The energy transition will be expensive

In 1965 britain struck gas in the North Sea. The government wanted to exploit its new fuel to heat buildings. But the gas that had been found was different from “town gas”, made from oil and coal, which most boilers were designed to use. So state-owned gas boards carried out an enormous project: the conversion of 13m buildings to a new heating technology. An army of contractors was recruited and enlisted for the task. “It seems quite wrong that, after two weeks’ training, ex-bus conductors, postmen and so forth can walk in and take one’s cooker to bits,” complained one housewife. No premises could be spared: a group of workers sent to Soho, home to London’s red-light district, found they had to wait in line to enter “one of the more dubious” clubs.

The chairman of British Gas hailed the completion of the project in 1977 as perhaps the greatest the country had carried out in peacetime. Yet it looks trivial compared with the challenge Britain and others now face: to heat all homes without emitting carbon dioxide. British officials estimate that, to meet the target of net-zero emissions, 28m-29m houses need reworking. The cost in the 1960s and 1970s was about 1% of annual gdp. If climate-friendly air-source heat pumps are the dominant technology in today’s transition, the probable bill will be worth 17% of 2019’s gdp, says the Office for Budget Responsibility (obr), the fiscal watchdog.

And that is only one sector. To hit the net-zero targets to which 91% of the world economy is now committed, many other transformations are necessary. Roads need ubiquitous charging-points for electric vehicles (evs) that will replace internal-combustion engines. The technologies to make cement or fly aeroplanes cleanly but inexpensively, or to capture carbon emissions from those industries, must be found. Above all, electricity supplied to the grid must be clean—and grids must be upgraded to cope with higher demand when everything runs on electricity.

The project is thus vast and expensive. Advocates of green investment have often presented this as an advantage: big infrastructure investment would be part of a “green new deal”, funded by cheap government borrowing, that would be able to take up slack in the economy and provide a long-term return in excess of interest costs. Even in the summer of 2021, after Joe Biden had already passed a huge fiscal stimulus in America, imf staff wrote that a green investment push could “[boost] demand and employment and [help] the recovery from the covid-19 pandemic”. More stimulus was always welcome.

Timing is everything

Yet inflation has now made clear that there is too much spending in the economy, not too little. Debt-interest costs are rising as central banks hit the brakes. The appeal of a green fiscal stimulus has dissipated. Far from using up slack, more public spending will now displace private-sector activity and further raise prices. The model for green spending is no longer the green new deal. It is Mr Biden’s Inflation Reduction Act (ira), which contains America’s largest slug of climate-related spending but reduces the deficit slightly by raising taxes and beefing up tax enforcement.

The bad news is that the cost of the climate transition to taxpayers will be much bigger than what is provided for in the act, or indeed in existing legislation in the rest of the world. The ira is estimated—with wide bands of uncertainty—to close only about half the gap between America’s previous trajectory, through which it would reduce its carbon emissions by about 30% between 2005 and 2030, and the Biden administration’s target of a 50% cut.

The good news is that green investment is still affordable, for three main reasons. First, the world is continuously replacing boilers, cars and power plants regardless of any energy transition. Incremental spending to replace them with green alternatives is much lower than the gross cost would be. The McKinsey Global Institute estimates that an annual average of 9.2% of gdp must be spent on physical assets to achieve net zero by 2050, but reckons this is an increase of only 0.9 percentage points over current plans. The imf and the International Energy Agency similarly put the necessary incremental investment over the next decade at 0.6-0.9% of cumulative output.

The second reason is that the private sector will pick up much of the tab. Households, for example, usually buy their own boilers and cars, and in the rich world private firms are responsible for about 90% of all energy investment. The obr’s central scenario assumes that the British government will pay about a quarter of the total cost of the transition (though it cautions that the actual figure could “vary greatly”). The resulting need for public investment is about 0.4% of gdp, on average, until 2050, a sufficiently small number to allow the British government to plan to meet it from within its existing investment budget. The imf has found that most estimates of the need for public-sector investment in the 2020s are of a similar magnitude, ranging between 0.05% and 0.45% of cumulative gdp.

Forecasts of taxpayers’ share of the bill depend on whether other policies are in place to encourage the private sector to invest in green technologies. Businesses and households put money to work where the returns are greatest. They will pony up the cash for net zero only if they are incentivised to do so. A particularly important factor is the extent to which governments impose carbon prices, which tilt the scales in favour of green investment. A failure to price carbon is doubly costly: it forces the public sector to shoulder more of the burden of investment, and deprives the government of a source of income.

Philippe Aghion, an economist, and his co-authors have found that a 10% increase in fuel prices increases by 10% a firm’s likelihood of investing in green technologies. Households also respond to price signals. America, where petrol taxes have been fixed in cash terms since 1993 and a federal carbon-pricing scheme looks unlikely to pass Congress, has just extended to 2032 its tax credit for evs as part of the ira. In Europe, where fuel levies are higher, the number of countries offering incentives for evs is falling, even as take-up grows. The stick of carbon pricing would make the carrot of subsidies less necessary. Using subsidies without carbon pricing “is a sure way to spend more than needed to achieve the desired goal,” writes Olivier Blanchard of the Massachusetts Institute of Technology.

Fortunately, carbon pricing is expanding. Nearly a quarter of greenhouse-gas emissions are priced, a doubling in five years, helped by the launch of China’s emissions-trading scheme for gas and coal power plants. Most carbon prices remain too low. But every dollar on the price makes investment in clean energy sources more attractive for the private sector.

Although the economics of decarbonisation are manageable, it is the politics that are hard

A final factor reducing costs for the public sector is that the green transition will pay off, not just in mitigated global warming, but through greater efficiency. One big pay-off comes from evs. Partly because they rely less on fluids than do internal-combustion engines, they require less maintenance. They are more efficient and have lower running costs. Should battery technology advance as expected, they will eventually be cheaper to buy than petrol cars. Cheaper transport will benefit the economy, boosting growth and consumers’ real incomes. These benefits may not be enough to offset the costs of weaning the economy off fossil fuels. But once those costs are sunk, there will at least be a pay-off.

And it is possible that things will go better still. Technical progress is hard to predict, and economists have shown firms’ green innovation to be “path-dependent”: the more a firm does, the more it is likely to do in future. The history of renewable energy also suggests there is a steep learning curve, meaning that, as more is produced, costs fall rapidly because of economies of scale and learning-by-doing.

Here comes the sun

The strongest evidence for this is the collapse in the price of solar energy, which became about 90% cheaper during the 2010s, repeatedly beating forecasts. Should other green technologies follow the same pattern of large falls in cost the world may find that net zero will eventually benefit both growth and the public finances. (A big breakthrough in hydrogen fuel, for example, could mean heating many homes using the existing gas network, rather than having to install heat pumps.)

Although the economics of decarbonisation are manageable, it is the politics that are hard. Timing is everything. Moving early and gradually gives economies more time to adjust, allowing them to reap the benefits of path-dependent green investment without much disruption. A late, more chaotic transition is costlier. The obr estimates that if Britain delays decisive action on decarbonisation to the 2030s, the eventual cost of the project will raise its debt-to-gdp ratio by nearly 45 percentage points.

Then there is the challenge of ensuring that the transition happens everywhere. The rich world plus China now account for about two-thirds of annual carbon emissions. Although Africa contains nearly a fifth of the world’s people, the continent is responsible for just 3% of the emissions that humans have ever put into the atmosphere. Yet by mid-century Africa’s population will have grown by 75% and will be much richer than it is today. Should its per-person emissions reach the level of India (about two tonnes a year, compared with 16 in America), the continent’s annual emissions will be roughly what America’s are today, calculates Jack Goldstone of George Mason University. India itself will also see its population grow by nearly 20% by 2050 and, on present trends, its per-person emissions will rise.

If the world is to achieve net-zero emissions without hamstringing the economic prospects of billions of people, the rich world must help developing countries decarbonise as they grow. At the Copenhagen climate summit in 2009, rich countries duly pledged to provide $100bn a year of public and private finance to poorer countries by 2020 to help them mitigate and adapt to climate change. The target is vaguely defined, but is clearly being missed. Meeting it is not just a diplomatic challenge, but a technical one, given the difficulty of promoting investment in poor countries in which property rights can be insecure.

The difficulty of co-ordinating decarbonisation internationally is another argument for early investment. The sooner the rich world invests in green technologies, reducing their price, the more likely the benefits are to spill over into the developing world, allowing them to pursue greener growth. The impact of low solar prices, for example, is already visible in India, which has almost a decade early met its target of 40% non-fossil-fuel installed energy capacity by 2030. It is increasingly plausible that the country’s clean energy capacity could overtake its fossil-fuel capacity within the next decade.

The world needs more such wins. But can rich countries invest enough for them? Europe’s energy crisis is speeding up its energy transition. High fossil-fuel prices hurt in the short run but are comparable to a carbon tax in their effects. In 2022 Europe will install 39gw of solar power, up 44% from what was already a record in 2021, according to SolarPower Europe, a lobby group.

In normal times the argument for debt-financing of climate investments would be strong. It is more efficient to spread costs over time than pay for a green splurge with sharply higher taxes. Yet high inflation and overheating economies mean that this is no longer a good time to increase deficits. The cash available for green investment may depend on whether politicians decide to join central banks in their fight against inflation. ■

Correction (October 11th 2022): A previous version of this article said the McKinsey Global Institute estimated an annual average of 9.2% of GDP must be spent on physical assets to achieve net zero by 2050. The correct figure is 7.5% of GDP. Sorry.