First, by one macroeconomic metric – the national ‘energy cost share’ (ECS) of consumer bills (domestic and business) in relation to GDP – the UK and EU haven’t been out of line with other countries, at least until the energy crisis. Our paper last year identified a relatively narrow range of ECS, with total consumer energy expenditures typically varying around about 7.5% of GDP amongst developed economies. The ECS in Europe was no higher than in the US, which has much lower energy prices, but is much more profligate in its use of energy.

In a subsequent paper published earlier this Autumn, we subjected that proposition to a rigorous econometric analysis, with a much wider set of countries. We find that the hypothesis of a limited ECS range holds broadly across developed countries (i.e. the ECS is almost independent of long-run energy price, and the variations observed are statistically insignificant). Over time, high energy prices drive adjustments, on both demand and supply, which tend to bring the ECS back within the stable range. Countries which had earlier subsidised energy to keep it cheap were actually worse off in terms of ECS, their structural energy-inefficiencies being deeply embedded.

Unfortunately though, most of the adjustment timescales are long – our first paper estimated, around quarter of a century. The adjustment processes involve innovation, enhanced efficiency – and structural changes, including outsourcing of energy intensive production (which has an influence, but which we estimated, generally not sufficient to undermine the basic conclusion). The recent paper confirms the high inertia in responses; the measured ‘half life’ of adjustment (time after a price shock to adjust half-way back to the long-run average ECS) in developed countries is around 12 years. The pain of the 2022 energy crisis has a long way to linger.

Moreover, the idea of constant ECS does not hold for most developing countries, which have higher ECS, which also grows with their energy price (at least when measured on purchasing-power-parity basis) – and their adjustment timescales seem even longer.

What bearing does this have on the current debates about energy prices? First, in no way does it mean, don’t worry; 12-25 years is far too long to endure the impact of disproportionately high energy prices without ameliorating measures. Moreover, the studies mostly measure response to global price shocks; the 2022 price shock and its aftermath have dominated in Europe, particularly the long cost tail of seeking to wean off Russian gas.

So we should first disentangle the problems of energy-intensive, tradeable industry (EITIs), arising from comparative energy prices, from the concerns about domestic energy bills.  Historically, the UK has tended to interpret economic principles of ‘efficient’ cost allocation as meaning equal prices, or at least equal distribution of costs, across all consumer groups.

In reality, for energy-intensive industry, comparative international energy price is the primary issue, including attracting international capital as well as the competitiveness of traded goods.

For domestic and service sector (eg. public and commercial) consumers, it is the overall bill that matters – and specifically, for households, the affordability of energy within overall household discretionary expenditures.

This latter means caring both about household energy efficiency, and distribution. Our recent paper – as well as more specific policy evaluations (such as a UCL evaluation of UK public sector loan schemes) – confirms that direct government energy efficiency programmes have had a clear impact in reducing energy demand (they can be both more rapid than pure price-induced reactions, and reach efficiencies that price alone cannot). Affordability necessarily also concerns how energy costs fall across consumer groups, especially since the better-off are generally more able to afford, access, and implement measures that may take more up-front investment but save energy over time.

So how does the UK response to date match up, and what are the main strategic options to manage energy prices and bills in the course of transition?

The remainder of this Commentary points to five areas for priority consideration (there are, of course, others).

1) Cost allocations and domestic bills

First, cost allocation. The system still carries significant legacy costs associated with launching the transition, in particular, the ongoing contracts under the Renewables Obligation scheme which dominate current the policy costs. Moves earlier this year to reduce industrial energy prices by exempting many energy-intensive industries from the bulk of such costs made sense.

The UK has been a real outlier in terms of the cost of electricity relative to gas, which a.o. impedes the move towards the efficiency of heat pumps. For the long-run economics of transition there is a strong case to spread the legacy costs across electricity and gas; however the welfare implications, and politics, of adding to domestic gas bills was untenable. Following policy reversals on attempts to reduce winter fuel payments for pensioners, the UK budget last week moved much of the legacy ‘Renewables Obligation’ support off bills, and on to general taxation – a sensible fix, but not a sustainable long-term approach to managing system costs.

The price of electricity also impedes the shift away from oil towards electric vehicles – which also implies a change in accounting mindsets. The Secretariat of State committed to reduce household bills by £300/yr, whilst seeking to accelerate the move to EVs. As long as ‘household energy bills’ are understood (and measured by Ofgem) as gas and electricity, it is untenable to expect them to fall if and as they incorporate a whole new sector of consumer demand, ie. personal transport. It makes no sense to exclude the cost of driving a gasoline car, but then include the cost of driving electric – which increasingly represents a net energy cost saving. Household bills must be understood, and reported, to either include personal transport or not.

The combined efficiency and emission savings afforded by electrification, across heating, transport, and many industries, underline the need for reforms which also support that wider transition.

2) Post-contract renewables

Second, we need focused attention to the treatment of assets coming off their support contracts. Over 5GW of renewables will be coming of RO support contracts within eighteen months – in 2027. In principle, one might expect that this could provide a stream of low-cost renewable energy, with the capital paid off – from generators which moreover made handsome and unexpected degrees of profits through the energy crisis.

The reality is of course more complex. But to the extent that there is a stream of paid-off renewables, consumers currently have no direct visibility of this; and if these renewables operate in the wholesale market, they will not bring down prices for anyone. Also as outlined in our briefing paper on post-contract renewables, their future prospects are actually varied and uncertain. At present, the government has no coherent approach or strategy for making best use of these past investments. If indeed the country has a forthcoming stream of cheap ‘post-contract’ renewable energy, the government needs to consider how to make best use of these for consumers – whether for energy-intensive industries, or to visibly help alleviate fuel poverty.

3) System flexibility and use of surplus renewables

Third, the cost of building and operating our emerging electricity system will depend heavily upon making the best use and efficient operation of renewable energy assets overall. Our paper on Generating Surplus identified the scale of potential surplus generation already by 2030, particularly at times of strong wind output, even without transmission constraints. Even with proposed built-out, increasing amounts of renewables output risks being shut out by transmission constraints and unused – which is potentially, an economic (and environmental) waste.

The key to making best economic use of renewables in these circumstances is to enhance system flexibility, most obviously through increasing storage capabilities over various durations. We need to also ensure that storage is located and used efficiently to enhance the use of renewables within a given region, i.e. with respect to location and transmission constraints. We have seen an extraordinary pace of innovation and cost reduction in batteries, and a wide variety of technologies hold promise for longer duration storage as well. If the government wants to make best economic use of renewables, then enhancing flexibility, at multiple levels in the system, needs to be given priority equal to, and alongside, increasing renewables capacity.

4) Energy efficiency revisited

Fourth: the budget announced the end of the ‘ECO’ energy efficiency scheme. This was launched a decade ago in the context of a misguided ‘Green Deal’ assumption that domestic consumers themselves could be the engine of household energy efficiency investments (see also the ex-post critique). ECO was therefore focused on more expensive measures, for poorer households – a focus which has proved systematically problematic. But the more that some or all households are relieved from high energy costs, the more important become overt policies for energy efficiency.

The net loss or gain from ending the ECO scheme will largely depend on the design of the ‘Warm Homes Plan,’ due to replace it. There are also ways of targeting low-interest loans to enhance buildings efficiency which avoid the mistakes of the Green Deal.   Again though, the requirement is broader. Increasingly, the built environment is no longer just a source of demand, but a source of value within the wider energy system – in which ‘fabric first’ is not always the best approach, either for the occupants or more widely.

5) Low interest loans

Finally, most elements of a low-carbon energy system are capital intensive: they are more or less expensive, depending on the time horizon considered, and in particular, the interest rate. The energy crisis and its follow-on repercussions have driven inflation, which in turn has driven up UK interest rates as the Bank of England uses the traditional (and mandated) tool to curb inflation.

This creates a double problem. Mark Carney amongst others already identified the ‘tragedy of horizons’ of short-termism in financial markets, relative to the long time horizons of climate change. Our studies of energy cost shares underline that energy is also a very long-term sector, and as pinpointed in a recent paper on ‘beyond externalities’, the capital intensity of low carbon assets at a time of higher interest rates brings a paradox. Energy costs contribute to inflation; whilst higher interest rates in general curb inflation, in the case of energy & infrastructure investment they exacerbate it, by driving up the cost of investment (and hence contract prices). The UK government needs to look carefully at the monetary rulebook to consider the case for using lower-interest loans to accelerate a lower-cost energy transition.

To conclude: the previous energy shocks were global and mostly driven by oil, driving structural changes on both supply and demand which helped to bring national energy-cost-shares back within the long term sustainable norm.  The recent energy crisis is different – and plays out alongside ever more potent impacts of climate change.  The UK’s recent measures may reduce the pain of high prices, but cannot mask the need for more far-reaching transitions, with deepened electrification across sectors. Yet the UK remains an outlier in the price of its electricity, especially relative to gas at end-use – a discrepancy which will only worsen as and when European gas prices recede. The measures taken this year do not solve the underlying problem; they are just modest steps on a much bigger journey.

With the US exiting from the process, China might have been a natural focal point. It accounts for more than 30% of global emissions, but despite continued economic growth its emissions have been flat for the past 18 months and it has now firmly committed to bring emissions down, towards its goal of net zero by 2060. China also wields huge international influence through the Belt and Road initiative.  So where does it stand?

At Belem, China was notable for its low profile. The UN process naturally has a core focus on cutting emissions.  The final documents’ omissions of any direct reference to phasing out fossil fuels underlines the political difficulty of such a focus, particularly when an implausible number of countries still hope to profit by selling more fossil fuels.

China did little visibly to push things forward. It added its voice to developing countries’ objecting to the EU’s carbon border adjustment mechanism, but even here China’s protests were distinctly muted. The mechanism aims to level carbon costs between domestic industry and imported products, to avoid adverse impacts on industrial competitiveness; China is currently expanding its own emissions trading system to encompass the same heavy industries, and knows that it may need to consider a similar mechanism.

An alternative framing would focus on the opportunities of solutions, principally from clean technologies where the pace of progress is breathtaking.

Enter the Chinese paradox.  Internally, its policies are grounded in two clear realities: that climate change is a pressing danger to the whole world (including China), which must be tackled; and that the solution is to accelerate investment and innovation across a swathe of clean technologies.

That focus has led to China now dominating global investment in renewables, with major cost reductions, but the real economic value lies deeper, in electrification. Basic physics dictates the energy efficiency gains available from electrifying end-use technologies of transport, heat, and many industries, instead of burning fossil fuels. In China, electric vehicles are now cheaper to buy, to drive, and to maintain than combustion engines (as they are in Australia and some other countries that eschew tariffs), and they accounted for 60% of new car sales last year.

Attention is turning to electricity storage and industry. China is becoming the world’s first electrostate. Whilst the share of electricity in final energy in the US has flatlined in 2010, in China it has doubled since the turn of the Century, shooting also past Europe where it has risen by about 30%. The US’s current efforts to cling to last century’s energy system is a potential gift to China, and Europe remains constrained by the inherent vested interests of its combustion engine car industry, and other legacy industries (witness the Scunthorpe steel plant in the UK).

It is not just industries, but mindsets. Many developing countries in Belem focused on the right to develop and profit from their fossil fuel resources. But the wind and sun are also major energy resources, and in fact more dominant in many developing countries. They could be clamouring for far more extensive use of those resources. What they typically lack is the technological capabilities, industries and finance – and, in many cases still, the desire, given again the drag of historical mindsets that equate economic opportunities with fossil fuels.

Yet China’s wider economic interests remain curiously ambiguous. It will not back fossil fuel phase-out until China itself is further along that road. It fears growing pressures to embed its international climate finance initiatives in the context of UN obligations. China is well positioned to benefit from global acceleration of the energy transition – but even this can be offset against a longer game: the more that other countries dither in the transition, the greater the chance for China to dominate ever further global clean technologies and supply chains.

Belem showed that Europe and the most vulnerable countries are not strong enough to overcome the resistance to progress on reducing fossil fuel use, most overtly led by Saudi Arabia with support of others including Russia, and the US. China is traditionally, diplomatically cautious on the global stage – preferring to state its position and deliver it, whilst resisting any suggestions it should “lead”.  The time will come for China to raise its voice, and that will form a decisive push for stronger action.  For the global good, the wait cannot be too long.

Published originally in a letter to the Financial Times, keep reading at UCL’s European Institute

EEIST. The year started with culmination of the (first phase of) the international EEIST programme on Economics of Energy Innovation and Systems Transition.  This was the brainchild of Simon Sharpe, who after many years in UK government concluded that the diplomatic challenges of climate change were insurmountable as long decarbonisation is cast primarily as problem of ‘burden sharing’.  Alongside the country reports of Brazilian, Indian and Chinese research colleagues, the final Synthesis report (Feb 24) highlighted insights from the overall programme including policy lessons from successes; it also underlined the extent to which different analytic and modelling approaches, as well as different country contexts, yield varied insights into the costs and opportunities of low carbon transition.

On a more personal note, this coincided with a most memorable birthday celebration (?) at the end of February. Despite the best efforts of the British railway system, many friends were able to attend the party and join a doctored rendition of the Beatles’ famous song, “Now I’m 64 …”.

World Development Report. Meanwhile, with UCL colleagues we completed two invited background papers for the World Bank’s World Development Report, “Escaping the Middle-Income Trap”. When finally published in the summer, the WDR itself reflected a new emphasis on the role of institutional, social and technological innovation in economic development. As indices, alongside capital value-added and social mobility, it added reducing emissions intensity – effectively, a proxy for displacing fossil fuels through infusion and innovation in energy efficient and low carbon technologies – as a key ingredient for enhancing economic development. Our background papers (see Commentary) contributed reviews of energy technologies, and innovation-related dynamics.

That same summer, two long-running research efforts were finally published in economic journals…

Energy Cost Share constancy. For a decade I’ve been intrigued at the claim of the Russian energy efficiency expert Igor Bashmakov, that the share of energy costs in GDP was approximately constant, irrespective of energy prices.  His original inspirate was the observation of how economies very low, highly subsidised energy prices, ended up with profoundly inefficient and wasteful energy systems; my own interest was also at the opposite end, the response to oil price shocks.  Working with Igor and colleagues, our paper on Energy Cost Constancy expanded analysis to a far wider set of updated data, advanced theoretical reasons for this observation, and discussed policy implications; as summarised in my Commentary, these are much more subtle than just “remove energy subsidies and tax carbon”.

Dynamic Determinants. In the Autumn came publication at last of a modelling study, that my wife had come to dub “the infinite paper.”  With important contributions from several former Cambridge colleagues and others, our analysis injects a new dimension to critiques of the economically-iconic DICE model, focused on the way in which including inertia and induced innovation can substantially amplify the benefits of earlier & stronger emissions abatement efforts whilst reducing long-run costs. Given the ubiquity of DICE as a reference point for most economic classes on climate change, reviewers insisted that we demonstrate how our model compares with DICE itself. Our appendix, duly added to pinpoint this, demonstrates that most of the apparent sophistication of DICE seems irrelevant compared to its lack of mitigation dynamics. The resulting paper Dynamic Determinants of Optimal Global Climate Policy is summarised in an INET commentary they deftly titled, “Time to stop rolling the DICE..”.

Infinite no more, but of course, the paper still raises a host of issues meriting further study and the model is very simplified – primarily, a stylised provocation for economics to take mitigation dynamics far more seriously.  I was tangentially involved in two other papers appearing in 2024 which speak to the real complexity of these issues, namely Modelling induced innovation for the low-carbon energy transition: a menu of options, led by our EEIST colleague Roberto Pasqualino, and The use of decision making under deep uncertainty in the IPCC, led by IPCC stalwart Robert Lempert.

The wider literature on energy transition has of course exploded over recent years. I’d intended this review as just a brief summary of works I was personally involved in, but I find myself impelled to mention two other, very different, contributions.

First, and so far inadequately recognised, 2024 saw publication at last of a remarkable contribution to economic theory, in Carl Christian von Weizsäcker’s concise book, Freedom and Adaptive Preferences.  Built on decades of work, he accepts the reality that human preferences adapt, something which seems an indigestible challenge to most economists given that fixed preferences (“the Utility function”) are typically a foundational assumption of classical economics. Instead, von Weizsäcker develops a whole new theoretical and mathematical framework for analysing the implications of preferences which adapt in the light of experience. To my mind, this is the kind of contribution that truly deserved a Nobel Prize. Amongst many other observations, he concurred that it likely provides a theoretical foundation for understanding the evolution of human altruism, and it potentially adds an important micro-economic perspective to the growing literature on ‘social macroeconomics’

Not on the same scale, but equally significant in terms of applied climate policy, a final pointer to a great paper on international spillovers by Michael Mehling. Climate policy is a global problem in which a coordinated global response is politically impossible. A lot of economic analysis and political discourse has focused on negative dimensions – “free-riding” and the cost of unilateral actions exacerbated by risk of carbon leakage, i.e. “negative spillovers”. But factoring in technological, institutional and social innovations implies large potential from positive spillovers, from actions in one region to others.  Mehling’s paper on “Good spillover, Bad spillover … ” is to my mind the first to thoroughly articulate this, and to sketch potential implications for policy.

2024 was widely heralded as the “year of elections.”   Given some of the outcomes, such broadened thinking on ways to make progress in a fractured world is sorely needed.

In August 2023 our researchers also published Seven Propositions for UK Electricity Policy to 2030, for the UK government to consider in electricity market developments for deep decarbonisation.

New UCL centre to address electricity market design for net zero

Press Release: Thursday 12^th September 2024

The new UCL Centre for Net Zero Market Design will work across academia, industry, government, regulatory bodies and other stakeholders, to provide expert advice on the best policies and practices for creating and maintaining effective electricity markets as we decarbonise power systems in the UK and beyond.

Based at the UCL Institute for Sustainable Resources, the new Centre will provide analysis and expert input for the UK Government’s programme to decarbonise electricity over the decade, including the ongoing Review of Electricity Market Arrangements (REMA) programme.

The transition to net zero energy infrastructure will involve major changes for electricity generation, networks and flexibility, likely requiring hundreds of billions of pounds investment, mostly from the private sector. The Centre aims to provide recommendations to ensure that electricity markets are robust, power supplies are reliable, costs are manageable and carbon emissions are reduced to net zero. An initial project will examine how increasing periods of potential surplus generation (e.g. on very windy days) will impact further investment in renewables, and what market design changes may be needed to bring forward storage or other flexibilities.

The new centre also will work with Masters courses at UCL to support the development of new talent and expertise, to help policymakers and industry to tackle upcoming electricity system challenges.

Centre Director, Professor Michael Grubb (UCL Bartlett School of Environment, Energy & Resources) said:

“This new Centre fulfils an urgent need for expert insight and academic rigour as the UK seeks to transition its electricity sector to net zero. This requires independent research, informed by industry data and expertise, backed by understanding the needs and constraints of practical policymaking. The evidence-based insights and recommendations from our Centre’s activities aim to help the UK deliver its globally-leading ambition, informed also by emerging international experience.”

The new Centre will offer original and independent academic insights into the policy and regulation of the energy markets, particularly around how to best integrate sustainable and renewable technology at a time when the energy market is being fundamentally re-examined.

UK electricity has already made significant steps towards decarbonisation. However, there are still many outstanding questions around the design and operation of a system predominantly powered by renewable energy. More than a third of the UK’s electricity now comes from wind and solar, but this shift has produced its own challenges, including a mismatch in power supply and demand as weather varies.

To tackle this issue, expanding storage capacity at different levels of the system from local to national is required to even out the supply. How to encourage the necessary investment and operational changes and to expand storage capacity both economically and effectively likewise needs further analysis.

Additionally, as more heat pumps are installed in homes and electric vehicles are on the roads across the UK, demand for electricity will increase.

Professor Jim Watson (Director, UCL Institute for Sustainable Resources) said:

“The UK has been a world-leader in liberalising its electricity system, and in the pace of its transition away from coal generation and the expansion of offshore wind energy. Sustaining progress is vital to fight climate change and ensure a sustainable world for future generations. It involves a set of new challenges but must protect consumers. The rest of the world is watching and the transition has to be done right. With research at the Centre, we’re analysing critical challenges facing the electricity industry.”

The research priorities of the Centre will initially focus on some of the major challenges outlined in the Government’s REMA programme, and will look to support global efforts to accelerate decarbonisation of electricity.

Over time, and informed by a senior Advisory Board of stakeholders, the Centre will continue to adjust its focus to keep up with emerging conversations and challenges as they arise.

Advisory board chair Simon Virley, Vice Chair of KPMG, said:

“No one organisation has all the answers when it comes to navigating the energy transition. So, we have to find new ways to collaborate across government, industry and academia to find the best solutions. I’m pleased to be chairing the Advisory Board, which can help facilitate that sharing of views and collaboration.”

The launch of the Centre has been supported by Centrica plc, SSE, Rothesay and National Grid.

Alistair McGirr, the Group Head of Policy and Advocacy at SSE said:

“We are delighted to help start up the new UCL Centre for Net Zero Market Design. We have been collectively thinking how to accelerate clean electricity cost effectively, and the Centre will provide welcome and important contributions to move us forward. We’re particularly excited by the important role the Centre will play in developing the future market design experts that will help solve the energy system challenges of the future.”

Chris Bennett, Director of UK Regulation National Grid said:

“As we approach the middle of a key decade on the path to net zero, we look forward to collaborating with and supporting the vital analysis and research of the UCL Centre on Net Zero Market Design to offer solutions and recommendations for the energy transition. The challenge ahead is a complex one which requires minds from across the academia, industry and government landscape to come together and we’re excited to play our part in this.”

Links

• UCL Centre for Net Zero Market Design
• Professor Michael Grubb’s academic profile
• The Bartlett School of Environment, Energy and Resources
• The Bartlett Faculty of the Built Environment

For a more technical summary of key points of the paper, see also “Time to Stop Rolling Dice: Why Bigger is Better in Climate Investments” published as an article by the Institute for New Economic Thinking.

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Anyone involved in energy technologies and systems probably knows the following intuitively.  Energy technology costs usually come down with scale and investment (typically if imprecisely known as induced innovation). Most major energy developments involve long-lived capital – whether specific investments in production (e.g. mines, wells), conversion (e.g. power plants, refineries), or networks (like electricity grids and fuel distribution); or indeed end-uses (e.g. energy efficiency of buildings).  Along with the times taken for new energy technologies to diffuse globally, this creates inertia in global decarbonisation.

For these and other reasons, energy systems are what economists call path-dependent to an unusual degree. What we have today depends on past decisions, what we do today affects what is possible in the future.

To many people that may seem obvious, but it is not how many stylised economic models – and most notably, the ‘canonical’ DICE model used globally in economics classes today – represents the economics of decarbonisation.  Pioneered by Prof William Nordhaus in the1990s, that model embodies a simplified world with a focus on the optimal trade-off between the presumed cost of emissions reductions at any given point in time, against the benefit of reduced subsequent climate change. In economic terms, the model calculates an equilibrium balance for each sequential period, based on projected ‘static’ technology costs which aren’t affected by the pace of emission cuts or scale of prior action.

My colleagues and I have now finally published a formal, stylised model on Dynamic determinants of optimal climate policy intended to challenge that thinking. It is the result of a long journey since we started probing ways to overcome the intrinsic limitation in such stylised economic modelling about the ‘abatement cost’ side of the problem, which has received far less attention from mainstream economics.¹  It is not by any stretch the only such effort, nor the most sophisticated; indeed, one of our points and motivations is that whilst many models have been developed to start grappling with these complexities (with more technologies, assumed lifetimes, maybe technology learning rates etc), their very complexity risks missing the big messages. None have displaced the general approach of ‘static-equilibrium’ models, as the archetypical approach to economics teaching on climate change, which still frames much economic thinking.

To be sure there has been vast economic debate about DICE and related models, but almost all the focus has been around representation of climate damages and risks (and how to balance that in present-day equivalent, through time-discounting). Yet this implicitly both neglects inertia in emission reduction, and assumes that low-carbon investments in one period do not affect the cost of future emission reductions. Consequently, such models tend defer stronger action until low carbon technologies are assumed – by the modeler – to ‘exogenously’ become cheaper over time, then allowing steep future emission reductions.

The bottom line is that our new analytic model demonstrates the optimal global level of low-carbon investment to be bigger – maybe much bigger – when the dynamics of energy systems are incorporated.

This is obviously true when faced with a fixed target, in which case recognising inertia in the energy system stops models from deferring action and then dropping emissions suddenly as the threshold temperature approaches.  We represent aggregate inertia very simply, in terms of a typical transition time required to achieve major system changes.

But it is also true for ‘benefit-cost’ models which seek an explicit ‘optimal balance’ of climate damages against the (presumed) cost of emission reductions, when we include a significant measure of what we term pliability.  This represents the overall ability of technologies and systems to respond to economic incentives, scale, and constraints (in early versions of the work, we called this adaptability, but our conference submissions kept getting shunted into sessions on adapting to climate impacts instead, the opposite of our main focus).

In this, readers may note a clear logical link to Bashmakov et al paper that I highlighted in the first of these three summer 24 Commentaries, #1 on Energy Cost Constancy. This showed the extent to which energy systems have adapted to past price shocks, so as to bring overall national energy expenditure back within a limited range. Yet, it takes time – maybe 2-3 decades – to complete the adjustments in technologies and system structures.

Readers would also be right that the underlying approach is not new; not least, it ‘just’ formalises the structural arguments we set out in a 2021 review paper critiquing the conventional modelling approach. But as colleagues observe, data and arguments are not enough: modern economics is a field in which “it takes a model to beat a model”.

The distinguishing feature of our model is a highly stylised representation of system-level dynamics – specifically, the logical consequences of induced innovation, inertia and path-dependencies – in emissions abatement.  Rather than representing the ‘economically optimal’ approach as one which trades off present costs of emission reductions against the future estimated benefits of avoided climate damages alone, it captures also the potential impact of present-day investments on future energy technologies and systems. Thus it reflects at system level the overwhelming evidence that technologies evolve in response to economic incentives and scale effects, and the reality that energy systems involve large capital investments with long lifetimes, and other factors (e.g. inertia from networks and institutions). Consequently, emission reductions in any given period face transitional costs, but also will reduce the costs of subsequent emission reductions through their dynamic impacts.

The new model shows that for any given set of assumptions about the severity of climate change, the economically optimal level of investment in emission reductions is sensitive to this core assumption. Indeed we show that incorporating these dynamics can more than double the economically optimal level of investment, for the same underlying assumptions about the severity of climate change damages.

The paper is novel in presenting a stylised model with an analytic mathematical solution (‘Theorem 1’), which pinpoints the mathematical significance of these dynamic factors and also highlights analytically the extreme sensitivity of optimal investment to time-discounting in the traditional ‘static-cost’ approach.[2]

An extension of the analysis (‘Theorem 2’) also presents the optimal level of investment when faced with a fixed goal, like the Paris Agreement temperature targets, designed to avoid potentially catastrophic risk thresholds.  Whilst the conventional economic models tend to ‘optimise’ a trajectory which involves late, steeply ‘negative emissions’ as the temperature limit is approached, to help clean up earlier emissions that remain in the atmosphere, the dynamic model shows a much smoother pathway of global emission reductions, with more effort to change course immediately.

The discussion in the paper underlines that of course our model, like all models, is a huge simplification.  But it doesn’t just imply that more effort is justified, whether in a target-based world or a ‘global cost-benefit’ framing.  By highlighting the importance of dynamic factors like induced innovation/scale economies, and inertia, it necessarily implies that policy effort needs to be more nuanced.  It doesn’t simply imply ‘a higher carbon price’ is justified.  It indicates that policy needs to prioritise actions to decarbonise the systems with the greatest inertia, and in areas with the greatest potential for innovation in technologies, supply chains, and business models in response to investments at scale.

In this, we hope the paper may also stimulate not only greater mainstream economics attention to the climate problem overall, but also contribute to far more sophisticated consideration of the ‘solution’ side of the problem – which seems inadequate in economic analysis – partly because of the over-simplified framing in conventional economic approaches.[3]

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A final Coda, on what may seem like something totally different.  As our paper was published, news arrived that a proposed new coal mine (for steel coking coal) in the UK has been ruled illegal.  This drew on a UK Supreme Court ruling from July stopping a new oil development on the grounds that emissions from burning the oil should have been considered. Proponents of the mine had argued that, aside from the claimed jobs benefits, the development would have a “broadly neutral effect on the global release of greenhouse gas”, because the coal produced in the UK would simply displace other coal.

It struck me that this is a little microcosm of the economic debate between static and dynamic characterisation.  In a static world, a more efficient new coal mine might displace dirtier mining elsewhere (at least if one ignores possible impacts on coal price of additional supply).  But building a new coal mine, intended to fuel coal-based steel-making for the next 25 years or more, puts more capital in the wrong direction. It enhances inertia in the coal and blast furnace steel sectors, and has obvious dynamic implications for other technology, investment and policy choices. It has global ramifications – influencing about expectations about what other countries might do and justify.  It pays no attention to the wider incentives and alternate investment paths – for example, in clean steel.

Thus it is vital for economic analysis, as well as wider debate, to understand not only what might be the impacts for emissions ‘today’, in a static worldview which justifies something ‘a bit cleaner’ now if it may displace something worse. Economic models and mindsets need to fully embrace the dynamic implications of decisions today, for the global transition over decades.

Notes:

[1] Top-decile economic journal in 2023 Rankings, Journal Impact Factor and Journal Citation Indicator Indices.

[2] The sensitivity of global climate cost-benefit results to the discount rate is well explored numerically in studies with DICE; our model shows that with the traditional static-cost equilibrium framing, the optimal investment includes a term that is inversely proportional to the discount rate to the power 6. 

[3] Indeed, a UCL Professor did research on the relatively small coverage of climate change in top economic journals; when I asked why, he said he thinks it is not because economists think the problem is unimportant, but because they think it is really conceptually simple (and therefore boring) – just calculate the damages, and set an equivalent price on emissions. Understanding the dynamics of energy systems makes it far more interesting than that.

The extent to which its recommendations are taken on board thus matters not just to those countries and three quarters of the world’s population, but in fact, to the entire world. But the report also presents an important intellectual evolution in the analysis of economic progression now entails.

The high-level policy narrative

The major policy thrust of the WDR is on the question of whether and how middle-income countries can aspire to join the league of rich, developed countries – to escape the ‘middle-income trap’ of the title.  The WDR points out that they are far from on track to achieve this, and is very direct about prioritising growth.  The question it addresses is why their growth has slowed down after basic industrialisation, leaving most of them still ‘trapped in the middle’.

The core argument is that the old mantra of investment to increase capital stock is inadequate – the economic returns to further capital accumulation, in itself, decline rapidly.  The focus thus needs to turn towards the enablers of better technology and innovation.

I say ‘technology and innovation’ as distinct, because the WDR argues that in fact there are two different “traps” – or at least, structural bridges to cross.

One is moving from a focus on investment per se, to the adoption of better available technologies, to maximise efficiency in its broadest meanings. This builds on many years of World Bank research on the fact that many developing countries – and particularly the low and lower-middle income countries – still predominantly use technologies that are far from the best available.  In economic language, most are far from the technology frontier, that reflects the trade-off of cost and performance across the range of available technologies.  In theory, they have had huge potential to catch up by absorbing better technologies, but few have done so. The implicit assumption of much neoclassical economics – and certainly, many optimising models – is that at least those economies with market economies and cost-reflective prices, by enabling people to buy the best products (in terms of the cost-performance trade-off), should gravitate naturally to the frontier. The fact that they have not – for some, decades after basic industrialisation took them to middle-income status – seems to fly in the face of the conventional economic reasoning.

Infusion …

In the area of energy, some of the statistics are particularly striking: the WDR notes (p.13) that “Middle income countries have .. both misallocation in the use of energy (with the energy intensity of GDP also 2.5 times higher than in high-income countries) and the lower diffusion of low-carbon energy technologies”, which the WDR notes as now often highly cost-effective.  An ‘energy efficiency gap’ has long been noted and debated globally amongst energy economists, and energy intensity is an imperfect measure. But the World Bank has developed extensive methods to measure distance from the technology frontier and its focus on developing countries being much further still from the frontier brings a new lens to what amongst my own research colleagues we came to term ‘first domain’ economic analysis – understanding the reality of why people and economies seem to be structurally inefficient, often operating far from the technology fronter, and (maybe) especially so with respect to energy.

To follow basic investment, the WDR thus notes the corresponding task as infusion of better technologies.  They chart the difficulty of moving from capital accumulation to adoption of leading technologies, as the first of the two ‘traps’.  Of course, that requires countering growing protectionism and barriers to trade, but the WDR also charts numerous other barriers, many arising from domestic policy, governance, institutions.

… and innovation

To varying degrees, the upper-middle income countries have managed to bridge this step to ‘infusion’ in at least some sectors – though they remain constrained by other path-dependencies. In energy, this includes the powerful role of incumbent fossil fuel industries and State-Owned enterprises, which typically dominate the coal investments (and are mostly marginal in renewables).

More generally, most of the of them still languish in the ‘second trap’ – the step to becoming innovators, and thus sharing the leading edge of innovation-related economic benefits, where the OECD countries (and increasingly, China, the main exception) dominate.

It is in this area that the WDR really starts to break new ground.  It had to, because the traditional focus of much equilibrium-focused economic theory, stressing optimal resource allocation, has had little useful to say about innovation beyond stressing the role of open markets. It involves going well beyond the traditional World Bank policy mantras of placing the central challenges as market liberalisation and subsidy removal to foster optimal resource allocation.  Understanding what moves the technology frontier, and in what directions (what we have come to call ‘third domain’ economics), thus becomes crucial – for that has been a key fount of wealth for the rich world, which most middle-income countries have failed to access.

New thinking on processes of creative destruction are woven into the intellectual fabric of the WDR.  This includes the Janus-like roles of incumbent industries, as both blockers and innovators. The traditional attention to SMEs as the fount of entrepreneurial innovation in market economies, shifts to understanding the interactions between SMEs and larger players.

Another key foundation is that innovation is fundamentally cumulative. It builds on the shoulders of existing capacities and nurtured capabilities, as well as supportive social environments. Hence, the WDR contends, developing countries cannot ‘run before walking’, pointing to the mixed (and limited) record of countries that tried to ‘leap-frog’ by shielding domestic industries from infusion of better international technologies. The step from ‘infusion’ of leading technologies to becoming innovators is itself difficult – the second ‘trap’ – and cannot be short-circuited.

Prescription and the new focus on energy and ‘emissions intensity’

To those of us directly engaged in energy and climate change, the WDR is especially interesting for its treatment of these topics.  As in the wider development community, past years have seen extensive debates within the World Bank between those emphasising the imperative to tackle climate change, and those stressing the need (and right) to prioritise development – often wary of the perceived ‘western-led’ climate agenda. The WDR is emphatically not a report about climate change, but it emphasises the additional challenges that climate change is posing for development. Indeed, the very first page of the WDR refers to the fact that “prospering while keeping the planet liveable will now require much more attention to energy efficiency and emissions intensity.”

That is useful but hardly revolutionary.  What is truly striking is the way the WDR redirects the attention of the growth agenda away from accumulation (of capital and labour resources), to more directly metrics of positive progress in relation to each of the three principal component factors of socio-economic improvement: capital, labour, and energy.  

Specifically, it calls for a focus on

• Monetary value-added as the metric of productivity of a nation’s capital, particularly regarding the productivity of firms;
• Social mobility, including education and social structures which allow the broadest application of talent by breaking down the barriers to progression of disadvantaged groups;
• And Emissions intensity reduction, as a metric which combines the intrinsic economic value of enhancing energy efficiency, the value of countries harnessing the rampant innovation now under way in clean energy technologies – and the avoided environmental damages (including climate change).

Thus the WDR clearly recognises not only the severe risks to development from climate change (and other environmental costs), but also the benefits of enhanced energy efficiency and the opportunities arising from the renewables revolution – including that middle-income countries, on both counts, are clearly lagging relative to the developed countries (whose own economies are now also clearly ‘behind the frontier’).

There are some really interesting technical dimensions of the WDR’s analysis that I will return to in a fuller article (maybe, along with some reservations about aspects of its energy policy analysis).  But I’ll finish with emphasising one broad global point, beyond the explicit scope of the WDR, which tbh has only recently really struck me.  Emerging from the confluence of different strands of research, is the extent to which the global energy system is currently still biased against the transition that almost everyone now acknowledges to be needed.

An article by Martin Wolf in the Financial Times highlighted two major aspects of this, and I was glad to get a letter in the FT outlining three more sources of structural economic imbalance – aside from some of the more institutional dimensions of incumbency highlighted in the WDR.   The UCL European Institute helpfully put these together in blog on the way current global energy markets are structurally stacked against clean energy, underlining the need for sustained government policy internationally – and the potential benefits just from ‘levelling the playing field’.

That, and the energy transition as a frontier of global innovation, is something that all economists should consider. And those are things that governments not only of the rich world, but all the 108 middle-income countries, would do well to ponder as they begin to prepare their second round of Nationally Determined Contributions on climate change, due next year.

*****  Background Papers *****

At UCL our own efforts contributed two background papers to the WDR, available on their website:

• Energy Technologies for Low-Carbon Development in Middle-Income Countries: Assessment and Implications.

And

• Dynamics of the Energy Transition: Innovation, Transition Economics and Path Dependency.

Nice to see several hundred downloads already of these rather substantial efforts.  Abstracts pasted below, in case of interest.

First, experience. The IPCC Sixth Assessment (Mitigation) saw sometimes vibrant debate between a majority narrative on the clear inadequacy of global trends and apparent paucity of effort – “everything much change” – and others looking more closely at the substructure – to learn and “broaden, deepen and accelerate what works”.  One oddity was how relatively little academic work focuses on evaluating what has been done, and what is has delivered – though it was sufficient to get the statements into the IPCC Summary for Policymakers on the extent to which those efforts had already shaved several billion tonnes off the growth of global emissions by 2016.

In November 2023 the Annual Review of Environment and Resources published our in-depth and updated review of this evidence, with the major work led by the brilliant combination of  Janna Hoppe and Ben Hinder: Three Decades of Climate Mitigation Policy: What Has It Delivered?.  We estimate that policies to date have reduced global emissions by 2-7 GtCO2/yr, but argue also that more attention must be given to other indices, including the remarkable progress in low carbon technologies, and enhanced efficiency, as well as land use.

In the run-up to COP, some big guns – the heads of three major international institutions – combined forces in the FT to call for no more business as usual: the case for carbon pricing.  One can sympathise with much of what they say in principle, and yet still be perplexed at the naivety of the message (and the theory).  It is sad but perhaps telling that after such an urging, the negotiations on market instruments were the one main element of the COP negotiations that failed to reach agreement.

One thing our mega review stressed was that, after 30 years of advocacy, no country has relied solely, or even predominantly, upon the standard economic recommendation of carbon pricing.  All have used a mix of policies, sometimes after struggling and failing with efforts to implement a carbon price.   A second paper, just published in the Oxford Review of Economic Policy, gives theoretical foundations for understanding this reality and, indeed, precisely why a mix of policy instruments makes economic as well as political sense.

Building upon the book Planetary Economics, we articulate fundaments for understanding Policy complementarity and the paradox of carbon pricing, emphasising that different policies can and must reinforce each other, not compete. The paradox is simple: carbon pricing cannot succeed unless its advocates are more humble and embrace the contributions that other instruments make to a successful transition strategy.

But for carbon pricing sceptics, one word of warning: it is the combination that counts. As my Indian IPCC colleague Shreekant Gupta remarked: if prices in an economy don’t reflect the strategic goals – including the imperative to cut emissions – then everything else will ultimately be harder.

A broad conclusion from these, and related works under the programme Economics of Energy Transition and Systems Transition, is that in economic and policy terms the world can, and now has the knowledge of how, to hugely accelerate global progress after the Global Stocktake – however strong, or weak, one views the COP28 decision to be.

My own broad submission to the Global Stocktake, available at https://unfccc.int/documents/627224, offered a brief take on some international lessons and possible implications for the international agenda.  But as one seasoned participant in the COP process remarked to me: the real world of implementation, ‘what works’, and the economics of the opportunities arising in the transition, increasingly seem like a different world from the ‘burden-sharing’ mindset of the COP negotiations.