Net-zero transition and social cost

It is often assumed that society inevitably wants and supports net-zero transition and see climate change as an existential risk. That is an assumption, and current social attitudes may change over time. To understand climate risks, one need to consider factors that have potential to reverse net zero transition. That can be current investments into fossil fuels that will lock production, energy security concerns, changes in climate risk perception, evidence of exorbitantly high social cost of transition, extensively high carbon costs (i.e., after some carbon price rise the policies will be reversed) or de-globalization trends.

Current climate risk practice relies on climate pathways stretching far in the future till the year around 2100. It’s difficult to see such long-term forecast realistic and useful for rational decision making. The better approach will be to design decision policy that will end up in optimal outcomes despite change of circumstances at any scenario.

What is the way to do that? I suggest any just economic system shall at all time periods benefit each subset of participants. Society and individuals will pay economic and social costs in anticipation of benefits. Thus, social cost of transition is an important and often obscured factor that have potential to control the transition policies and will drive climate transition efforts. Better understanding of social cost at national and corporate dimensions will help to make more plausible climate transition decisions.

Carbon price is currently defined by voluntary-based carbon trading markets (which are created by authorities with a few incentives and artificial limitations), can be set by governments in form of policies or potentially as a direct tax on emissions. Clear price of carbon is expected to “focus minds” and create economic case for companies and individuals to rapidly transition onto new carbon-efficient way of doing business and living. However due to superficial nature of carbon price, another rational response is to fight, and that can result in suspended or halted net-zero transition. The actual response partially depends on a balance of individual costs and benefits. But more importantly on perception and expectations of net-zero transition outcomes.

The higher real or perceived social costs of transition, the more efforts will go into resisting and fighting against the carbon and transition policies. That is the channel how social costs will influence carbon price. Meanwhile level and volatility of the carbon price provide rationale for investments into technological evolution in energy storage and carbon capture technologies (pushing marginal price per unit down), investments into renewables and electrification of energy infrastructure, and naturally curve the adoption of EV. These investments will effectively lower the social costs of carbon transition.

Carbon price is the component of the end-user price of energy. Energy companies use customer sales revenues to finance both fossil fuels and renewable energy infrastructure. Optimal response to rising energy costs is to keep capital in fossil fuel (so called “last-person-standing” strategy) rather then in renewables. The actual transition depends on credibility of management strategy commitments. Their credibility to a large degree is influenced by the readiness of society to pay social costs (i.e., premium for green products, tolerate destruction of communities around fossil fuels production, etc.) and track these commitments. Higher energy price (and associated social costs) rapidly establish a need for government to intervene and redistribute cash flow (see current response of the UK government to high carbon price with “windfall” tax which is expected to last for several years. This is an example how high energy price reduce rather than increase ability to invest into renewables).

Understanding this dynamic is not an easy task. It’s even more difficult to see how constant “push” from regulators to enable net-zero transition will be able to sustain for several decades. There is a real need to engineer self-reinforcing dynamics in the process of “net-zero journey” or identify other forces in place (i.e., around other parts of ESG agenda and SDG goals) that will continue push at least partially. That is why “just transition” is not only the matter of ethics in climate change, but the factor to archive the success. And this must be done on the backdrop of slow-moving factors like GDP, population growth and urbanization.

Recent events give hints that response to the physical risks may also play out differently than currently anticipated. BoE expect residential property in some areas in the UK to not be able to obtain insurance policies (with corresponding hit to ability to obtain mortgage and property price). Will that happen or the social pressure onto the government will create response? Alternative solution may be introduction of the national policies / laws that mandate insurers to issue policy and spread the risks among customers, or there be a new law (like national “climate” insurance contribution) which spread the climate risk mandatory among all citizens and residents, or there be a regular “climate risk” tax on companies considered as climate change perpetrators.

There is a need to separate climate risk management, when one need to get prepared to tackle risks in advance as things may appear and change unexpectedly, and climate change strategy where you see the change coming and have time to game response.
I suggest climate change policies must be created under presumption of egoistic behaviour for most participants (responding both with rational signals and irrational perception). And design of policies and strategies must be focused on short term optimal orientation. (How the transition to net-zero will then come?)

Subsequently new types of scenario must be proposed:

  • Social effects of carbon transition perceived to be so high that after initial efforts government will give up and allow climate warming to accelerate. There may be a few cycles of attempts. That will accumulate both physical and transition risks.
  • Formation of climate clubs of countries. Some countries will group based on preferred climate policy (net zero or no action) and will separate themselves with import carbon tax tariffs policies and carbon trading mechanisms and even export carbon compensation mechanism. This will create barriers between two (or more) clubs in trade and energy. There will be significant divergence of energy transition policies (some clubs stay coal and oil while other clubs transition to renewables). This may split global economy based on developing and developed country segments.
  • Mandated government policies to introduce “climate insurance” tax to support non-insurable assets (residential or maybe also commercial) similar to national insurance in the UK.
  • Rise of carbon tax plus raise of energy prices will start to create a real drag on regional and global economies. The assumed policies to transit to efficient renewable energy technology will not follow though due to social protests, technology issues and economic scaling. That will push to remove carbon tax policies and stimulate fossil fuels industries.

Get Free Consultations

Dr. Tymur Khusainov
Sustainable Finance and ESG Consultant