally agreed climate target is to limit the global temperature increase to two degrees Celsius. Looking forward, what is necessary to attain that objective? Consider three scenarios. The top line in Figure 2 assumes no change to climate policy. With the current (minimal) policies in place at both the national and international levels, emissions of carbon dioxide equivalent (carbon dioxide plus other gases that produce warming effects) are projected to increase roughly one percent per year over the next five decades—trending up, not down.
The next scenario, shown at the bottom of Figure 2, is one in which the world meets the two-degree target. To stay on this path, emissions must decline sharply and immediately. Whereas current policies will result in a rise in emissions of almost 25 percent between 2015 and 2030, the two-degree path requires a decline of 30 percent by 2030 and reaches zero emissions shortly after midcentury.
Finally, consider the path of emissions under the Paris accord, shown in the middle line in Figure 2. Emission estimates through 2030 reflect actual national commitments, while those after 2030 are projections assuming countries continue to deepen their commitments at the same pace as during the period between 2015 and 2030. The emission trajectory under the Paris accord is virtually flat, rising three percent from 2015 to 2030 and then declining slightly after that. Of course, these projections assume that the Paris commitments are actually fulfilled.
The main takeaway is that meeting the two-degree target cannot happen without an immediate and steep drop in emissions. Even if all countries meet their Paris objectives, that will reduce emissions only a fraction of the necessary amount.
We should recognize that some countries have moved beyond Paris in their domestic commitments. Many are aiming for zero net emissions by midcentury or shortly thereafter. These are soft commitments, however, lacking a binding international agreement and the actual policy mechanisms that will be necessary for implementation. The administration of U.S. President Joe Biden, for example, has promised deep emission reductions but has not put policies in place to meet those promises—no carbon pricing, no major increase in energy research, and no proposals to retool international agreements.
There is a vast chasm between aspirations and policies. Economic studies indicate that there are three steps countries can take to bridge the gap: price carbon emissions, promote low-carbon technologies, and improve the architecture of international climate accords.
The single most important step to achieve climate objectives is to put a market price on the emissions of carbon dioxide and other greenhouse gases, such as methane. For succinctness, this is commonly referred to as a price on carbon. The fundamental economic logic is that raising the price of a good reduces consumption—whether that good is cigarettes, gasoline, alcohol, or emissions. A high carbon price is necessary if we are to change the behavior of thousands of local and national governments, millions of companies, and billions of consumers.
The power of carbon prices can be explained with the example of using coal for electricity generation. When burned, one ton of coal emits close to three tons of carbon dioxide. If the government levies $50 per ton of carbon dioxide emitted, this will add approximately $140 per ton to the price of coal. This will more than double the cost of coal-fired electricity. Producers would have a strong incentive to transition away from coal in favor of low-carbon fuels (such as natural gas) or renewable technologies (such as wind, solar, and nuclear power).
Other sectors will feel a smaller impact. A $50 carbon price would add $230 per year to the cost of driving a gasoline-powered car but only $1 to the average household’s annual cost of banking services. Across the economy, carbon prices tilt the playing field against emissions. The higher the price, the steeper the tilt.
A second point, which is less obvious, is that the carbon price needs to be equal across countries and sectors. It won’t do for some sectors, such as motor fuels, to have astronomical carbon prices while other sectors, such as electricity or aluminum production, have low ones. Harmonizing prices allows the world to attain its climate objectives at minimum cost. Calculations suggest that placing the burden of reductions on only half of all countries or half of all sectors will at least double that cost.
Meeting the two-degree target cannot happen without an immediate and steep drop in emissions.
How high a carbon price is necessary? Estimates of the “social cost of carbon”—which calculates global economic damage per ton of emissions—would suggest a price of around $50 per ton in 2021, rising to $85 per ton in 2050.
This price is unlikely to attain the two-degree objective or the target of zero net emissions by 2050, however. Doing either would require much higher prices. I estimate that these ambitious targets would require carbon prices of $300 to $500 per ton in 2030, rising as high as $1,000 per ton by 2050. But the estimates from different models vary widely because the technologies needed to reach zero emissions are still speculative.
In reality, carbon emission prices and the regimes under which they operate are completely inadequate. According to World Bank calculations, in 2019 the average global price was about $2 per ton of carbon dioxide. This is not even in the same universe as what is necessary. Low carbon prices are one reason why climate policies have been so ineffective.
There are dozens of carbon pricing plans in place in different regions of the world, each setting its own price and varying in terms of the share of the region’s emissions that are covered by the regime. The largest is the European Union Emissions Trading System (ETS), which operates as a multinational carbon trading scheme. Even the ETS, as impressive as it is, has two flaws. One problem is that the price is so volatile: it has varied from $4 to $75 per ton of carbon dioxide over the last decade. More important, the ETS covers only a fraction of the European Union’s economy—slightly less than half. Other regional carbon pricing regimes, such as the California cap and trade system, have a very high coverage rate but a very low tax. Still other systems, such as those of Sweden and Switzerland, have very high prices but very low coverage.
The policy necessary to meet international climate objectives looks very different from any regime currently in operation. It needs to have the price adopted by Sweden or Switzerland and the coverage rate of California—something like a price of $100 per ton of carbon dioxide and close to 100 percent coverage. High and harmonized carbon prices are key to climate change policy, but those that exist today tend to be low and fragmented.
Governments must also increase their support for low-carbon technologies. Just as countries used extraordinary incentives to develop COVID-19 vaccines in record time, we need to use all our ingenuity to accelerate the development of low-carbon technologies.
The reason for the urgency is that moving to a low- or zero-carbon global economy will require replacing large parts of our energy infrastructure and/or developing brand-new carbon-removal technologies. Fossil fuels accounted for 84 percent of the world’s primary energy consumption in 2019. By a rough estimate, it will take on the order of $100 trillion to $300 trillion in new capital to reach zero net emissions over the next four decades. And much of that new capital must come in the form of technologies that are largely unproven or immature today. Research and development is urgently needed to make this possible.
Why is government support necessary? From an economic point of view, R & D suffers from a severe externality in the same way that climate change does. The public returns on green innovation are much larger than the private returns. Indeed, there is a double externality for low-carbon R & D. Green inventors get only a small fraction of the returns on their innovations to begin with, and then the low prices of emissions exacerbate the problem.
Carbon capture and sequestration provides a good example of this double externality. Economic returns on the research and commercialization of CCS spill over to other firms and future consumers. But the captured carbon is worthless in most countries because carbon emissions are drastically underpriced, which makes investments in CCS commercially nonviable—and therefore out of the question in corporate boardrooms.
The same logic holds for advanced nuclear power, fusion power, and the burgeoning hydrogen economy: none of them have any advantage over fossil fuels as long as carbon prices remain low. Hydrogen will never be the energy carrier of the future when carbon prices are $2 per ton.
It should be emphasized that the primary requirement is support for research and development, not production. Developing new low-carbon technologies and energy sources is much more important than subsidizing the current generation of low-carbon equipment in cars, houses, and industry.
The U.S. government’s research budget today reveals misplaced national priorities. In 2019, federal R & D spending on military systems—such as aircraft, drones, artificial intelligence, robots, and nuclear weapons—totaled $60 billion. By contrast, advanced energy and renewables received only $2 billion in government R & D funding. While there may be political logic to this disparity, there is no societal logic to the imbalance given the climate threats the world faces in the coming years.
Why have landmark international agreements such as the Kyoto Protocol and the Paris accord failed to make a dent in emission trends? The reason is free-riding—countries neglect to do their part, putting their national interests over global interests. A country displaying this syndrome might say not just “America first” but “America only.” Nationalist policies that maximize one state’s interests at the expense of others—beggar-thy-neighbor policies—are a poor way to resolve global problems. Noncooperative approaches to issues as diverse as tariffs, ocean fisheries, war, outer space, and climate change lead to outcomes that leave most or all nations worse off. The result of pervasive free-riding is that international climate policy has reached a dead end.
The fatal flaw in the 25 UN conferences leading up to Glasgow is that they are essentially voluntary. Countries may agree to take action, but there are no repercussions if they withdraw from the accords or fail to keep their commitments. When the United States dropped out of the Kyoto Protocol, there were no penalties. In every climate agreement to date, there have been no penalties for nonparticipation or for breaking promises. Voluntary climate change treaties produce very limited emission reductions—this is the lesson of both history and economic theory, and it is validated by the three-decade decarbonization trend shown in Figure 1.
Current carbon emission prices are completely inadequate.
One proposal to combat free-riding in climate treaties is what I have called a “climate club.” Scholars who study effective international agreements find they include sticks as well as carrots—that is, they set penalties for nonparticipants and rule breakers. Trade treaties and the World Trade Organization system epitomize such an approach. They require countries to make costly commitments that serve the collective interest, but they also penalize countries that do not keep their commitments.
This could be a template for an effective climate agreement. Take an example that we have modeled at Yale and that has been studied at other universities. Suppose a climate club agrees to establish a minimum target carbon price. Under club rules, countries would be required to impose a minimum domestic carbon price, say, $50 per ton of carbon dioxide, that rises over time. The implementation mechanism may vary by country—a government could decide to use a cap and trade or a carbon tax, for instance—and each country would keep its own revenues.
The new feature—and the key difference from existing climate agreements—is a penalty for nonparticipants and countries that fail to meet their obligations. In our analysis, this takes the form of a uniform tariff increase. Such a penalty is simple to administer and serves as a powerful incentive. Our modeling suggests that a carbon price of $50 per ton plus a uniform tariff penalty of three to five percent would be sufficient to induce strong participation in a climate club. Other projections have also found that the club can succeed in bringing most countries onboard if its initial members include key players, specifically China, the United States, and the European Union.
The world has made little progress in slowing global warming. Even with all the policies implemented over the last three decades, the rate of global decarbonization is unchanged. If we hope to meet our climate objectives, we must enact a swift and sharp downturn in emissions.
An effective policy must introduce high carbon prices, harmonized across countries and across sectors. Actual carbon prices are virtually zero today; they should immediately increase to around $50 per ton of carbon dioxide and rise steeply after that. High emission prices will help remedy the problem of underinvestment in low-carbon technologies, but governments must provide additional support. Right now, countries severely neglect the fundamental energy research and development that will make possible a low- or zero-carbon economy. Finally, coordinating effective international policies will require some kind of club structure—an agreement that uses both carrots and sticks to induce countries to implement critical reforms.
High carbon prices combined with investment in low-carbon technologies and international participation in a climate club—this is the mix of policies we need to meet our ambitious objectives.