---

This article is part of a special series discussing the economic dimensions of environmental issues ahead of the - COP 21 Climate change Conference held in Paris on 30 November-11 December 2015. Read more about it here.
 

Billy Pizer holds joint appointments as professor in the Sanford School of Public Policy and as a faculty fellow in the Nicholas Institute for Environmental Policy Solutions.

---

Climate change poses one of the greatest public policy challenges of our time. The consequences involve significant consequences that span generations and national boundaries. Mitigation requires re-engineering a global energy infrastructure that has been a key ingredient for economic growth for more than one hundred years. And, ultimately, this boils down to changing the behavior of billions of people and businesses, making decisions every day about how to heat and cool their homes or power their factories, how to get to from place to place, and more generally what kind of lifestyle they wish to lead or business they wish to run.

To do this cost effectively, public policies will need to change the incentives that people and businesses face every day. Chief among these is pricing carbon dioxide emissions, through a tax or emissions trading. Such a policy, broadly applied, provides the clearest signal these billions of decision makers that carbon dioxide emissions are costly and that there is value to reducing them. This kind of signal drives both immediate changes as well as investments in physical and human capital that will affect change in the future.

At the same time, pricing carbon dioxide is not the only policy that will be necessary to change behavior, particularly low carbon investments that will be repaid over long periods of time. For a variety of reasons, carbon pricing is unlikely to either cover all emission sources or to match the expected damages being caused. Other market failures may also limit the ability for even the “right” carbon price to deliver a cost-effective response. For these reasons, attention often turns to traditional regulatory tools and various forms of subsidies directed at low carbon investments.

Here, I would like to briefly describe four guideposts that might guide policies aimed at financing low carbon investments. Considerable attention has and continues to be focused on ways to implement traditional regulatory tools in more flexible ways – for example, by making various performance standards tradable wherever possible. Research into subsidies and other financial tools is somewhat more recent and, moreover, involves a broader range of academic and professional expertise including economic development, financial markets, fiscal, monetary policy and related institutions. The four guideposts I have in mind are (1) remove subsidies for high-carbon technologies; (2) improve the cost-effectiveness of low-carbon subsidies; (3) encourage private sector innovation; and (4) maintain transparent public policy tools that support cost-benefit accounting. The first three may be relatively obvious, but are worthy of examples and repeating. The last is somewhat different, and seeks to avoid policies that obscure or complicate prudent policymaking more generally.

Level the playing field for low carbon technologies

In 2009, world leaders at the G-20 summit in Pittsburgh called for an end to subsidies for fossil fuels. While the primary concern was the subsidies received by consumers for fossil fuels and electricity in some countries around the world, attention also focused on production subsidies. Oil and gas companies often benefit from generous tax provisions related to development expenses. In the United States, pipelines and other particular infrastructure projects – but not renewable projects – can benefit from financial structures that avoid corporate taxes. Across a range of government and multilateral development and trade institutions, fossil energy projects may receive financial support even when such support should not be necessary.

While pricing carbon and subsidizing low-carbon technologies make sense from a climate change point of view, removing fossil subsidies makes sense from the even broader perspective of sensible economic policy. Fossil subsidies encourage resource depletion at prices below cost and with the added burden of raising government revenue through other taxes that likely discourage economic growth. Such subsidies can be politically difficult to remove, but recent experience in a variety of contexts suggests it is possible. These kinds of reforms, and providing support to countries seeking these types of reforms, should be of the highest priority.

Improve the effectiveness of public sector finance

If policymakers want to use public sector resources to support low-carbon investments, a variety of tools are their disposal. Subsidies can be provided in cash or in the form of tax credits or low interest loans. They can be allocated based on well-defined rules or bureaucratic discretion. And they can be defined in terms of delivered outcomes (either delivered production or installed capacity), costs incurred, or simply a requested amount. Not all of these choices make sense in a given situation, and often one choice or another can lead to more emission reductions at a lower budgetary cost.

Space limitations preclude discussing all the issues here, something I consider at greater length with co-authors in a forthcoming paper. However, a number of questions emerge that often lead to better answers: what is the nature of the problem addressed by the subsidy – is it more about innovation and lowering technology costs in the future or the direct reduction in emissions right now? Can the subsidy create better incentives for performance, typically by tying payment to outcomes, or does it need to be paid up front? Is there a subsidy design that ensures more value flows to the ultimate investment versus intermediaries? 

A final question is whether markets can be used to increase competition for public subsidies to reduce costs and increase performance. This is particularly relevant when a finite amount of public funds are available for allocation. The Pilot Auction Facility for Methane and Climate Change Mitigation (www.pilotauctionfacility.org) is one example of such a mechanism.

Encourage innovative private sector finance

Distinct from public sector finance and explicit subsidies, public policy along with private sector initiative can lead to significant increases in climate change mitigation efforts. In contrast to explicit subsidies to turn unprofitable activities into profitable ones, innovative private sector finance catalyzes profitable activities facing non-financial barriers (noting this distinction is not always obvious). Perhaps the best example of this kind of work is the Global Innovation Lab for Climate Finance (www.climatefinancelab.org). 

Working with private sector stakeholders, the Lab works to develop innovative financing tools to catalyze private investment in low-carbon technology (among other climate friendly investments). Donor government finance pilots that can eventually be sustained by development institutions, if they work.

Other ideas have emerged entirely from the private sector itself. For example, in the U.S., Master Limited Partnerships (MLPs) have provided a convenient and popular vehicle for investments in pipeline and certain types of qualifying energy investments based on special provisions in the U.S. tax code. These qualifying investments do not include renewable energy projects. Recognizing the potential appeal of such a vehicle for renewable investments, but unable to change the tax code, NRG Energy created a “synthetic MLP” called NRG Yield in 2013 that replicated the financial characteristics of the popular MLPs. This structure has since been duplicated by at least half a dozen companies, now called “YieldCos,” and facilitated billions of dollars of renewable investment. Encouraging and rewarding such innovation could be an important part of public policy.

Maintain transparency and balance in public policy

Against this backdrop of seeking innovative finance for low carbon investments, it is natural to think about public sector financial institutions (central banks and other international financial institutions) to see if new approaches might be found their toolkits. Here, it is important to make a distinction between – on the one hand – innovative ways to deliver public finance, to match particular investor interests, or to address particular project needs, and – on the other hand – innovative ways to raise public funds, potentially disguising and/or hypothecating public subsidies. The latter, I would argue, can run counter to broader interests in transparency and balanced public policy.

I have observed at least three examples that trigger this concern. In the U.S., prior to Federal Fair Credit Reporting Act (FCRA) of 1990, government loan guarantees did not “score” as a budgetary cost until and unless a default occurred. While such guarantees are now scored and budgeted based on estimates of expected loss and fair market value to the recipient, previously this absence of budgetary cost encouraged their use by the government with considerably less scrutiny than other activities. Undoubtedly, this was viewed as an “innovative” mechanism when it was first created. At the same time, there was a real cost, both in terms of the expected loss and the added risk (however small) to the government’s balance sheet.

Five to ten years ago, an idea was circulated to have an international institution, say one of the multilateral banks, borrow funds in the market at their low borrowing rate based on the sovereign guarantees of their shareholders. They would then invest the proceeds in high grade corporate debt with a higher return. The difference in rates would provide a cash flow that could be used to subsidize clean energy projects. This is not unlike the loan guarantee prior to 1990, in that both provide a subsidy that would not appear to cost anything unless a default (on the loan or the corporate debt) were to occur. In reality, there is a cost in terms of additional risk on the lender’s (the US Government or the MDB) balance sheet.

A third example is the idea of using Special Drawing Rights (SDR) to finance climate change investments, a proposal that arose in the context of the U.N. High-level Advisory Group on Climate Finance. SDRs are essentially financial obligations issued by the US and other sovereign nations that are held by the International Monetary Fund. It is these SDRs (currently valued at over $200 billion) that provide the IMF with much of its ability to intervene during regional or global financial crises. A repurposing to use existing SDRs for climate change purposes would reduce funds available for any future financial crisis. Creation of new SDRs would represent an additional liability for IMF members, regardless of whether government accounting would view this as a cost.

Ideas or activities like these run counter to the basic tenets of public policy: costs and benefits should be transparent and, in particular, limited public funding should be spent on the most beneficial public projects. Placing additional liabilities on government balance sheets can have real costs if obligations are called and the risk itself ultimately raises the government’s cost of borrowing. It is not a costless enterprise. Moreover, if an enormous new source of government revenue or subsidization is going to be created, why should it solely focus on climate change? That may be the most pressing issue today, but it is conceivable that other crises will appear in the future. A subsidy program hard-wired to a particularly large revenue source could be problematic as needs change.