Kickstart my … Climate Change Policy !

Kickstart my … Climate Change Policy !

 

Ganga Prasad G. Rao

Energy, Environmental and Mineral Economist

gprasadrao@hotmail.com

 

 

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.