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Analysis: Are we really making rational climate investments?

The EU is making economic pledges on an unprecedented scale. But are they really enough?
Unfortunately, the answer is no. Not if want our investments to be rational. In this guest blog, Senior Analyst Ulf Holmberg explains why.

When the European Commission in December 2019 announced its ambition to make the union climate neutral by 2050, they were rightfully applauded by almost everyone. Undoubtedly, the European Green Deal was a huge step in the right direction as the deal included the revision of relevant climate-related policy instruments and freed up monetary resources to help economies transition towards climate neutrality.

The European Green Deal Investment Plan (EGDIP) is expected to mobilize investments of at least €1 trillion in sustainable investments over the next decade. It was also decided that 30 percent of the massive €750 billion COVID-19 recovery fund would be set aside for greening the economic recovery. In total, this adds up to climate related investment pledges of about €1225 billion over the forthcoming ten years. This is a truly a significant amount, but is it enough?

Ulf Holmberg works as a Senior Analyst, has a PhD in Economics and a history within central banking.

My name is Ulf Holmberg and I am a Senior Analyst at the commercial bank Swedbank in Sweden. Since I am personally interested in the question, I have taken the opportunity to explore the need for future climate change related investments. Below I’ll present some key findings that can be used to understand how much a country should invest to decarbonize and the economic consequences of doing so.

I started out by examining the amounts a nation would rationally need to invest in combating climate change over a 30-year investment horizon, as implied by the European Green Deal. I use the term rational to describe that if the cost of climate change is known, a nation or state acts rationally only when it invests enough to offset for these costs. In this regard, the rational investment amounts can be found by comparing the overall economic costs of doing nothing with the economic benefits of keeping global warming below 2 degrees Celsius. For the calculations I use academic estimates on the long-term global economic effect of climate change. In particular the results presented 2018 by Kompas, Pham and Che; which when it comes to the found economic impact, was confirmed by a study done by the International Monetary Fund (IMF) in 2019.

Graphics: European Commission

So are the EU investment pledges rational? Unfortunately not. Bearing in mind that the Green Deal part of these investments will be implemented over the course of a decade, it is found that the pledges made so far corresponds to only about 50 percent of the unions rational ten year investment amounts. Thus, either the EU should be even more ambitious, or its member states need to start investing more to fill up the remaining €1185 billion on decarbonization. To some extent this is on already occurring as e.g. Germany has pledged an extra€40 billion and France €30 billion on green recovery. But even if all EU countries would pledge comparable amounts with regards to the size of their economies, the rational investment amount would not be met.

The rational investment amounts above are huge, no doubt, but not unique to the EU. Assuming that the US aims to honor the pledges made in the Paris agreement, it is found that they should invest at least $480 billion annually to combat climate change which corresponds to almost 70 percent of the US annual defence budget. So far, the US government has pledged only smaller amounts on this cause. Instead, the private sector seems to have taken the lead as currently the size of the US green economy accounts for about 7% of U.S. gross domestic product (GDP).

Massive investments in renewable energy are needed to combat climate change. Pictured: A wind farm in Italy. Source: Svensk Vindenergi

While the investments need to be made today, the full extent of the economic consequences of climate change occurs far into the future. It is therefore important to note that I have discounted the academic estimates of future gains and losses in order to obtain values that can be used today (their present values). When doing so, I have taken a precautionary approach and given the amounts presented a very high 5% discount rate. As such, they could easily be challenged for being too small and as highlighted by Harvard economist Martin Weitzman, in the case of catastrophic climate change the severe consequences would override the effect of discounting.

This suggests that low discount rates should be used. In a recent survey it was found that most economists would favour a low discount rate, and that the median response was a low 2%. If one re-does the analysis above using the 2% median it is found that the US should annually spend over four times its annual defence budget on investments directed towards combating climate change, and that the pledges made so far by the EU only accounts for about 9% of the rational investment amount. Similar results can also be found for all other countries, and taken together, the results indicate that our ambition to invest our way out of the climate crisis is seriously underfunded.

It’s easy to make the mistake of thinking about these investment amounts as costs, costs that only possibly will give rise to an uncertain future gain. Such objections could be made by those that would like to steer public funds towards other competing projects. But the amounts presented and discussed should not be viewed upon as costs in the usual sense, as they are investments that could generate economic gains also in the short-term. In fact, my estimates suggest that most economies are likely to benefit directly, since effectively done public green investments could contribute positively also to current annual GDP growth. In fact, even if only 70 percent of the investments are done effectively, the EU economy most likely will benefit from it. A similar claim can be made for the US, while it seems like China requires a somewhat higher degree of efficiency.

Even though the positive economic growth effects underlying these claims are uncertain estimates, they are also probably understated. This is because the economic growth estimates assume that the investments are made using public funds alone. If the investments instead would be made in collaboration with the private sector, the investments positive impact on growth would most probably be even larger. It thus seems like we are acting irrationally. The good news is that most economies would benefit today, not only in the future, by being more rational.

Guest Blog written by ULF HOLMBERG, PhD

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