A new study appearing in Nature Climate Change (of which I am a coauthor) explores how institutional considerations of risk affect the cost of large-scale investments in the power sector that increase or reduce carbon dioxide emissions. Unlike previous studies that assume uniform costs for investments, we apply financial charges that vary from country to country and for different technologies. We find that these differences significantly increase overall costs of mitigation (up to 40 percent globally), and even more dramatically alter the pattern of regional effort (with increases up to 100 percent in developed countries with lower investment risk). These results further highlight the challenges facing climate negotiators working to create a long-term, comprehensive post-2020 agreement this year in Paris.
Previous studies assume that firms throughout the world have access to technology and finance at the same cost. However, in the real world, that is not the case. Financial charges vary significantly from country to country depending, for example, on the integrity of judicial systems and the competence and credibility of public administration. Investments in currently non-commercial or politically challenged technologies—such as carbon capture and storage and, in some nations, nuclear power—bear higher financial charges.
Relaxing the assumption of uniform investment risk has important implications. We assessed the consequences of variable investment charges in the electric power sector, a major well-studied component of global mitigation costs. We modified an integrated assessment (IA) model to include variations in investment risk by region and technology. To account for regional finance charges, we used an index based on a survey of investment risk compiled by the World Economic Forum that reflects input from some of the world's most knowledgeable business experts.
The model computed the magnitude and distribution of mitigation costs for a scenario that reduces global emissions by 50 percent by 2050, a level long under consideration by scientists, negotiators, and politicians aiming to achieve a new climate treaty at the end of this year in Paris. Compared with results with uniform investment risk, we found two major differences: 1) mitigation costs rose substantially, and 2) effort shifted to nations with lower investment risk. These appear to have important implications for the negotiations—both for the cost of achieving goals and in considerations of burden sharing—because investment risks depend so much on national frameworks that enable business to invest.
Besides assumptions that technologies were available everywhere at the same cost, earlier assessments made other simplifying assumptions, such as that firms can trust governments to adopt policies that are credible over long time periods. Simplifications and idealized scenarios have been an essential first step in modeling how the global economy functions, and what that means for national greenhouse gas emissions. However, as the Intergovernmental Panel on Climate Change (IPCC) concluded in its most recent assessment, more realistic assumptions are needed to improve cost estimates.
From the outset, our research aimed to incorporate aspects of institutional behavior in the treatment of investment in an IA model. The team (with members from the Joint Global Change Research Institute [JGCRI], the University of Maryland’s School of Public Policy, Resources for the Future, and the University of California, San Diego) benefited from a range of expertise in public policy, political science, business, investment and finance, as well as integrated assessment. Importantly, we were able to modify the treatment of investment in the Global Change Assessment Model (GCAM), an IA model developed by researchers at JGCRI and widely used over the years in mitigation assessments.
Our intuition suggested that investment risks were important, but, equally, we could not hope to understand completely, let alone implement in a model, the full complexity that accompanies institutional investment decisions. The idea to utilize a two-dimensional representation of risk, based on national business climate and technology, emerged from discussions of how to frame the analysis. It allowed us to incorporate some of the well-understood variability in investment costs in ways that seemed appropriate to a first foray into accounting for institutional interactions that govern investment decisions. We imagined the results would be important, but we hadn’t appreciated how large they would be, or how much they would shift the national (regional in the model) pattern of effort.
We believe that this research opens a new front in consideration of real world effects that materially influence management of climate risks. For example, consideration of institutional reform to lower actual and relative investment risks could be an important element of cost-effective climate mitigation, and a factor in discussions of burden sharing. As well, other sectors, such as transport, appear to present quite different challenges. Unlike investments in electric power that largely are located domestically and used to satisfy domestic demand, facilities to manufacture advanced vehicles can be sited in nations with the most attractive circumstances for investment, because logistical costs to export products are relatively small. Such considerations open the door to further institutional challenges associated with foreign direct investment and trade.
