Kickstart my
… Climate Change Policy !
Ganga Prasad
G. Rao
Energy,
Environmental and Mineral Economist
Introduction
An important, even critical lesson in environmental
economics is the anticipation of future, irreversible environmental damages and
providing a resolution for them in the present. A further specific case concerns
the anticipation of very low probability environmental risks but which have the
potential to cause very large, unprecedented damages. Such is the case with
Climate Change. The seemingly inexorable increase in global CO2 emissions, the
consequent accumulation of CO2 concentration in the atmosphere, and the
‘inertia’ built in to the global warming cycle implies rising sea levels across
years and decades – whether gradually, or cataclysmically, as well as
irreversible changes to seasonal weather patterns that could, among a multitude
of other impacts, potentially affect hundreds of millions residing by the
coasts, cause the spread of tropical diseases, and endanger habitats. Most traditional
Climate change responses have tackled the externality with static, even nominal
policies that do anticipate the gravity of potential cataclysmic climate
change. Environmental Finance, which provides for market-based, financial instruments
and policies to target environmental concerns of the future, is appropriate and
even expressly indicated to internalize low probability, large potential damage
risks such as Climate change.
The Motivation
Let us, to start with, presume various entities, private and
public/governmental, have covered partially for climate risks to their assets
and constituencies, in their asset insurance policies or have budgeted and
implemented public programs to address them. These ‘private and separate’
insurance policies and programs provide covers for the more acute and immediate
of climate change risks. They do not yet cover for the larger risks to the Commons
– cataclysmic melting of ice sheets, cataclysmic sea-level rise, sea ingress
and flooding, and epidemics, to name a few. On another front, the Sheikhs,
representing Global Oil producers – both private and public - fear the risk of
‘cataclysmic stranded assets’ that might occur should the hundreds of billions
of barrels of oil discovered and proven but yet unexploited, be laid to waste
due a cataclysmic climate event. On yet another front, the Capitalistic economy
and indeed, the capital markets, lack a global financial instrument against
which to environmentally benchmark their investments, anticipate future private
risks and risks to the Commons, and indeed provide for damages. Finally, take
cognizance of the Environmental Innovations market - a market that responds
with technological solutions to opportunities as they derive from the WTP that
exists in the society to address potential damage from irreversible (and
cataclysmic) Climate change. What is necessary is a strategy that ties together
these disparate interests but which have a common cause, a common thread
running across them, and guides them to solutions that are both privately
optimal and group-pareto.
To this end, consider an innovative environmental finance
strategy that reaches out to the world of insurance on one hand, to the
Innovation markets on the other, and leverages the self-interest of competing
stakeholders to obtain a theoretically defensible, self-correcting, ‘closed’
solution to cataclysmic climate change. These instruments and policies
anticipate irreversible risks and damages forced upon future generation due
unsustainable consumption in the present, and ‘PV-hasten’ them, forcing
stakeholders to face up to risks affecting future generations and design
policies that either pre-empt the undesired outcomes or mitigate them. The
proposed policy employs innovative financial concepts to design a strategy that
creates appropriate incentives for the various stakeholders and brings about
anticipative solutions that avoid the irreversibility of cataclysmic damages
not addressed by some of the myopic climate change policies already implemented
or currently under debate.
The Design
To set the ball rolling, conceive of a Sheikh ‘Resource
Bakey 2’, equivalently a ‘Resource Curse 2’, that is a PV-Monetization of
proven, but unexploited oil resources yet in ground, in the opposite and paired-complement
of the Environmentalists’ ‘Bakey Green 2’ and separated by a ‘Closed Cycle
Innovation Oo’ that is a Justice-facilitated PV-borrowing against FV economic
rents from prospective innovations. (For those pedantic, the Resource Bakey 2
is implicitly the aggregate losses in the share price of resource-owning public
entities and the fall in national currency due the reduction in reserves from
environmental unsustainability) This composite ‘Bakey Green 2 RC 2’ money pot, essentially
the monetization of denied Resource-based futures, provides the necessary
capital to design and fund a system that anticipates and corrects cataclysmic risks
and returns those denied futures to humanity. The grand design, in essence,
involves offering Sheikhs and Environmentalists an opportunity to enrich
themselves in the short run by having them bid up Carbon taxes and fund a ‘Sustainability-cum-Damage’
fund pot, and, simultaneously, creating an Innovation fund that supports
innovation that either pre-empts or mitigates the impacts of cataclysmic
climate events, thus and together bringing about a sustainable future fully
prepared for climate exigencies.
Make a leap of faith and presume that the global aggregate
insurance policy covers (and existing publicly-funded climate change-caused
damage alleviation programs) for anticipated Climate change impacts represent a
reasonable lower bound of projected Climate Change damages (The lower bound
representing largely private, acute and ‘neighborhood’ risks). If we further
assume Insurance Houses have, as part of their prudence and diligence, (fully)
provided for these future damages in the various financial and physical assets globally,
then, one could (half-)defensibly issue ‘Cover Coins’, a derivative currency, on
the face value of the sum of the covers and program budgets. Cover coins,
priced in dollars, represent ‘Policy cover trigger risk PV currency’ – a PV price
on the risk of the policy covers being triggered, whether in the present, or in
various time periods extending to the term of
the cover. Leveraged by risk arbitrageurs to anticipate and evaluate
changes in the ‘trigger risk’ and price the shares of Insurance firms, cover coin shadow prices are
benchmarked to variables that impact upon the risks of triggering claims on
policy covers. Cover coins are therefore a convenient instrument to examine
‘trigger risk’ – the risk that the policy cover might be invoked - on insurance
policies. Their Shadow price-NAV falls with expectations of prospective climate
change-triggered claims and increases with expectation of reduced insurance
claims. This logic predicts that an enlarged Carbon tax, Tc, should, by
lowering projected climate-change-related damages, lead to a reduced ‘cover
trigger risk’ and consequently increase the shadow price of Cover coins, and
vice versa. Changes in the Cover coin shadow price and its corpus are supported
by the ‘Bakey Green 2 - RC 2’ money pot sourced respectively from the
Sustainability Cause and Resource-intensive sovereign funds in the capital
markets. Since an inflation of the Cover coin shadow price is, in the context
of climate change, equivalent to enhancing environmental sustainability, it is justifiable
that Cover coins trade against measures/instruments/policies that obtain
reductions in trigger risk, in this specific case, a Carbon tax. The rate of
trade-off between the two, as revealed in the Cover coin – Carbon tax market, then
reveals the effectiveness of the carbon tax in reducing the Trigger risk, equivalent
in the present context, of avoiding a (cataclysmic) climate event of the
future.
Cover coins issued at face value are distributed equally,
and at no cost, to the participants: Sheikhs and Environmentalists - in the
‘Cover coin – Carbon tax points' market; risk-arbitrageurs being permitted to
trade as speculators in the market. Justice, serving the Aggregator role, accepts
the entire liability embodied in the aggregated private policies and public
programs, if for the authority to issue ‘Carbon tax points’ and offer them for
sale to the Sheikhs and Environmentalists in return for variably priced Cover
coins. Carbon tax points are simply graduated, incremental carbon tax amounts, priced
in cover-coin currency, that when exchanged against cover coins, cumulate to
the existing base of carbon tax. The stakeholders are informed of the
opportunity to enlarge their cover coin wealth by buying in to a higher carbon
tax; the more rapid the purchased carbon tax ramp-up, the more they may retain
of that wealth accretion. Justice, with an upward sloping supply curve for
Carbon tax points, deals the Carbon tax (points) to the Sheikhs and
Environmentalists who have different demand curves for them due differing
perspectives concerning climate change, its impacts, and the magnitude of
damages. Given that purchase of Carbon tax points adds to Carbon tax and thence
to the shadow price of Cover coins, both antagonists have an incentive to deny
and outbid each other in their pursuit of larger Cover coin wealth, thereby
driving the Carbon tax higher. Consequently, the Carbon tax enlarges with sale
of incremental carbon tax points exchanged for incrementally higher-priced Cover
Coins. This bidding for carbon points continues until the Sheikhs and the
Environmentalists have reached their separate equilibria. These equilibria may
be conceptualized as the intersection of the Justice carbon tax point supply
curve and the stakeholders’ demand curves. These supply and demand curves shift
in or shift out to raise or reduce the optimum carbon taxes should the ‘shadow
price’ of cover coins fall or rise due any reason, including environmental
sustainability. (Conversely, risk arbitrageurs ensure the enthusiasm for
short-term profits do not unjustifiably raise carbon taxes up through the
roof.)
At equilibrium, the Cover coins are more equally distributed
between the three parties – Sheikhs, Environmentalists and the Justice
intermediary, and crucially, have appreciated due the decreased likelihood of
the insurance damage covers being triggered. (The appreciation of the Cover
coins provides the justification to claim that insurance policies limited to
covers for private assets have since expanded and now cover risks to the global
Commons as well). The Sheikhs are richer for the Cover coin appreciation while
the Environmentalist may claim to have sacrificed wealth for bringing about
environmental sustainability by bidding up a large carbon tax despite a loss in
cover coin trading.
The Innovation Gears
Consider next a Guild of technology suppliers who innovate
and offer energy/pollution-saving and damage mitigating technologies
appropriate to various oil price regimes in return for a share of the economic
rents. With a store of technologies for the historical range of oil prices, members
of the guild only respond and innovate when stimulated with oil prices
significantly higher than the historical extreme. Anticipating these innovation
incentives and disincentives, conceive of a fund for carbon-saving innovations,
that derives both from ‘Bakey Innovation Rents’, and from the ‘CC Innovation 2
pot’. The initial corpus of this ‘Closed Cycle Bakey Innovation Rent’ which
represents cumulative economic rents denied technology suppliers since the last
oil price-extreme, is, upon the initiation of trading in the ‘Cover coin –
Carbon tax’ market, inflated with resources from the ‘CC Innovation 2’ pot (in
the complement of the ramp up of the carbon tax rate). (This design recognizes
the complexity that even a large carbon tax might not trigger a fresh oil price
high). Representing as it does rents
from innovations denied as well as the potential for future rents due the
carbon tax ramp-up, the innovation corpus is made available to technology
suppliers who, if they accept the innovation challenge, are obligated to design,
bring in to existence energy/pollution-saving and damage mitigating innovations
that generate rents at least equal those loaned for the innovation challenge from
the Innovation pot.
As indicated above, the pace of the prospective innovation is
influenced as much by the magnitude of the carbon tax ramp up tolerated by the
Sheikhs as it is by the last price extreme. A sharp and large rise in carbon
tax that causes the price of oil to increase as much, is likely to trigger
large innovation responses when the oil price trips a new ‘high’. In fact, even
the pace of the carbon tax ramp up might independently impact upon innovation
incentives. The energy-saving Innovations turn the society more sustainable and
efficient, and predictably, reduce current and projected future climate
change-related damages. This long-run impact of innovation on oil demand and
revenues is the price the Sheikhs pay for obtaining the Resource-QE funded appreciation
in the Cover coin corpus. They also act to check any unbridled enthusiasm that
the Sheikhs may harbour for large gains overnight.
By tying the issue of Innovation funds to the ramp up of
carbon taxes funded by the monetization of unexploited resources, the paired ‘Resource
– Innovation’ pot provides a defensible means to both enlarge the climate
change damage cover and, simultaneously, trigger energy-saving innovations .
More Design
At the end of the carbon tax bidding and ramp-up, the entire
Cover Coin corpus is redeemed at NAV and the proceeds transferred to a Sustainability
Pot – a pot designed with two mutually complementary portions – a publicly
traded Sustainable Bonds portion consisting the retained Cover coin
appreciation vested with the Sheikhs and the Environmentalists, and an untraded
CC Damage bonds portion comprising of the initial corpus of Cover coins and its
unassigned/residual appreciation plus the Justice Cover coin gains from the
Carbon tax point trading. The publicly traded Sustainability Bond market is
driven by a multi-tiered Sustainability index whereas the untraded, CC Damage
Bonds are driven by a Justice Climate Change Damage function, CCDF, that links
aggregate potential climate change damages (and consequently, the NAV of the
Damage bonds) to such variables as lagged CO2 concentration, its trend, current
sea level and its projected rate of rise, population density, current and
expected income, etc. (The CCDF is likely to be collinear with the
Sustainability index) The Sustainability bond markets informs the larger public
of the state of Sustainability and provides them a means to participate in furthering
the same, while the untraded CC Damage Bonds provide for and even discharge
Sustainability and CC-related damage claims. The traded Sustainability Bonds
are funded by a ‘Sustainability 2key CC Oo RC Bakey’ while the untraded CC
Damage Bonds, positioned in the opposite hedge of the traded Sustainability
Bonds, draws upon a ‘Sustainability Bakey CC Ookey RC 2’, administered by a Sustainability Fund
Administrator, SFA. Together, the irregularly waxing and waning portions
constitute the complementary Sustainability and Damage Bonds corpuses.
Whereas the carbon tax was bid up between the Sheikhs and
the Environmentalists under Justice supervision, the constitution of the
initial corpus of the Sustainability bonds follows a different logic. Aware the
Sheikhs had and have an incentive to get away with a low carbon tax, and
Environmentalists with as high a carbon tax as possible, Justice chooses to
first constitute the Sustainability Bond corpus with Sheikh-retained Cover
coins corpus and initiate ‘in-house’ simulated trading with projected damages as
determined by the Justice-endorsed Damage function. Should the Sheikhs have
chosen a small carbon tax with a long ramp-up period, the Justice CCD function
would project large damages consistent with the projected elevated
concentrations of CO2 and sea-levels, and trigger a price crash during the ‘in-house’
re-pricing of Cover coins to Sustainability bonds prior to the start of public bond
trading. In other words, the Sustainability Bond prices would fall and reduce
the worth of the retained Cover coins transferred over to and reincarnated as
Sustainability Bonds (and in the obverse, increase Sustainability Bond prices if
equilibrium carbon taxes were large and its ramp steep). Next, Justice transmutes
the Environmentalist’s Cover coin corpus in to the Sustainability Bonds but at
a price as revealed post the in-house, one-time re-pricing. The Sheikhs
gain/loss in the re-pricing is the Environmentalist’s loss/gain. (For those
conscientious, the criterion of who stands the Justice-enforced, in-house, one
time, bond re-pricing could be resolved by assigning it to the one who gains
more in the Cover coin trading sessions). Justice then opens the Bond gates to
public trading post the conversion of Cover coins to regular Sustainability Bond
units. This strategy attenuates the natural incentives faced by the two
antagonists and forces a middle-path to achieve climate sustainability.
By design (and collinearity), the shrinking of the Sustainability
bond corpus post a fall in the Sustainability index and Sustainability Bond
NAV, and signifying reductions in Sustainability, induces an expansion of the
complementary, untraded Closed cycle Damage Bonds portion with the ‘Sustainability
Bakey –CC Ookey – RC 2key’ trio-money pot as it stocks funds anticipating
larger environmental damages. Conversely, a large Carbon tax that guides the
economy to environmental sustainability reduces damage claims in the CCD
section of the Bond market as reflected in a reduction in the CCD Bond NAV and
the shrinking of the CCD Bond corpus.
Caveats, Incentives, and
Outcomes
The success of the strategy outline here depends crucially
on the magnitude of gains offered to the competing stakeholders. The strategy
assumes presumes stakeholders will seek the maximization of their financial
gains. Given the incentives they face, the Sheikhs weigh the potential for
large PV gains upon unexploited resources (and banking them as Sustainability
Bonds), and the possible loss from the one-time re-pricing of the Sustainability
bonds against the fear of stimulating oil-saving innovations, and ‘deal’ with
the Environmentalists a carbon tax magnitude and time path that, in their
opinion, obtains the largest gain for the smallest cost. Consumers-Households,
faced with a sudden and large increase in oil price, reduce oil consumption in
the immediate-run, substitute away from oil in the medium, and seek renewable
alternatives stimulated by innovations in the long run. They could potentially
be compensated if they were invested long in the Sustainability Bond market and
short in the CC Damage market. It is a mixed bag for the Environmental
community; the design permits Sheiks to enrich themselves with a Bakey Resource
largesse even as they exert joint control over the pace and magnitude of carbon
tax hikes. Hedged to the opposite of the Sheikhs in the Sustainability Bond
market, the Environmentalists reap a gain in the one-time bond re-pricing whose
magnitude enlarges with sustainability deficiencies (a moral dilemma indeed!). The
Carbon Innovations market lights up with an enlargement of carbon taxes; the
incentive sharpened by a faster rise that trips a historical high-price
benchmark. Elsewhere, the pace of Innovation is as much determined by the
competition for Innovation fund, and its potential rents as it is by the size
of the Bakey Innovation corpus available to innovators – determined both by the
length of sub-historical high price regime and by the magnitude of the
enlargement of the carbon tax.
Discussion
There are innumerable policies that have been proposed over
the years and decades to counter global warming and climate change. While these
policies have anticipated global warming externalities and the damages, their
effectiveness at correcting the unsustainability is suspect. Most policies seek
to abate emissions by suppressing consumption. The nature and dynamics of
innovation in carbon abatement technology is less appreciated. Existing models
presume carbon taxes may be started at low threshold levels and ramped up
slowly over time without impacting the macro-economy. While there is some truth
to that, it is just as true that a graduated tax response evokes little by way
of consumer reaction or technological innovation, and eventually only serves to
inflate oil prices in to consumer’s habituated behaviour. The generation of a
significantly higher carbon tax that anticipates and triggers appropriate
responses to pre-empt the larger of covered damages from low-probability, high
damage cataclysmic climate change, is a distinguishing feature of the strategy
presented here.
The mechanics of the innovation strategy suggested here cumulates
innovation funds benchmarked to energy price trends relative to historical
extremes such that more funds are available for externality-abating and
damage-mitigating innovations should energy prices have fallen from highs, and
stayed low to induce more consumption and enlarged environmental externalities.
The mirroring of the Carbon-tax ramp in Innovation funds jump-starts innovation
and provides early sustainability solutions that pre-empt environmental
irreversibilities. The PV-hastening of innovations appropriate to an economy
with historically unprecedented energy price hikes increases the efficiency of
energy use in the economy and abates pollution externalities thereby
anticipating and pre-empting what would otherwise be a cumulating, irreversible
risk upon the society that might trigger cataclysmic environmental damage.
The strategy above offers Sheikhs a horned dilemma. The
opportunity to monetize the RC 2 in to Sheikhs-owned Sustainability bonds as a
multiple appreciation of the aggregate outstanding climate damage insurance
cover corpus may only be realized by permitting carbon taxes to enlarge
significantly and at a rapid pace that triggers energy/pollution-saving
innovations. The bitter-sweet policy however has the potential to turn the
large and growing repository of carbon in the bowels of the earth sustainable
for exploitation in the future decades. Having said the above, it is just as
important to realize the actual outcomes will depend upon many other factors.
The design and parametrization of the damage function, the dynamics of the
innovation markets, the degree of non-linearity in the retained fractions of
Cover coin appreciation, the design of Sustainability Bond pricing and indeed
Damage bond pricing, all impact upon the probability and magnitude of the
indicated outcomes.
A general observation from the design and the projected outcomes
of this strategy is the advisability of PV-hastening large and irreversible
risks to the Commons of the distant future exploiting the capital markets. Such
Sustainability-enhancing policies contrast sharply with the marginal and
incremental carbon tax policies followed over the past decades, and which
continues to this day to the detriment of global environmental sustainability.
The strategy outlined above exploits the existing insurance
covers for climate change as the lower bound estimate for Climate change damages
and enlarges it defensibly to a larger interpretation involving the global
commons as well. It offers the nations of the world a credible alternative strategy
to monetize what would otherwise be stranded reserves discovered at substantial
opportunity cost to the economy, and apply it productively to induce
innovations that accommodate its sustainable exploitation, in essence
furthering resource conservation and resolving unanticipated cataclysmic
Climate change that might catch humanity short of policy options. Most
importantly, the strategy exploits the scientific basis of climate change, the
economic principles of damage assessment, ‘closed-cycle finance’, the
capitalistic logic of innovations, as well as dynamic arbitraging in risk
markets to bring about an optimal and defensible solution to potentially
cataclysmic climate change.
