December 10, 2022

Confronting the Growing Odds of a Late and Disorderly Energy Transition

The Network for Greening the Financial System (NGFS) has published its latest climate risk scenarios with an accompanying assessment of the global energy crisis.
Released earlier this month, the assessment by a team of central bankers — led by Luiz Awazu Pereira da Silva, deputy general manager of the Bank for International Settlements in Switzerland – argues that it’s not too late to avoid a late and disorderly energy transition.
On the contrary, it says, the world energy crisis of 2022 – the most acute in half a century – presents a narrow but unique opportunity to accelerate the transition to net zero.
Founded in 2017 by eight countries — China, France, Germany, Mexico, the Netherlands, Singapore, Sweden and the United Kingdom — the NGFS now comprises 116 central banks and financial supervisors including the National Bank of Cambodia.
Operating from a secretariat at the Banque de France in Paris, the network is currently chaired by Monetary Authority of Singapore Managing Director Ravi Menon.
In a statement released on Sept. 7, the Singapore central bank governor noted that natural disasters were increasing in frequency and intensity.
“Climate change is not taking a pause for the current energy crisis,” Mr. Menon said.
“The key risk to guard against is to lock into a carbon-intensive pathway that will prove very costly to transition away from in future or lead us into catastrophic climate change.
“We must ensure that any increase in carbon intensity to alleviate the energy crisis is strictly temporary. We must seize the opportunity presented by the current high prices of fossil energy to accelerate investments in renewable energy and substantially increase energy efficiency. The financial sector must stand behind this effort.”
Mr. Pereira da Silva, a former deputy governor of the Brazilian central bank, made similar remarks.
“The current crisis, with all its tragic dimensions, represents also a unique opportunity to take decisive action toward the net zero transition,” he said.
“Its longer-term benefits are even stronger especially after the relative price shift with the sharp rise in the cost of fossil fuel. This can be additional incentives to be used to show it is not too late to avoid a delayed and disorderly transition.
“Today, accelerating the transition is even more so our best option to reduce the social and economic costs, the large financial risks that climate change is bringing us.
“Naturally, this has to be done with pragmatic decisions and coordinated planning to help overcome the challenges associated with the scaling up of necessary investments in non-fossil energy sources and mitigate the negative redistributive impacts of ‘fossilflation’.”
A SUMMARY OF THE ASSESSMENT APPEARS BELOW
The release of Phase III of the NGFS climate scenarios on Sept. 6 coincided with very particular circumstances for the global economy with three main developments.
First, the Russian invasion of Ukraine in early 2022 exacerbated increases in fossil fuel prices, which started in 2021. Compared with December 2020, prices had increased by 2.5 times for oil and 4 times for natural gas as of mid-2022. Attempts to find quick substitutes to ease the gas shortage spurred dramatic demand for coal. Prices have been high and volatile ever since.
Second, inflation has picked up, notably on the back of higher oil and gas prices with a possible contribution from the energy transition. Central banks have been addressing this with determination in a timely fashion by tightening monetary policy. But increasing the supply of clean energy is more necessary than ever.
Third, the global economy has been confronted by an unprecedented number of climate-related extreme weather events from floods in Europe and China a year ago and now in Pakistan to repeated extreme heatwaves and droughts in South Asia, Europe and elsewhere over the past six months, not to mention a series of wildfires. These events strongly illustrate worse developments to come as climate change becomes more visible and chronic consequences accelerate.
The NGFS Phase III scenarios provide a first attempt to measure the impact of the growing frequency and intensity of acute physical risks on GDP while improving estimates of the impact of chronic physical risks.
Despite being conservative and partial, these estimates under the Current Policies scenario are strongly diverging from those under an orderly transition Net Zero 2050 scenario as early as 2030, rising to a 5 percentage point difference in 2050 and increasing dramatically afterwards.
Shifting away from gas to coal, rising global coal consumption to all-time highs and expanding natural gas infrastructure are major immediate setbacks for the de-carbonisation of the global economy.
Moreover, the latest estimate shows that carbon emissions were on the rise again in 2021, further depleting the remaining carbon budget.
The jury is still out on the longer-term effects of these relative price changes in the primary energy mix and whether they can spur the much-needed reduction in greenhouse gas (GHG) emissions.
However, the NGFS scenarios can shed light on the impact of these developments on the transition and help navigate the current difficult choices.
GROWING ODDS OF A LATE AND DISORDERLY TRANSITION
The war in Ukraine, in addition to being a tragedy, is a wakeup call to the costs and risks of fossil fuel dependence. It has offered a unique opportunity to accelerate the transition to low-carbon energies.
The higher cost of producing energy with fossil fuels has three effects.
First, it spurs energy efficiency – necessary to reach net zero emissions by 2050, as evidenced by the massive adjustment following the 1970s oil price shocks.
Second, it makes renewable and nuclear energies much more economically attractive. At a time when part of the world has already been investing in the energy transition, the relative returns on such investments are much higher than they were a year ago.
Third, it may also spur investment to increase fossil fuel production, although returns could be compromised by the future tightening of climate policies (via regulation or carbon pricing mechanisms).
The transition requires major investments in renewable electricity infrastructure and storage – 40 percent more each year on average in the Net Zero 2050 scenario compared with the Current Policies scenario.
But it also requires fossil fuel investment decreases of 40 percent in extraction and 70 percent in electricity generation (based on the same two scenarios).
Eventually, the success of a transition hinges on this capital reallocation, where overall annual increases in energy investment are limited to about 5 percent.
This capital reallocation is now even more challenging.
Supply bottlenecks or technological advances were already critical issues constraining the pace of the transition.
Now, new investments to increase the supply and diversify the sources of fossil fuel raise the probability of a Too Little, Too Late scenario.
It also puts international collaboration at risk and raises the odds of a disorderly transition.
The odds of a Too Little, Too Late scenario are growing. But a successful net zero transition is still in reach.
The cost-benefit analysis of such an option is far more favourable due to the importance of energy security.
The more certainty investors have about government commitments to achieve the Paris Agreement – and their willingness and capacity to maintain fossil fuel prices at a relatively high level even after the war (via higher carbon pricing or incentives for low-carbon energy for example) – the larger the funding of greener production and consumption.
The global energy is crisis as an opportunity to tighten regulations in the real economy (by phasing out fossil-fuel vehicles, for example), accelerate the implementation of carbon-pricing systems and provide subsidies for renewable and other transition technologies to at least compensate for the normalisation of fossil fuel prices forecast in the near term.
This means giving up the future possibility of cheaper fossil-fuel energies which means partly missing out on their disinflationary impact, if not compensated by lower renewable energy, to make sure time is wisely spent on adjustments to avoid fossil fuels.
The consensus among experts is that an early and orderly transition is less costly than a late and disorderly adjustment. If fossil fuel prices are simply maintained at current levels, there is no further inflationary impact.
Turning to price stability, central banks are well placed to secure the return of inflation to low and stable levels even without a windfall of future decreases in fossil fuel prices.
SHIFT IN FOSSIL FUEL PRICES IN A LONG-TERM PERSPECTIVE
Since the start of the war, fossil fuel prices have quickly caught up with future prices needed to achieve the NGFS orderly scenario for Net Zero 2050.
For instance, the oil price increase between 2020 and mid-2022 is as large as the increase required by 2040 under this scenario.
If sustained, this increase should discourage recourse to oil and other fossil fuels by nearly as much as a carbon tax increase would generate by 2040.
But there are several caveats.
Short-term costs are associated with abrupt shifts in fossil fuel prices. When a 10 to 15-year price trajectory is known in advance – as in orderly scenario for Net Zero 2050 – the adjustment costs of the transition can be spread over time.
But a sudden price increase as in 2021-22 is much harder. Businesses and consumers cannot adjust production and consumption overnight or within a few months.
So even an abrupt and immediate transition to net zero, would be more costly than under the orderly NGFS scenarios.
This is by far the cheapest and safest possible option.
But supply constraints on natural gas and changes in relative prices could also lead to an opposite course of action – replacing gas with coal which, based on preliminary studies, could more than double GHG emissions.
A potential risk here is to see substitution in energy consumption translated into production of more fossil fuel energy.
This could make the low-carbon transition much less likely, leading to the worst-case Too Little, Too Late scenario with extremely high costs driven by fossil fuel energy prices in the short-run and a dramatic increase of acute and chronic physical risks in the long-run.
Some European countries have started to think about a return to coal and emerging markets like China and India have raised coal production following winter power shortages in late 2021.
The situation is aggravated by too fast energy price increases in the short term which have impaired people’s disposable income and weakened their purchasing power.
Low-income households are suffering the most.
Targeted government support like temporary subsidies could help people in need live through this accelerated transition by changing their consumption behaviour in the longer term.
Public investment in infrastructure needed to transition – such as railways and low-carbon cities – and research into new technologies would also increase the chance of an orderly transition.
In the medium to long run, consumption of fossil fuels is most likely to fall if prices remain high and renewable energy consumption increases.
The years following the oil shocks of the 1970s witnessed major improvements and innovations that led to energy efficiency and a more balanced energy mix. We especially saw increased use of nuclear energy in response to oil price surges.
MAXIMISING THE ODDS OF AN ORDERLY TRANSITION
THE energy crisis has put us on a path towards a delayed and disorderly transition. The risk of shifting to a Too Little, Too Late scenario, too abrupt changes in energy prices and constraints to increase low-carbon generation capacity in the short term have heightened risks of a return to the use of coal to ensure energy security.
This can strongly delay promised carbon emission reductions, or even put the transition at risk.
What can we do to alter the transition course back and ensure we reach the Paris Agreement goals while minimizing the related economic and social costs?
First, governments need to reaffirm collective and individual commitments to tackling climate change.
They also need to make their transition plans transparent and adapt them to the latest geopolitical developments. Hopefully, this is already happening.
Where possible, governments could also think about ways of making carbon pricing a pivotal instrument for the energy transition. The near doubling of oil prices from an average US$ 55 a barrel to US$ 115 in May 2022 will likely reduce oil consumption in the long run.
When the geopolitical situation eases, pressure on energy supply will be alleviated and fossil fuel prices will fall.
Policy makers should therefore seize the opportunity to lock in higher fossil fuel prices for end users.
An obvious way would be to scale up carbon taxes or other price regulations to discourage fossil fuel consumption.
Governments could act now to design and implement carbon-pricing mechanisms, scale back energy-related tax cuts and subsidies or introduce carbon taxes or emissions trading systems.
To help vulnerable households, governments should leave relative price signals to function to the extent reasonably possible – by providing monetary subsidies, for example.
International solidarity and cooperation would greatly help the implementation of carbon taxes worldwide and minimise collateral damage to competitiveness and growth.
Finally, even with carbon pricing in place to keep fossil-based energy expensive, the transition away from fossil fuels to alternative energies and new technologies cannot happen without a major reallocation of capital to fund more efficient energy use, storage technologies and a higher share of renewables in the energy mix.
In this regard, finance – both public and private – plays a critical role.
And this calls for collective and timely actions to scale up green and transition finance and spur the much-needed innovation and technological progress without which a green transition is just not possible.
In this regard, the Central Banks and Supervisors Network for Greening the Financial System has leveraged its members’ experience and set out some key considerations to enhance market transparency and develop market incentives to unlock new efficient tools for financing the transition.
Although an abrupt transition to net zero is the most preferable option to ensure we reach our climate goals, the implied economic and social costs could disproportionally impact certain parts of populations.
Targeted government measures are needed to limit inequalities and incentivise changes in consumer preferences.
CONCLUSION
The energy crisis puts the world economy at a crossroads.
It may have significantly heightened the risk of a disorderly energy transition – or at least a significant delay thereof – and is putting the entire transition at risk, with immense environmental and economic costs.
Without readily available green replacements, abrupt price increases and the resulting rapid shutdowns of carbon-intensive energy sources put energy security at risk and could cause a GDP contraction of 5 to 10 percent within five years.
At the same time, renewed demand for coal in the absence of sufficient natural gas supply delays the planned reduction in carbon emissions. An abrupt and immediate replacement of fossil fuels with renewable sources of energy is not as easy and cheap as a pre-war orderly transition scenario would have implied.
The increase in fossil fuel prices is an opportunity to accelerate the energy transition.
It means that returns on renewable energy are significantly higher than they were when oil prices fluctuated near US$ 60 a barrel.
The experience of the 1970s reminds us that abrupt increases in oil prices led to massive increases in energy efficiency and substitution away from fossil fuels.
Against the latest energy market developments, a comparative reading of Phase III of the NGFS scenarios provides important insights into where we are on this transition pathway – and what we can do to reverse course and ensure we transition to net zero.
The key resides in designing appropriate pricing mechanisms to discourage fossil fuel consumption and making low-carbon energy sources more competitive through research and investment into renewable technologies.
Policies to protect the most vulnerable, well-designed communications about the need to internalise the social costs of carbon-intensive energy and certainty about the carbon-pricing path are essential.

Source: Agency Kampuchea Press