Tag Archives: emissions

Empirical Calibration of Climate Policy using Corporate Solvency

By Ben Caldecott

The fundamental goal of climate policy is to incentivise emissions reductions and the transition to lower carbon processes and technologies. When firms face new costs related to reducing carbon emissions, they may suffer some loss of financial condition as they restructure their businesses.

However, if the firm becomes bankrupt as a result of such policies, not only will this restructuring not occur – possibly causing high-emitting industries to expand in less constrained jurisdictions (carbon leakage) – but social value can also be permanently destroyed in the form of: the dissolution of organisational capital; deadweight losses paid to liquidators; and the incurrence of costs on unemployed workers. Corporate failures, especially if they are unnecessary, add to the social cost of tackling climate change. Reductions in solvency that are less than bankruptcy can also impact the ability of firms to employ people and finance investment.

At present, policymakers do not have a means to accurately and impartially gauge the impact of climate policies on corporate solvency. If they did, policymakers could optimise climate policy so that it delivered the least loss of corporate solvency for any given level of emissions reduction.

In a new paper published in Climate Policy, we propose that existing measures of corporate solvency be used for this purpose. Such measures could act as an objective tool for policymakers. In particular, solvency metrics could be used to empirically calibrate the optimal stringency of climate policies. They could also be used as a way to determine the generosity of any industrial compensation to address losses to corporate solvency.

Financial statistics are currently used in this way to calibrate many other areas of government policy. For instance, policymakers monitor and regulate certain aspects of corporate solvency in the financial industry (such as capital reserve requirements) in order to reduce the risk of bankruptcy while maintaining profitability. Similarly, central banks also consult economic statistics when determining monetary policy.

An ideal solvency trajectory for firms affected by climate change policy would cause corporate solvency to initially decline – approaching but not exceeding ‘distressed’ levels – and then gradually improve to a new ‘steady state’ once the low-carbon transition had been achieved, at which point the carbon-limiting regulation would continue. If any compensation was provided to industry to help offset reductions in solvency, these would also then be gradually phased-out. This sequence is depicted by the U-shaped solvency trajectory below.

An additional advantage of using financial statistics to calibrate environmental policies generally is the fact that this process would be objective. At present, there is considerable potential for industrial outcry and political lobbying to influence policy resulting in negative social consequences. By contrast, a climate change policy partly based on corporate solvency could be adjusted relatively mechanically at each financial reporting period, and would be automatically sensitive to variations in the business cycle.

The question of where the optimal solvency threshold should lie is crucial for the practical application of climate policy calibration. For instance, depending on the regulator’s particular goals the relevant benchmark could be either; (i) an overall average solvency level, (ii) a minimum solvency level for the most financially distressed firm, (iii) or a maximum solvency loss for the most affected firm.

Moreover, the policy goal may not just be solvency for affected firms but also their competitiveness, in which case, depending on the regulations faced by international competitors, the optimal lower bound for solvency may need to be raised in from financial distress to some other higher level. The availability and timeliness of financial data will also influence the optimal threshold. Since the financial position of firms may deteriorate between financial reports, it may be prudent to adjust thresholds upwards to add a margin of safety against rapid solvency losses.

Of course, it would be equally essential to ensure that firms could not ‘game’ their financial statements in order to present an artificially dire picture to sympathetic regulators. It may also be the case that within a given emissions target, it may not be possible to maintain the solvency of all affected firms. In such cases the emissions target may need to take precedence over solvency concerns, but nevertheless the use of policy calibration via solvency could still be an efficient way to minimise the bankruptcy losses that may be necessary in order to achieve a desired emissions goal. Future research could refine this optimal policy threshold.

Our proposals highlight the potential of existing corporate solvency metrics to help policymakers objectively minimise negative social impacts for a given emission reduction target. Failure to take account of (or simply wish away) the social impacts associated with bankruptcy or reductions in corporate solvency resulting from climate policy would be serious mistake. It will increase opposition that could successfully undermine climate action. It would also allow fossil fuel interests to continue misleading policymakers and broader society about how climate action is negatively impacting their businesses. Transparency and objectivity enabled by financial data is already integrated into other areas of policymaking and regulation. It should also be embraced by policymakers concerned with climate change.

About the Author

 

Ben Caldecott is the founding Director of the Oxford Sustainable Finance Programme, at the University of Oxford Smith School of Enterprise and the Environment.

 

Advertisements

What if Negative Emissions Fail at Scale?

By Alice Larkin (University of Manchester, Tyndall Centre for Climate Change Research)

It is recognised in the climate science community that literature and research informing the Intergovernmental Panel on Climate Change (IPCC) and relevant policymakers is heavily weighted towards Integrated Assessment Modelling (IAM) work. This prioritises emission-cutting solutions that can be more easily characterised and quantified over those that are challenging to evaluate precisely, such as how society may respond to a major policy shift.

Yet putting options into the ‘too difficult to quantify’ box, is a huge mistake, as my co-authors and I argue in a recent paper published in Climate Policy. Coupled with our desire to precisely quantify, and communicate, numbers, it is important to recognise that there appears to be an optimistic bias that assumes future technologies will solve present-day social and environmental problems.

Perhaps in most wealthy people’s minds, this would be the ideal – no need to disrupt ‘normalised’ lifestyles that include frequent flying, high levels of material consumption, an ability to have what we want, when we want. It is then easy to see why Negative Emissions Technologies (NETs) fit neatly into the climate mitigation discourse. They could lead to net negative emissions in future, avoiding a need to invest political capital in more unpalatable areas such as lifestyle change, and reducing consumption.

But what if NETs fail at scale – what then? Our article argues that they are being so heavily relied upon to inform policymakers, that we are losing sight of alternatives. Furthermore, delaying meaningful debate on the demand-side of the equation is at odds with what the climate science is telling us. There is a finite carbon budget for avoiding 2°C, so the sooner emissions are cut, new habits and behaviours established, and infrastructures to support low-carbon lifestyles put in place, the lower the risk of devastating climate change impacts.

It is not uncommon for humans to be optimistic about what technology can deliver and by when. Carbon capture and storage – even without biomass– is a good example. And with most modelling work being done by those of us in privileged positions in terms of wealth, it is unsurprising that lifestyle change is low down our priority list.

My problem with this optimistic techno-centric approach is that we (wealthy people in high emitting countries calling the shots on climate change) are not only choosing climate change futures on behalf of ourselves, but we are making choices on behalf of others. Whilst we may well be able to adapt to early climate impacts by making marginal adjustments to our everyday living, by installing more air conditioning, moving away from low-lying coastlines, paying insurance companies to repair our homes after floods etc., that isn’t a luxury that most people in the world will have.

Furthermore, with globalised social media, those who will be most impacted by climate change are able to observe us continue as is, while they struggle to adapt, fund and cope with changes in their climates. Global social media lifts the lid on inequalities we are not prepared to address, as this paper highlights.

If big emitting countries, and the big emitters within those countries, are prepared to put in place stringent polices aiming to significantly reduce absolute fossil fuel consumption, even for a few years while establishing low-carbon infrastructure, there would be a much better chance of achieving the 2°C goal. While many industrialising nations will be trying to transition their own energy systems away from fossil fuels, and may well put more industrialised countries to shame in terms of the pace of change, they will still need space for economic growth, and therefore a near-term rise in emissions, to improve standards of well-being.

A meaningful, deep and an equally large body of work focusing on how to build systemic change around energy demand and material consumption is urgently needed. As long as IAMs dominate climate literature, a more balanced perspective of opportunities on the demand side will be overlooked, and time is running out.

Air travel is an example that brings this clearly into view. As academics, we are not prepared to look at the evidence that air travel is one of the most difficult sectors to decarbonise, with constraints on demand needed here more than anywhere (see also my paper All Adrift: Aviation, shipping and climate change policy, also published in Climate Policy). Yet I doubt the number of flights attributable to climate change research activity is declining. The reality of taking a carbon budget perspective, is that one flight taken by me this year, removes a chunk of the budget available for someone in a developing country to heat or cool their home. We are all part of the system – my behaviour here changes the climate impacts others experience elsewhere.

I have a background in climate science, and climate modelling, and I’m certainly not against modelling contributions, but it is essential that we are not blinded by precise quantification to the extent that we overlook the full possibility space. This is particularly important when basing decisions on models that combine the laws of physics with the ‘understandings’ (and certainly not laws) of economics. Not everything can be quantified in a way that is appropriate and useful for policymakers. Other ways of looking at the world are essential and need to contribute to the debate. If we don’t start to make a concerted effort to do that soon, we may well have missed our chance to demonstrate real intelligence in tackling climate change.

About the Author

 

Alice Larkin is Head of the School of Mechanical, Aerospace and Civil Engineering and a Professor of Climate Science and Energy Policy in the Tyndall Centre for Climate Change Research, University of Manchester.