How to Pay for Climate Change?

November 8, 2023

How to Pay for Climate Change?
by J. Paul Horne – Oct. 3, 2023

Thanks, David, for Thornton (“Tip”) Parker’s timely reminder (Cumberland Advisors commentary of Sept. 15, 2023) that we must better understand how the economy must change to deal with the rapidly rising cost of climate change. But despite disastrous fires, droughts, and floods, he notes that most citizens, and corporate interests “try to protect what seems to work for their comfort and benefit, while giving up as little as possible.” 

Moreover, many political leaders seek votes and campaign funding by denying climate change, supporting fossil fuels, and obfuscating the huge costs of climate mitigation. The reality is that we must all pay because, as Parker bluntly puts it: “Mother Nature owns the house, and we have to play by her rules.”

But how many Americans comprehend the magnitude of the cost climate change is imposing for the foreseeable future and how we will pay those costs? Some answers emerged over the past few weeks, as major international institutions presented their latest assessments of climate change, including the UN Climate Summit, the International Energy Agency’s (IEA) “Net Zero by 2050” report, the OECD’s Clean Energy Summit; the IMF’s new economic forecast incorporating climate factors; and the White House Climate Resilience Summit. 
 
These serve as preparation for COP 28, the UN’s annual climate meeting, scheduled in Dubai between Nov. 30 and Dec. 12, to assess progress in meeting climate mitigation goals: to limit global warming to 1.5 degrees Centigrade and to achieve net zero emissions (NZE) by 2050. These objectives were set at the 2015 Paris agreement which has been signed by 194 countries, including the U.S. and the EU.
 
Evidence of the rapid rise of climate costs was confirmed with the recent White House report that 23 separate billion-dollar climate disasters occurred in the first eight months of 2023, a record. The Office of Management and Budget (OMB) estimated weather-related disasters cost $165 billion in 2022 and its Long-Term Budget Outlook forecasts climate-related costs will rise dramatically. (See: Analytical Perspectives, Budget of the U.S. Government, Fiscal Year 2024 (whitehouse.gov) .)

The OMB outlook posits the U.S.’ underlying long-term GDP growth potential at 2.1% but could be significantly degraded by accelerating climate disasters. The climate trend expected by OMB could cost the federal budget $2 trillion annually and reduce U.S. GDP by 3%-to-10% percent by 2100. To limit such climate costs, the Biden administration notes the multi-billion-dollar investment by the Inflation Reduction Act and infrastructure legislation will help make the U.S. economy more climate resilient. (See: https://www.whitehouse.gov/briefing-room/statements-releases/2023/09/28/fact-sheet-biden-harris-administration-hosts-first-ever-white-house-climate-resilience-summit-and-releases-national-climate-resilience-framework/ .)
 
The IEA warned in late September that coal, oil, and gas must be replaced by renewable energy sources far more rapidly than is happening. This follows its 2021 recommendation that the fossil fuel industry should halt exploration for new fossil fuel sources. The IEA now urges governments to reduce demand for oil from 100 million barrels per day to 77 mbd, and natural gas from 4.15 billion cubic meters to 3.4 bcm by 2030, very ambitious targets.

Comprehensive estimates of climate change costs were published by the IEA in its May 2021 report “Net Zero by 2050 – A Roadmap for the Global Energy Sector” (see: Net Zero by 2050 – A Roadmap for the Global Energy Sector (windows.net) ; and McKinsey & Company’s “The Net Zero Transition”, published in January 2022. (See: https://www.mckinsey.com/capabilities/sustainability/our-insights/the-net-zero-transition-what-it-would-cost-what-it-could-bring .) 
 
The IEA highlighted the immense investment required to shift global energy use away from fossil fuels enough to achieve NZE and temperature stabilization by 2050. Annual investment in the energy sector alone would have to rise from USD 2 trillion globally (the 2016-2020 average) to almost USD 5 trillion by 2030, easing to an annual USD 4.5 trillion by 2050. From 2.5% of global GDP in the base period, total capital spending on transitioning to non-fossil energy would have to rise to 4.5% of forecast GDP in 2030 before falling back to 2.5% by 2050, assuming the NZE and temperature targets were met.
 
McKinsey’s report, published in January 2022, on achieving NZE by 2050 considered the energy and land-use systems that produce 85% of global emissions and the energy situation in 69 countries. The 27-year transition to NZE would significantly impact demand, capital allocation, costs, and employment. Cautioning that its analysis was not a prediction but rather an “order of magnitude”, McKinsey’s conclusions are striking. 

Capital spending on physical assets for energy and land-use systems in the transition to NZE by 2050 would total about $275 trillion, or an average $9.2 trillion per year, $3.5 trillion more than today’s investment rate. This would “be equivalent, in 2020, to half of global corporate profits, one-quarter of total tax revenues and 7% of household spending.” Moreover, the increased spending would be front-loaded from 6.8% of GDP today to 8.8% of GDP between 2026 and 2030. The unit cost of NZE electricity production could be 20% higher globally in 2050 than today but significantly higher during the transition period. Employment would be significantly impacted with an estimated 200 million jobs created in new sectors and 185 million lost in the fossil fuel and related sectors. No estimate was made of the transition from the old to the new jobs.
 
Noteworthy, however, is that neither the IEA nor McKinsey attempted to quantify the costs of damage caused by weather-related disasters occurring ever more frequently and in intensity, nor of the cost of the massive transfer of homes, offices, factories, and infrastructure to higher ground. In May 2023, however, Deloitte published a survey of top insurance companies which showed they are facing significantly increased risks in their climate–related investment and underwriting decisions. The survey emphasized that more insurers should enhance decarbonization strategies, as well as innovate in their climate insurance and management of climate risk. 
 
The U.S. property and casualty insurance industry suffered losses of $5 billion in 2021, which ballooned to losses of $26.5 billion in 2022. The industry reported 23 confirmed climate-related disasters with losses exceeding $1 billion each in the U.S. as of August 8, 2023, with losses almost certain to exceed those of 2022. Between 1980 and 2021, the U.S. experienced an average of seven-to-eight natural disasters annually, but in 2022 alone, there were 15 with losses from each exceeding $1 billion. Deloitte reported the cumulative cost of weather disasters over the last five years totaled $788.4 billion
 
The IEA, IMF and McKinsey also emphasized that governments must rapidly reduce their direct and indirect support for the fossil fuel industry, as well as related sectors such as transportation and construction if NZE is to be achieved. The IEA estimates global subsidies for fossil fuels totaled $1 trillion in 2022, even as oil and gas companies reported a record $4 trillion in income. The IMF estimated total global subsidies, direct and indirect, to fossil fuels and associated sectors at $5.4 trillion annually. Yale University’s School of Environment reported in October 2021 that fossil fuels received $5.9 trillion globally in 2020, similar in magnitude to the IMF estimate. (See:  Fossil Fuels Received $5.9 Trillion In Subsidies in 2020, Report Finds – Yale E360 .) The Senate Budget Committee reported in May 2023 that U.S. subsidies, direct and indirect, to the fossil fuel industry totaled $20 billion annually – a figure that seems low in comparison with the IEA and IMF estimates.  (See: https://www.budget.senate.gov/chairman/newsroom/press/sen-whitehouse-on-fossil-fuel-subsidies-we-are-subsidizing-the-danger-#:~:text=It’s%20not%20just%20the%20US,to%20the%20fossil%20fuel%20industry. )

Coping With Climate Change Costs
 
To cope with the climate crisis, “Tip” Parker suggested the U.S. “create” dollars that are “the critical, leadership tools” needed. But he thinks this may be difficult because U.S. dollars are “scarce resources” and because more deficit spending would exacerbate inflation which climate change already generates.
 
He proposes that “the only fair and democratic approach is for the country to organize itself as a single, comprehensive climate change risk pool that is backed by the government’s ability to create dollars as they are needed.” While vague, this suggests a massive extension of FEMA’s flood insurance that is currently delivered by some 50 private insurance companies.

Parker’s suggestion, while not elaborated on, may reflect several misunderstandings. The first is that the U.S. fiscal deficit today results primarily from over-spending. In my view, the U.S. fiscal deficit results from numerous fundamentals: a propensity to reduce taxation, over-consumption, inadequate saving, and investment, and all in an economy whose potential real GDP growth is less than 2%. 
 
The U.S.’ total tax burden (including Social Security) is the lowest of advanced economies. The OECD reports the U.S. tax-to-GDP ratio of 26.6% in 2021, ranked 32nd out of the 38 OECD member countries, ahead of Costa Rica, Turkey, Chile, Ireland, Columbia, and Mexico. The OECD average was 34.1% and most truly advanced countries were above 35%. (See: https://www.oecd.org/tax/revenue-statistics-united-states.pdf .) Increasing the progressivity of individual and corporate taxation and improving tax collection efficiency would sharply reduce the U.S. deficit and its inflationary impact. 

Over-consumption and inadequate saving also contribute to the underlying U.S. fiscal imbalance. Personal consumption expenditure represented 68% of GDP in the first half of 2023, compared with 50%-to-55% in other advanced economies. As a result, the U.S. household saving rate is around 4%, compared with the long-term average of 8.8%. A chronic U.S. current account payments deficit (trade and services) must be financed by capital inflows from foreign investors who deem the U.S. a haven.
 
The Federal Reserve can “create dollars” with its independent monetary policy, swelling its balance sheet, as it did during the 2007-09 financial crisis and again during the Covid pandemic. But as we are seeing, the Fed must also use its control of money and credit to quickly reduce the supply of dollars and credit to control inflation. But whether the Fed could create enough dollars during a decades-long climate crisis to finance the costs of coping with weather disasters is not at all clear.

Dollars can also be “created” by deficit spending authorized by Congress. But if increased deficit spending regularly exceeds potential GDP growth and productivity, as it has been, such deficit spending is inflationary and hence counterproductive. But today’s bitterly divided legislative branch seems incapable of even approving a budget, not to mention reducing the deficit by cutting spending or raising taxes or, preferably, a sensible combination of the two. 
 
Given the magnitude of rapidly rising climate-related costs and the huge increase in investment required to achieve NZE and to stabilize global temperatures, the U.S. faces a major fiscal challenge. It is clear we must start a painful process of massive reallocation of resources away from consumption and toward more saving, investment, and increased taxation, aiming to rapidly achieve NZE and to stabilize global temperatures.

 

This post was originally Featured on the Cumberland Advisors Commentary page. 

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