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Why It May Make Economic Sense To Tackle Global Warming

Highlights

Global warming of 3 degrees C. is likely to cost us 2% of global output. It is set to affect emerging and developing economies much more than developed ones.

Uncertainty about the costs of climate change and its characteristics of a global public good, which give rise to the free-rider problem, explain why policymakers and market participants have not done enough to cut carbon emissions.

Putting a global price tag on carbon would be the first best solution to fight global warming. Because of coordination problems, our second-best option is therefore change initiated at regional, country, and local levels--as well as by markets.

Capital allocation toward green investment may be considered as a competitive differentiator in portfolios and a strategy to achieve sustainable business models.

Technological hurdles are impeding a quick shift to a low-carbon economy, suggesting investment in this space is set to grow in importance and will likely be met by public support.

Dec. 05 2018 — Climate change is no longer a problem for the future. It has already started to alter the functioning of our world. Every year seems to bring more climate-related shocks--such as floods, hurricanes, harsh winters, and hotter summers--that weigh on economic activity. As temperatures climb, the occurrence of natural disasters is set to rise: Recent research shows that under business-as-usual carbon emissions, the risk of extreme heatwaves and floods is likely to increase by 50% this century (Mann et al., 2018). This means the global economy will increasingly have to cope with the consequences of global warming.

The latest United Nations Climate Change Conference, COP24, is bringing together experts and policymakers over the next two weeks (Dec. 2-14) to assess progress toward implementing the 2015 Paris Agreement and mitigating global warming. A recent report by the U.N.'s Intergovernmental Panel on Climate Change (IPCC) shows that global warming is already affecting our lives and that limiting global warming to 1.5 degrees Celsius is becoming increasingly unrealistic. Here, we look at the economic implications of climate change, why progress in reducing our emissions has been slow, and ways policymakers and markets can still act to mitigate global warming.

The Cost Of Inaction Rises Along With Global Warming

Research shows that global warming is costly. More frequent extreme weather events that damage infrastructure will lead to faster capital depreciation. This will lower the rate of return on these investments and thus the incentives for capital accumulation. Increased temperatures are set to affect the labor supply through higher heat-related morbidity and mortality, as well as weigh on workers' productivity, as hotter days tend to be associated with a reduction in working hours.

Putting all these factors together, studies find that global warming of 3 degrees C., which is the estimated trajectory based on countries' current pledges since 2015, would lower global output by 2%. Warming of 6 degrees C., which is slightly above upper estimates of the business-as-usual carbon emissions scenario, would push global output 8% lower (Nordhaus and Moffat 2017). Granted, current estimates are rough, given the large number of assumptions needed to model climate change. This suggests we might even be underestimating the costs of climate change. Yet, one robust result is that the higher the temperature, the more damaging climate change will be--and in a nonlinear way (see chart 1).  

Studies also find that climate change will not be uniform across countries and thus have important distributional effects. Emerging and developing economies in the Caribbean, Asia, and Africa are most exposed to climate change (see charts 2 and 3). By contrast, advanced economies will suffer less from global warming. This is not only because they are better prepared than emerging or developing economies, but also because they are located in colder regions today. This wealth redistribution is likely to exacerbate migration flows to wealthier regions, putting pressure on land use and social systems.

Climate change also represents a challenge for policymaking as it raises uncertainty about the state of the economy. In the long term, its costs are a clear downside risk to growth but also a source of increased volatility. As extreme weather events occur more often, they will also damage economic activity in a nonpredictable way. In the short term, policymakers will have more trouble disentangling the effects of climate change from the effects of other policies on the underlying state of the economy. For example, statisticians have struggled to identify seasonality in first-quarter U.S. GDP numbers linked to colder winters.

So Why Have We Done So Little To Lower Carbon Emissions?

Although it is clear that the cost of inaction rises with higher temperatures, the world has struggled to lower carbon emissions (see chart 4). Limiting global warming to 1.5 degrees C. now seems almost out of reach. According to the latest IPCC report, it would imply lowering carbon emissions to net zero by 2050. So why have we struggled to tackle global warming?

One big hurdle is that its cost remains uncertain and the worst effects will occur in the future, once they are irreversible. This makes it difficult to compute the opportunity cost for acting now. If we discount the future too much, there is little ground for action today. The Trump Administration's announcement to withdraw from the Paris Agreement even suggests that some see no need to redirect resources toward greener energy to mitigate climate change or lead climate initiatives that carry significant economic benefits.

Another issue, which explains why policymakers have struggled to coordinate globally, is that climate change has all the characteristics of a global public good. A country has little incentive to change its behavior on its own since emissions are diffuse across borders and reducing them is costly, giving rise to the free-rider problem. For some policymakers, the worry is that firms might relocate their activity to countries with weaker environmental standards. Meanwhile, though they are the most affected by climate change, developing countries have less funds available to fight against it and may prefer to target other priorities, such as reducing poverty.

Meanwhile, the market on its own is unlikely to reach an optimal equilibrium, because most consumers and companies do not directly feel or internalize the cost of climate change. Although global warming is increasingly affecting consumers and firms through more frequent floods, hurricanes, and wildfires, it still comes with problems of attribution. It remains unclear that all of the impact is due to climate change. What's more, only a small number bear the costs, which are massive. The others do not feel the consequences of global warming and are more worried that a switch to greener spending may hurt their purchasing power or profits. In short, without a nudge or fiscal incentives, private consumption and activity will not actively seek to mitigate the impact of higher emissions on climate change.

A Few Avenues To Mitigate The Cost Of Inaction

Putting a global price tag on carbon would be the most efficient way to reduce carbon emissions. Taxing carbon or limiting its use would ensure that firms and consumers internalize the cost of global warming today. This is also the recommendation of policy experts (for example at IPCC, OECD, World Bank, and International Monetary Fund). The High-Level Commission on Carbon Prices recommends a carbon price of USD50-USD100 per ton of CO2 by 2030 to achieve the Paris Agreement goal. However, the coordination problems we have outlined above have made it difficult to put that into place.

The second-best approach is to initiate change at other regional, country, or local levels. Importantly, this gives countries more flexibility to design policy in line with their priorities and constraints, and removes the difficulty of reaching a global compromise. In terms of carbon pricing, this is where most progress has happened so far. Finland and Poland put a carbon tax in place in 1990, the EU created the first Emission Trading System (ETS) in 2005, and other jurisdictions have replicated these efforts since then. With China set to put its ETS in place in 2020, the World Bank estimates that all regional, national, and supranational initiatives will cover about 20% of global emissions. The next step toward a global carbon price would be for countries that have already established an ETS to link them together--similar to the current Swiss-EU initiative. While this is a big improvement, this is far from a global carbon tax.

Beyond carbon pricing, policymakers have many other ways to support a greener economy. They can foster greener investments and behaviors through fiscal policy, regulation, increased awareness by civil society and more climate-friendly public infrastructure. If well-designed, those policies can provide immediate economic and social benefits. To name a few, decreasing the reliance of an economy on fuel reduces its exposure to oil-price shocks; switching to less-polluting cars provides direct health benefits; and better-insulated homes reduce the energy bill for households.

Investing in resilience to climate change in the most exposed regions can help smooth the distributional effects of global warming. It can also be an immediate source of growth, as those regions tend to be less developed. Given that developing countries have tighter budget constraints, developed countries could think of green development aid.

Markets also have a role to play in climate change mitigation. As the cost of global warming is increasingly visible and rising, it is only rational for markets to start pricing its cost. All other things being equal, companies that integrate environmental goals in their strategy are more likely to achieve sustainable long-term value creation, especially if environmental regulation goes into a similar direction. In some industries, energy also represents an important proportion of operating costs, meaning gaining in energy efficiency may lead to productivity gains. With consumers and investors becoming more aware of the consequences of climate change, there is also a case for providing "environmentally friendly" alternatives. Indeed, we can see that there is increased demand for such instruments from the fast-growing green bonds market, which may surpass $200 billion in 2018, after reaching $160 billion in 2017 (see "Untapped Potential: How The Green Economy Is Broadening," published on Nov. 5, 2018). Interestingly, more than 90% of labeled green bonds have been rated investment grade.

Taking Advantage Of Sustainable Investment

As global decarbonization intensifies, so too has awareness about "green" investment--that is, investment considered environmentally beneficial. This kind of capital allocation may be considered a competitive differentiator in portfolios due to the potential for assets with improved cash flow, greater risk mitigation, and a more sustainable business model in the long term.

Against this backdrop, we have seen a plethora of diverse industries--many from traditionally "nongreen" sectors, including metals, mining, petrochemicals, heavy industry, energy, and power--looking to broaden sustainability strategies. What's driving development? In part, greater awareness of climate risks by corporates, investors, and wider society that has been an outgrowth of national and regional climate initiatives.

China's recent surge of investment into clean energy and sustainability initiatives signals an acceleration of the country's agenda to become a green superpower. It already accounts for nearly 71% of global production of solar panel technology and manufactures more lithium ion batteries than any other country in the world. China's greening policies, an integral part of the country's transformative Belt and Road Initiative, could represent an acknowledgement of the role that sustainable investment plays in attracting foreign capital. Indeed, the country's energy and climate goals for 2015 to 2020 are estimated to require between US$480 billion and US$640 billion of investment. And by 2040, China plans to have invested in excess of US$6 trillion into low-carbon power generation and clean technologies, which, if fulfilled, could far exceed that of many EU countries and even the U.S. (see ''Greener Pastures: China Cuts A Path To Becoming A Green Superpower," published on Nov. 5, 2018).

Such ambitious and publicized targets emanating from China have fostered rivalry in other corners of the globe. This, combined with the Trump Administration's announcement to withdraw from the Paris Agreement, have sparked concerns in the U.S. that technological developments will stall in a more isolationist environment. Yet hope for the U.S. remains in the form of state-led initiatives. This September, Jerry Brown, Governor of California, formally announced the state's commitment to achieving a carbon-neutral economy. To this end, he signed SB 100, a mandate to set California on a path to deriving 100% of its power from clean sources by 2045, up from today's figure of 35%. California now also boasts a carbon-trading system that includes transport fuels and a low-carbon fuel standard, both of which are likely to promote development of advanced biofuels and associated technologies. California represents the largest state in the U.S. by population and economic output, and other states are following suit, introducing heightened renewable standards, implementing energy efficiency targets, and developing decarbonizing technologies, though, for the moment, these initiatives are largely clustered on the West Coast and in the northeastern part of the country.

The EU-wide goal of reducing CO2 emissions by 40% compared to 1990 levels by 2030 has served to raise the profile of global sustainability efforts. Even oil-rich Norway has been looking to decarbonize further, tightening its standards with a focus on its transportation sector, where there is still room for improvement.

Technological Disruptors And Moving Forward

For both private investors looking to diversify their portfolios and governments looking to fight global warming, investment in low-carbon and renewable energy sources will likely grow in importance. If low-carbon projects and renewables are to proliferate, the energy supply needs to be guaranteed. To provide vital backup to the grid and bridge supply shortfalls during intermittent weather, energy storage via batteries will need to improve and become commonplace. But there is still some way to go, suggesting there might be a case for increased public support for the technology. For example, storage capabilities would have to increase 200-fold to meet California's renewables target. But once capacity increases, growth could be exponential. And as renewables technology advances, forecasts can be benchmarked against real operating performance, providing more clarity and data, and ultimately encouraging increased investor appetite for renewables assets.

Overcoming technological hurdles and navigating complex political and regulatory environments are imperative for green investment to continue to grow. Low-carbon power projects reside at the intersection of economics and politics, where the continued deployment of energy technologies will require ongoing access to capital markets. Even with improved economics, this will require a higher level of transparency about the performance and cost of these assets. This may be an expensive proposition in the short term but one that may well pay off in the future.