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Commentary

Carrots First

Anne Simpson, Global Head of Sustainability, and Ben Meng, Chairman of Asia Pacific, Franklin Templeton, consider how government incentives can accelerate the shift to green energy.

Many government policies – both carrots and sticks – are driving the global transition to greener energy systems. To analyse the global transition drivers, we compare regulatory sticks, like carbon pricing, with carrots, like feed-in tariffs that subsidise solar renewables.

Carbon sticks

For many years, the primary climate policy recommended by many economists was carbon pricing.  Carbon price signals offered a more elegant response to the CO2 emissions challenge compared to government subsidies, which can be inflexible and susceptible to wasteful overcapacity. In contrast, carbon pricing gives companies the freedom to reduce emissions by whatever means they see fit.

If carbon pricing offers a more efficient road to our zero-carbon future, there’s progress to celebrate, as over 46 countries price greenhouse gases. One notable participant, China, launched the world’s largest carbon market in 2021, covering one-seventh of global CO2 emissions, and three times larger than the European Union’s emissions trading system (ETS).[1]

Looking ahead, India plans to launch its own national carbon market in 2026. Unlike China, India’s stakeholders will target high-carbon sectors such as power generation, alongside a range of industrials like steel and cement.[2] The framework for India’s pricing mechanism derives from the EU, which added a carbon ‘market stability reserve’ to its ETS in 2019.

No pain, no gain

A growing cohort of economists now admit price signals haven’t been tough enough to force greater long-term investment in cleaner fuels. In 2012, economists concluded that Europe’s ETS programme had quite limited effects on the rate and direction of corporate clean-energy innovations. Thanks to the new price stability mechanism, the EU’s carbon price signals are exponentially higher today (see below).

The global carbon-pricing map above raises two key questions. Firstly, how high are carbon prices today? Secondly, how high should carbon price signals be? This depends on specific future goals such as reaching net zero by 2050, calculating future carbon sequestration costs or measuring the social costs of carbon (SCC) that each tonne of carbon inflicts on humans.

There is growing certainty that, outside the EU, average carbon prices are simply too low to redirect capital at the scale and speed needed to achieve these goals. Case in point, China’s price is just US$8 per tonne of CO2, far below the EU. Nonetheless, China’s carbon pricing will reduce the carbon intensity of its coal-fired plants in the near term, before scaling up in the future. Moreover, the EU plans to implement a carbon border tax that will have positive ripple effects across the globe. The EU’s carbon stick will help incentivise trading partners to transition their economies more quickly.

Subsidised carrots

Turning to subsidised carrots, at last year’s Chinese Communist Party’s National Congress, President Xi Jinping spoke of reaching carbon neutrality by 2060, while reiterating the principle of “establishing the new before destroying the old”.[3] Xi’s philosophy isn’t unique to China and can be seen in how government loans and capital in the 1990s helped jump-start solar industries, including in Germany.

Notably, economists studying the mechanics of technological innovations find economies of scale and learning-by-doing play an outsize role in lowering costs and improving quality across clean-energy technologies.

For example, while India’s national carbon market is just emerging, its largest power company is now committed to building 60 gigawatts of solar PV electricity by 2032. This is because power from newly-built solar capacity in India is now cheaper than the power from existing gas and coal-fired power plants.

As for green-energy carrots overturning free-market orthodoxy, BloombergNEF notes that G20 governments handed out US$3.3 trillion of direct fossil fuel subsidies from 2015 through 2019.[4] These direct subsidies don’t include the mountain of implicit subsidies from governments that don’t currently impose national carbon prices.

As for solely focusing on carbon sticks to incentivise the energy transition, that approach can deliver short-term pain, while concealing longer-term gains for the environment, public health and most economies.

In our view, it’s better to lead with government carrots that accelerate the arrival of cheaper green energy and well-paying jobs before phasing in higher carbon prices.

Today, the Biden administration is deploying incentives like green-energy procurement contracts that will accelerate demand for 100 gigawatts of solar power systems over the next decade. In response, the EU unveiled its own green industrial strategy. While it does not offer new funding, the plan aims to streamline the approval of national green-finance tools already available in Brussels.

Over the long term, we see these programmes expediting the push of green technologies, with competition among the US, China and EU reducing the costs of green technologies even faster.[5]  We believe the ability of investment analysts to produce alpha will increasingly hinge on analysing how government carrots and sticks are accelerating both opportunities and risks across private and public investments.

The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of Franklin Templeton.  

 

[1] Source: Busch, C. China’s Emissions Trading System Will Be the World’s Biggest Climate Policy. Here’s What Comes Next. Forbes. April 18, 2022.

[2] Source: Choudhary, K., and Macquarie, R. Disentangling India’s new national carbon market. Sustainable Policy Institute Journal. Winter 2023.

[3] Source: Yin, I., and Yep, E. China to boost development of new energy system, climate change governance: Xi. S&P Global Commodity Insights. October 17, 2022.

[4] Source: Climate Policy Factbook: Three priority areas for climate action. BloombergNEF. July 20, 2021.

[5] Source: Conley, T. Green subsidy race? 5 experts explain what to expect. World Economic Forum. March 30, 2023.

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