The Great Carbon Arbitrage

The Great Carbon Arbitrage

Tobias Adrian (International Monetary Fund), Moritz Baer (University of Oxford), Patrick Bolton (Columbia Business School and Imperial College) and Alissa M. Kleinnijenhuis (Stanford University and University of Oxford)

One of the goals of the 26th Convention of Parties (COP26) held in 2021 was to reach a global agreement to phase-out coal. COP26 noted that “coal power generation is the single biggest cause of global temperature increases,” and recognised “the imperative to urgently scale-up the deployment of clean power to accelerate the energy transition.” However, in the end, the convention could only agree on accelerating independent efforts towards the phase-down of unabated coal power.

A key reason cited for this lack of progress is the cost of the power system transition requiring phase out of coal power and deployment of clean power. But this cost needs to be balanced against the benefits to the society. To inform this debate, in a recent paper, “The Great Carbon Arbitrage,” co-led by academics from the University of Oxford, Imperial College and Columbia Business School and the International Monetary Fund, we estimate the costs and benefits of a global coal phase out.

We rely on asset-level data to measure the “gross” benefits, defined as the product of the avoided emissions and the social cost of carbon, from a scenario-based phase out of coal power globally. We weigh these gross benefits against the gross costs of ending coal power, i.e., the sum of opportunity cost that firms need to be paid to offset non-realised revenues from retired coal plants and the investment costs of replacing the global production loss with renewable energy.

Our analysis shows that phasing out coal is not just a matter of urgent necessity to limit global warming to 1.5°C; it is also a source of considerable economic gain, in terms of net benefits, defined as gross benefits minus gross costs.

Based on our conservative estimate of the social cost of carbon at US $75 per tonne of CO2, lower than the current price of carbon allowances in the EU ETS, we estimate the global net benefit as US $77.89 trillion. This represents around 1.2% of current world GDP every year until 2100. For a less conservative estimate of US $168 US dollars per tonne of CO2, which does not rule out plausible catastrophic climate events, we find that the carbon arbitrage grows to US $211.03 trillion.

Additionally, we find that the climate financing needs – i.e., the gross costs – to end coal globally are around US $29 trillion, in line with other estimates. The majority of climate financing needs occur thus between 2024 and 2050, with relatively lesser investment needs in the far future. Investment costs for the developed world to cover these global annual climate financing needs would be in the range of 0.5% to 3.5% of advanced economies GDP.

Some argue that no government in the world has enough money to make such sizeable investments and have called on the private sector to steer the required funding to renewable energy investments. Most of the funding for these investments can indeed come from the private sector but a significant amount of public money to enhance these investments will still be needed, raising questions around how much.

In our paper, we show that for every dollar of public funds nine dollars of private financing can be tapped through blended finance arrangements and conclude that the overall strain on public finances is not inordinate. One example of such an approach is the Energy Transition Mechanism (ETM) by the Asian Development Bank to help remove coal from the Philippines and Indonesia’s energy mix.

Importantly, our analysis highlights that there is a clear economic rationale for advanced economies to provide climate financing that accelerates the coal phase out internationally. The climate financing needs are large, but they are nonetheless small relative to the social benefits.

A broad policy implication from our analysis is that if compensation was built into an agreement to phase out coal, and if the promised transfers for green investments to developing countries were linked to incentive structures to put in place transition plans for phasing out coal, the social gains from such an agreement would still be enormous. Given such sizable social gains from phasing out coal, it is in our interest to seek to overcome any hurdles that prevent the carbon arbitrage from being reaped, and create a global climate financing regime that enables this great carbon arbitrage.

Future research will seek to expand such an analysis to other fossil fuels, such as oil and gas, to provide a comprehensive picture of the distributional challenges involved and to capture the relevant fossil-fuel dependencies more accurately for advanced economies.

A computational tool of the analysis can be found here.