Standing up for environmental economics

I feel sorry for environmental economics. As a discipline it is too often viewed as ‘quasi-economics’ by more orthodox practitioners and is often treated with extreme suspicion by environmentalists. Despite this, the subject has managed to flourish within state bureaucracies and today’s conservation rhetoric is guided by the concept of ‘ecosystem services’, which smacks of the influence of economists. I was therefore surprised to read this short piece by environmental economist Zara Phang who reports that reference to the subject was almost completely absent during the launch of the Malaysian chapter of the UN’s Sustainable Development Solutions Network.

Zara’s piece also effectively makes the point that there needs to be a change in the way ‘sustainability’ is perceived. For environmentally beneficial initiatives to gain traction within governments across the world, it is vital that the economic benefits of sustainable initiatives – namely in the form of avoided future costs – are properly recognised so that ‘sustainability’ ceases to be viewed solely as an economic burden. An example of this is the work of TEEB that looks at valuing the benefits of biodiversity:

Through developing ways of valuing the economic benefits of the environment, environmental economists are making contributions to the pro-sustainability debate the importance of which, I believe, should be better recognised.  

A brief comment on the energy price debate

Over the past few weeks, a barrage of double-digit energy price increases announced by major providers has attracted condemnation from politicians and the media. Price increases put pressure on the real value of wages and threaten to increase levels of fuel poverty incurring significant social costs in the form of adverse effects on physical and mental health. These problems also raise concerns about equality as the pinch of rising energy prices is often felt most severely by society’s most vulnerable. For these reasons, energy affordability is high on the political agenda – and rightly so – but to me, the present fixation on low energy prices is problematic.

Although recent price rises have been met with a sense of indignation, the UK enjoys energy prices that are well below the EU average (see below). From an economic perspective, low energy prices reduce incentives to improve energy efficiency and invest in substitute technologies such as renewables – both measures that are integral to the process of green transition. Low prices also constrain energy company profits that are essential to financing much-needed investment to improve the UK's energy infrastructure.

It appears that present political efforts to secure fuel affordability are set on tackling fuel prices but I would argue that this approach is unimaginative and will impede progress toward achieving a green transition. Rather than seeking to keep prices low, an alternative approach to ensuring fuel affordability would attempt to increase low incomes. As well as general macroeconomic and industrial policy to encourage the creation of skilled manual jobs (the sort of employment that provides middle-income salaries), more specific measures would include fuel energy subsidy payments to the low-waged and un-waged. Such an alternative approach would allow energy prices to rise, providing the incentives that any green transition will need, while mitigating the most significant social costs.

To further address the social discontent that energy price increases with inevitably cause, politicians could also take steps to ensure that energy company profits are also being used to fund socially beneficial investment. Despite enjoying considerable profits, energy firms are investing less in new assets to improve the UK energy system than the value of depreciation of existing assets. If this trend continues then a furore over future price hikes would be justified. It would be far more constructive, however, to act now and use the regulatory system of the UK energy market to demand energy companies increase levels of investment.

Fuel affordability and securing a green transition are both undoubtedly important issues, but the present political emphasis on energy prices imposes an artificial trade-off between the two. Although this trade-off can be overcome through the pursuit of more imaginative and ambitious energy-affordability policies such as those discussed above, the problem with such alternatives is that they are more complex and harder to achieve than a seductively simple energy price freeze. In order to achieve a socially and environmentally sound energy market it is vital that British politicians don’t let fear of complexity compromise the quality of policy.

  

'Shareholder value', short-sighted stock markets and green transition financing

'Chicago, Board of Trade II' – Andreas Gursky (1999)

While estimates of the cost of moving to a green economy vary, one thing is clear: achieving a green transition is not going to be cheap. To move to a green economic model, substantial increases in research and development in areas such as energy efficiency are necessary alongside considerable investment to replace old technologies with newer, cleaner substitutes. Such measures have large financial requirements with the UN Environment Programme estimating that 2% of global GDP (currently US$1.3 trillion per year) will be needed to finance the transition to a green economy by 2050. When confronted with such a hefty figure, the question of how to finance a green transition becomes significant and is one subject that I hope to address over the course of this blog.

Following the financial crisis, governments have found themselves facing tight budget constraints and, as aging populations continue to place upward pressure on social security expenditures, public financial resources devoted to green investments are unlikely to increase. In these circumstances, the private sector is critical to financing a green transition with some studies estimating that as much as 80% of the capital needed to address climate change issues in future decades will come from the private sector. However, despite the clear importance of private sector financing, international organisations acknowledge that there is a fundamental conflict between the long-term nature of much green investment and the increasingly shortsighted behaviour of corporations (for example see pg. 623 here and pg. 29 here). If the private sector is going to fund a green transition, this considerable barrier must be addressed.

While the causes of such corporate myopia are complex, Lazonick and O’Sullivan (2000) explain how changes in corporate governance ideologies that emerged in the 1970s and 1980s have had a major impact. The ‘shareholder value’ hypothesis argued that misaligned incentives between the owners of corporations (shareholders) and corporate decision-makers (managers) had led to falling profit rates in the US and that, in order to redress this, incentives should be aligned by tying managerial pay to stock price performance.

This practice, which has proliferated over the subsequent decades, wouldn’t in itself disincentivise green investment if stock markets were far-sighted and stock prices reflected predicted corporate profits over periods of, say, 10-25 years. The problem is that they don’t. Share prices tend to respond significantly to current period profit results indicating that contemporary stock markets are extremely short-sighted. The combination of ‘shareholder value’ corporate models and myopic stock markets has led to what has been termed ‘quarterly capitalism’: a situation in which managers are incentivised to do whatever it takes to ensure good quarterly or annual profit performance in order achieve high stock values and by consequence a nice heavy pay packet. Several studies evidence such corporate short-termism (for a summary see pg. 3-4 of Haldane 2011) with Graham et al (2005), for example, finding that 78% of a sample of executives wouldn’t invest in a project that lowered earnings below quarterly expectations even if, beyond this, it yielded increased profit.

In contrast to the short time horizons of contemporary corporations, green investments only tend to be profitable in the long run as large up-front costs are offset by efficiency gains over extended periods. In a system of ‘quarterly capitalism’, managers balk at the high upfront costs of such projects owing to the reduction in current profits they would cause. In these circumstances, substantial green investment by the private sector is unlikely.

It appears, therefore, that financing a green transition is at an impasse: private sector investment is essential but current management practices mean it is unforthcoming. Reluctance of governments and regulators to exercise their influence over the operation of financial markets makes fatalism here easy: the increasing short-termism of stock markets and managers appears as an unfortunate but inevitable development. But this belief is wrong. Haldane (2011) emphasises, there are a number of measures through which the myopia of the private sector can be redressed including, for example, making managerial pay dependent on performance over an extended period rather than annual stock prices.

Achieving a green transition is a long-term game that demands substantial financial resources. While the magnitude of these financial requirements is beyond the capabilities of the public purse, it should be recognised that action by governments is necessary in order to address the current system of ‘quarterly capitalism’. Without these measures, private institutions will continue to shun long-term investments and the green transition will remain unaffordable. 

Burtynsky vs the EKC - economic growth and the environment

 The photographs to the right are the work of Edward Burtynsky, a photographer who seeks to document the impact that mankind has on the landscape. To me, his spectacular photos powerfully illustrate the impact that economic production and economic growth have on the environment, presenting such production as polluting and environmentally destructive.  Somewhat unsurprisingly, however, a significant body of environmental economic literature argues the opposite of this maintaining that economic growth is ultimately beneficial for the environment. So which relationship growth-environment relationship is correct?

The optimistic hypothesis discussed in the economic literature is known as the Environmental Kuznets Curve and was developed after several empirical studies during the early 1990s observed that inverted-U relationships existed between economic growth and a range of environmental quality indicators (for example see Grossman and Krueger 1991). In an attempt to explain these observed relationships, Panayotou (1993) has decomposed the net effect of economic growth on the environment into distinct scale, composition and abatement effects concluding that EKC relationships occur as the relative magnitude of these effects changes over time. Initially the scale effect dominates as increased production causes increased environmental degradation but this is eventually offset by the composition and technology effects as economic production shifts from industrial to service sectors and resources are devoted to abatement activities.

While the vast majority of the EKC literature is extremely reluctant to draw generalised conclusions about the nature of growth-environment relationships, the EKC is a much abused piece of economic theory that is often seized upon by those opposed to environmental policy in order to deny any incompatibility between economic growth and environmental quality. Such cavalier use of the concept conveniently overlooks the fact that no empirical studies have observed that EKC relationships exist for greenhouse gases and makes the significant error of confusing correlation with causation as, even in the cases where EKCs have been observed it is not suggested that economic growth per se causes the inverse-U relationship.

A likely explanation of EKC trends is that as richer countries deindustrialise and develop service-based economies, they export environmental degradation to other less developed rapidly industrialising countries (Cole 2004). This is a significant point as it implies that the growth-environment experiences of wealthier countries may not be replicable as other countries develop; the world will always demand manufactured goods and these have to be produced somewhere. Another interesting explanation emphasises the significance of democratic rights and equality with Torras and Boyce (1998) arguing that more equal power distributions – assessed using literacy, political rights and civil liberties indicators – are significant determinants of the EKC relationships that have been observed for certain air and water quality indicators.

Several further factors that are often ignored by EKC fanatics include the existence of natural thresholds and irreversibility in environmental systems and the neglect of feedback effects from the environment and the economy – for example the significant disruptions in economic activity that may result from increased climate variability. A discussion of these issues can be found in section 2.7 of Panaytou (1993).

Overall, it appears that neither my negative interpretation of Burtynsky’s photos nor the optimism of the EKC is entirely representative of the environmental impacts of economic growth: the empirical evidence suggests that economic growth is – under certain conditions – able to achieve improvements in local environmental quality but not reductions in environmental pollution at a more global scale. Despite this ambivalent conclusion, in the context of global warming and climate change it is the latter point that is most relevant which implies that economic growth alone cannot be relied upon to achieve a green transition. 

Hi and welcome to Green Transition!

The image in the heading is a photo of the border between Haiti and the Dominican Republic. Despite each side of the border experiencing a common climate and topography, the radical difference in outcomes is clear: the Dominican side is richly forested while the forest on the Haitian side has been completely harvested. To me this illustrates how human institutions are significant determinants of environmental outcomes which implies that changes in these human institutions can achieve significant environmental changes.

As the scientific evidence of anthropogenic climate change continues to grow, it is apparent  that such institutional changes are necessary in order to mitigate the severity of global warming and adapt to a changing and increasingly variable climate. To put it simply, economic activity needs to change (as illustrated in the Soulwax video below) and the term 'green transition' can be used to describe the process of change from current economic practices to an economic system that is less environment-intensive and more environment-resilient.

Coming from a background in economics and geography, I intend to use this blog to explore two related topics:  the various ways in which such a green transition can be achieved and the ways in which economic methods themselves need to change in order to enable more environmentally sustainable decision making.

As well as developing my own opinions on these subjects, I hope that this blog will make readers aware of some disputed areas within environmental economics and highlight the importance of economic methodologies as – despite sounding like a cripplingly dull topic – these practices significantly impact environmental policy decisions and are therefore critical to achieving a green transition. 

Enjoy!