Author: Douglas Prentice, lecturer in Masters Degree at Edinburgh Napier University and lecturer of European Energy Centre (EEC) management, finance, carbon and green deal courses.
Economic issues regarding Sustainability
The BBC reported that atmospheric C02 concentrations at the Earth System Research Laboratory Mauna Loa Hawaii exceeded 400ppm for the first time. Its daily average concentration figure on Thursday 9th May 2013 reached 400.03.
As well as the technological issues related to climate change this phenomenon poses unique economic problems that raise new, fundamental issues, both about uncertainty and about public goods and public policy.
We can consider a simple macroeconomic model of how we might achieve a socially optimal level of activity in the case of energy generation and consumption. This can readily be done using a standard model of the Social Cost of Carbon (SCC) and the Marginal Abatement Cost of Carbon (MAC) as is shown in Table 2.
Table 1: Comparison of SCC and MAC for different Stabilisation Goals
Source: ‘The Social Cost of Carbon and the Shadow Price of Carbon: What They Are, And How To Use Them In Economic Appraisal In The UK’ Economics Group, Defra December 2007 www.defra.gov.uk
At a level of atmospheric concentration of 550ppm the SCC in £tCO2 is shown on the y axis as SCC (550). If the stabilization level were chosen at 450ppm and the MAC isoquant was invariant then the cost per tonne would be higher at the MAC (450) price reflecting the higher current marginal cost of achieving the higher level of abatement needed to stabilize at the lower 450ppm level.
Since economic analysis typically assumes that people are more sensitive to losses than gains the utility value to outcome graph typically takes the following S shape, concave above the reference point, and convex below it:
Table 2: Schematic of Value Function
A significant property of the value function, called loss aversion, is that the response to losses is more extreme than the response to gains. The well-known reluctance to accept a bet on the toss of a (fair) coin suggests that the pain of losing a sum of money exceeds the pleasure of winning the same amount. Thus the proposed value function shown is steeper for losses than for gains as in Table 2.
These properties of the value function have been supported in many studies of risky choice involving monetary outcomes. Furthermore it is well known to economists that households do not have stable risk preferences across different risks; greater risk aversion is displayed for larger risks. Taking account of these observed attitudes to risk therefore becomes an important part of the risk-planning for sustainable housing projects.
As Dieter Helm of Oxford University has pointed out that Kyoto made Europe look good but much was “smoke and mirrors”. Europe’s reduction of reliance on energy intensive industries has caused the moving of coal-intensive industries to economies like China. In the UK carbon emissions from production declined from1990- 2005 by 15%, but carbon consumption rose 19%. A net increase! Germany is now switching from nuclear to coal, and emissions are increasing whilst the US has the fastest falling emissions amongst developed countries through switching from coal to gas – whilst Germany is currently switching from gas and nuclear to coal. Helm argues therefore for a move to gas as an interim measure – a ‘relatively cheap way of buying time and heading off disaster’. As he graphically points out not only is Europe faced with the sovereign debt crisis, and low growth due to bank retrenchment and government austerity but Europe risks losing more of its industrial base to Asia.
Table 3 below shows the level of support for fossil fuel subsidies in different countries as reported by the International Energy Agency.
Table 3: IEA and OECD estimates of fossil-fuel subsidies and other forms of support
Source: IEA (2011), OECD (2012a)
The IEA reports that the biggest hydrocarbon producers in emerging and developing countries tend also to be those that subsidise their consumption of fossil fuels the most – such as Libya, Nigeria, and Venezuela.
As the IEA says however, fossil fuel subsidies are a poor policy for redistributing income since they are often poorly targeted, they distort price signals, and they encourage fuel smuggling. Energy subsidies are expensive, they promote excessive consumption of energy and emissions, and as the IEA points out they don’t help the poor, because they tend to benefit the most those that need it the least
Sustainable Project development
The use of the marginal abatement cost curve is now well established. Table 4 below from the EC shows the cost effectiveness of different types of policy or activity, with amount of abatement in Mt CO2e on the horizontal axis and the cost of abatement on the vertical axis. Figures below the axis have negative costs – ie they save money as well as reduce emissions.
Table 4: Cost Effectiveness of Clean Energy Technologies
Source: Energy Efficiency’s Contribution to Reducing World Poverty: The Role of the Regional Commissions,” Economic Commission for Europe, 2008
So we can see that things like building insulation, lighting systems and water heating all save money as well as carbon, compared to other things such as solar, wind and carbon capture and storage which whilst reducing carbon emissions to the atmosphere also can cost quite large amounts of money. Thus projects in buildings have the best immediate financial and environmental impact.
Not only this but UNEP research shown in Table 5 below indicates that they create more jobs per pound spent than many other activities eg PV projects create greater than 50% more jobs than highway construction, biomass creates nearly twice as many jobs as health care, and insulation retrofit programmes create nearly three times as many jobs as municipal infrastructure.
UNEP reports in the context of energy generation for affordable low carbon housing that
- construction approx 10% of global GDP (USD7.5 trillion) , employs 111 million people
- construction, renovation, and maintenance together contribute up to 40% of countries’ GDP and on av 10% of country-level employment
- 40% of global energy consumption (60% of electricity), 25% of global water, 40% of global resources, one third of GHG emissions comes from buildings
- there is a very large inefficient buildings stock worldwide, representing significant energy saving opportunities because their performance level is frequently far below current efficiency potentials.
- Buildings is a key sector for GHG reduction (to double in 20 years)
- energy consumption in buildings can be reduced by 30 to 80% using proven and commercially available technologies.
Table 5 Jobs Generated Per Bn Dollars of Expenditure on Selected Programs
Source: UNEP Why Clean Energy Public Investment Makes Economic Sense
Sustainable Energy Generation in Transitional Economies
Consequently energy efficiency in buildings offers an outstanding opportunity for developed & developing countries to cooperate in achieving common but differentiated action to realize significant GHG reductions.
Table 6: energy & emissions Table 7: GHG emission from energy use minimization by gas & per sector, 1990–2008
source: UNEP source: EEA
The key targets as Table 7 shows are to reduce energy use (kWh) and carbon emissions (kgCO2e) either per square meter per year or per occupant per year. So the opportunity for energy and carbon savings in housing is extremely large. The following table shows this in relation to all principal areas of carbon abatement.
Table 8: Estimated economic mitigation potential by sector and region
(using technologies and practices expected to be available in 2030)
source: Defra 2005
The impact of climate change on cities in transitional economies
Over the next century, the major growth in cities will take place in developing countries. More people will move to cities as farmers find that the profitability of continuing to farm has declined due to changes in climate. As these people move to cities, city wages will decrease and rents will increase. Thus the urban poor will suffer even more from such migration. Those cities that offer rural migrants a high quality of life are likely to attract even more of such migrants which will exacerbate the problem.
Economic development can play a very important role in shielding the population from such risks by providing households and governments with the resources to build better quality housing, better urban infrastructure and to enforce better planning laws. Economic development offers the best strategy for poor cities to cope.
Table 9 below shows the level of housing stock per 1000 inhabitants across Europe and Central Asia. There is considerable variation eg in the EU the average is 470 houses per 1000 inhabitants, in Bulgaria and Hungary it is over 500 but in Kyrgyzstan it is only 209 and in Tajikistan only 163.
Table 9: Housing stock per 1,000 inhabitants
Source: Habitat for Humanities, National Statistical Offices, Eurostat, Euroconstruct,
Regarding usable floor space the situation is even more extreme – in Western European countries on average 38m2 per person but less than a quarter of that, only 9m2 in Tajikistan.
Table 10 Average useable floor space (m2) per capita
Source: Habitat for Humanities, National Statistical Offices, Eurostat, Euroconstruct, Build Econ
Given these statistics, and the UNEP data on housing above, concentrating activities on housing and energy supply use by housing and distribution of that energy to housing makes for a triple benefit:
- Emissions abatement from improved energy use and improved fabric performance
- Improved social welfare and health improvements from more efficient housing
- Economic (re) generation from housing newbuild and retrofit
Housing remains a very attractive investment despite the economic crisis. Prices have fallen in both nominal and real terms. In the US, for example, Shiller has shown that house prices in the first quarter of 2012 were down more than 40% in real terms from their peak.
Nevertheless, housing remains a popular investment. A survey by Fannie Mae in the first quarter of 2012 found that 58% of US citizens viewed housing as an investment with ‘a lot of potential’, 65% viewed it as a ‘safe’ investment, but. Only 55% viewed shares as an investment with ‘a lot of potential’, and only 15% viewed them as ‘safe’. This popularity is surprising because, over the post-war period, US house prices have been essentially flat in real terms while the US stock markets have risen more than fourfold in real terms over the same period.
Sustainable Financing Mechanisms
As Barbier has pointed out both the debt crisis and global warming represent economies drawing down assets faster than they can replenish them.
In the case of the debt crisis, economies are spending more wealth than they are accumulating. In the case of global warming and other symptoms of ecological scarcity, we are using up nature’s capital and its vital services at an alarming rate. Rather than adding to wealth – both financial and natural – economies are squandering it. This is not a new problem but has occurred throughout history, although this tendency has accelerated in recent times.
Stiglitz and Stern have argued that we face two crises: a deep global financial crisis, caused by inadequate management of risk in the financial sector; and an even deeper climate crisis, the effects of which may seem more distant but will be determined by the actions we take now. The scale of the risk from climate change is altogether of a different and greater magnitude, as are the consequences of mismanaging or ignoring it. They point out that the financial crisis and its damage will be fixed whereas climate damage may be irreversible. Whilst the economic crisis will leave the US and other economies greatly weakened it will be imperative to increase efficiency.
Effect of crisis on RE finance
For many companies and individuals it is now much more difficult to raise money
Banks are lending less (if at all) on shorter terms (typically 5-7 years where before it could have been 20 +years); they are much more risk averse and charging larger spreads (bps over LIBOR) and demanding shorter paybacks.
Equity investors are also much more risk averse now tending to demand higher IRRs and investing shorter term. Investors became reluctant to invest or make acquisitions, the perception being that they were being asked to pay too much for some opportunities. Some investors considering multiple opportunities may have been unable to complete the marginal transactions because access to all funding was reduced.
Companies, such as project developers, were forced to sell assets or equity because they cannot access capital elsewhere to construct assets or service debt.
The lack of debt available in the market due to problems in the banking sector means difficulty for investors completing acquisitions where debt is required to supplement the available equity, or to enhance equity returns to an acceptable hurdle level. Some investors were being requested by investment committees to justify investments made at the height of the market (ie pre October 2008) – as these are now perceived as risky for current market conditions and the given level of returns.
Some institutional investors or pension funds may have a cap set on the amount of RE, as a proportion of the allocation within wider infrastructure funds. In this case if the non-RE infrastructure parts have been contracted, then the RE may be constrained by the mandated ‘cap’.
Many of these conditions will take some time to play out, and it is better to assume that capital raising will remain difficult for quite some time. Therefore projects have to be:
- Very well structured and technically supported
- Accompanied by a very thorough and well placed risk management policy
- Managed by experienced teams
This means that the case for a RE investment has to be very robust.
A complex matrix of factors determined whether or not a transaction gets approved, these include:
- existing strong client relationships (and ancillary client business)
- returns offered by an individual transaction;
- risk inherent to the transaction;
- existing experience in that sector or activity.
The cost of lending has risen substantially, for example, project finance fees have been seen to double and margins treble.
- Prior to the financial crisis, banks would routinely underwrite and syndicate loans, this enabled transactions above £30m/£50m to be completed.
- Following the financial crisis, lenders were not prepared to underwrite and so deals were being done on a ‘club basis’.
- Reduced tenors: banks became extremely reluctant to offer debt for more than a 6 or 7 year period (or tenor), compared to the 15-20 year loans that were available before the crisis.
This means project developers will have to refinance the project, taking the risk of what financial conditions will be like at that point in the future. Some banks returned to home markets, particularly if government capital injections or stimulus provisions have conditions linked to nationally focused activity.
In response to the crisis most governments provided monetary support in the form of quantative easing; the global stimulus packages have now reached nearly $3 trillion, mostly by G20 economies. In doing this some G20 governments have included “green” investments in their stimulus packages to reduce carbon dependency, enhance economic recovery and create jobs.
For example, the $787 billion recovery program in the United States includes around $100 billion to retrofit buildings, expanding mass transit and freight rail, constructing a “smart” electrical grid transmission system and expanding renewable energy supply. These investments amount to 0.7% of US GDP over the next two years, and are anticipated to create around 2 million jobs.
Denmark, Germany and the UK have adopted initiatives in the past year to expand renewable energy supply and employment. The $146 billion UK Renewable Energy Programme is expected to create160,000 jobs from 2008 to 2020. 12 percent of China’s $586 billion stimulus is for energy efficiency and environmental improvements, rail transport and new electricity grid infrastructure.
The IEA estimates that, once growth resumes, fossil fuel demand will rise by 45%, and the oil price could reach $180 per barrel. The remaining oil reserves will be concentrated in fewer countries, the risk of oil supply disruptions will rise and oil supply capacity will fall short of demand growth. Greenhouse gas (GHG) emissions are likely to increase by 45% to 41 Gt in 2030. If atmospheric concentrations of GHG lead to 5-6°C warming, global GDP could fall 5-10%, and by more than 10% in developing economies.
The above brief summary of current research shows the importance of having a basic but sound understanding of the economics and finance relating to housing and carbon emissions and this is one of the principal objectives of the EEC short training courses – providing accessible and cost effective but practical training to participants to equip them with a better understanding of some of the key issues.
For more information on Renewable Energy Management and Finance, please visit: https://www.euenergycentre.org/training/renewable-energy-management-and-finance-course/
Alternatively, email training@EUenergycentre.org to find out more about European Energy Centre Renewable Energy training courses.