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Insight | Carbon Neutrality: New Puzzle for Economists

June 16, 2021


Chinese President Xi Jinping announced last Sept. the country's aim to have CO2 emissions peak before 2030 and achieve carbon neutrality before 2060. China has since been moving to set targets and draw up specific plans to do its utmost to contribute to the global fight against climate change.

In an article published recently in the Guangming Daily, a national Chinese-language paper, Liu Qiao, professor of finance and dean of Peking University's Guanghua School of Management, offers insights into carbon neutrality and the impact this concept will have on the country's economic and financial system.

Efforts to achieve CO2 emissions peak and carbon neutrality are of strategic importance for China since they help steer the country onto a path of long-term, high-quality and steady development that is also more sustainable and environment-friendly, balancing long-term goals and short-term targets. It means that the mode and momentum of China's growth will experience profound changes, weaning it off the reliance on energy imports. The move also shows China's willingness to shoulder its responsibility in building a community with a shared future for mankind and might help boost its global influence.

Emissions reduction has become a hot-spot topic among economists in recent years. William D. Nordhaus, a Sterling Professor of Economics at Yale University and one of the two recipients of the 2018 Nobel Memorial Prize in Economic Sciences, titled his Prize Lecture “Climate change: The Ultimate Challenge for Economics.” Using the DICE model (Dynamic Integrated model of Climate and the Economy), he computed that the social cost of carbon (SCC) is 31 U.S. dollars per ton of CO2 in 2010.

Meanwhile, economists are studying China's prospect of achieving its two major carbon goals. For the emissions peak, current research efforts mostly focus on the amount of reduction in carbon dioxide emissions per unit of GDP in 2030 and the average annual GDP growth for the coming ten years. With numerous methods of calculation, peaked emissions of CO2 is estimated in the range of 10.8 billion tonnes and 12 billion tonnes. However, a conclusive method remains elusive.

For China, time is short and the task is strenuous. The time afforded to China is considerably less than what developed countries had, which means that it must make extra efforts. Some might think these efforts are simply the changes in energy production and consumption modes, but in reality, they cover a wide spectrum of industries and entails deep impact. Compared with developed countries in the West, China will have to overcome a series of challenges and embrace more profound reforms.

First, going carbon neutral is not only a technical issue but also involves the economic and management aspects. It requires the clarifying of the interplay between short-term, medium-term and long-term carbon neutrality goals at the level of economic theories, balancing development and emissions reductions, choosing the optimal technology roadmap and prioritizing between cutting emissions and reducing pollutants. Meanwhile, a clear goal should be set for the total volume of carbon emissions as determined by cost–benefit analysis since different technology roadmaps mean different financing capacities, different investment and financing structures as well as different industrial and regional impacts.

Second, achieving carbon neutrality not only means the breaking down of goals and tasks but also involves systemic designs and public policies. Even with a clear goal of total emissions volume and a detailed schedule, we would still need to design a mechanism of incentives and restraints based on the many micro-aspects. For instance, how to rectify the negative externalities of carbon emissions; how to achieve the internalization of external costs through carbon emissions trading; how to set up a carbon pricing mechanism; or how to construct a financial and tax system accordingly.

Moreover, achieving carbon neutrality is both a macroeconomic topic and a microeconomic one, including the particular issue of how to integrate firms and individuals into the carbon neutrality drive. Efforts should be made to encourage individuals to actively practice low-carbon lifestyles and reward companies for innovating their businesses for lower emissions.

Last but not least, efforts from the government and the market are both needed to achieve carbon neutrality, which means that research into how to better coordinate market mechanisms and governmental functions should be strengthened. After all, compared with a commodity market characterized by clear property rights, carbon emissions pose much more complicated questions in this regard.

In short, both opportunities and challenges await. In terms of system, governance reforms at the national level are a must; in terms of policy, special tax and financing systems should be mapped out for carbon neutrality; in terms of technology, demand for low and zero-carbon technology as well as carbon-negative technology will increase; in terms of industry, carbon neutrality will change firms' business concepts and make them rethink corporal governance, strategy and investment decisions, internal management and production process. This series of transformations will provide fertile ground for theoretical innovations in economics and finance.

It is a fundamental task of economics to respond to economic practices. According to Liu, economists must answer the following questions first if China is to achieve its carbon neutrality target.

How will the carbon neutrality goal alter the production function? When it comes to economic growth, people often cite the Solow Growth Model, which explains long-run economic growth by considering capital accumulation, labor growth as well as increases in total factor productivity (TFP). However, under the circumstances of carbon neutrality, carbon might switch from a restraining condition to a significant factor of production alongside capital and labor. Consequently, carbon, as a factor, will alter the production function and further boost the development of economics.

What impact the carbon neutrality goal will have on the development mode of China's economy as well as its industrial and regional dynamic development? Take the financial sector. The goal will bring changes to the financial system, which include the appearance of more environment-friendly financial products and services such as green bonds and green loans, financial intermediaries adapting their services and ideas to carbon pricing and carbon trading, and the birth of new types of financial organizations such as green banks.

How to determine the amount of investment, sources of capital, investment structures and return on investment that are needed to achieve carbon neutrality and how to design related financial products and services accordingly? It is currently estimated that China needs investment totaling at least one hundred trillion yuan (15.6 trillion U.S. dollars) to achieve this goal by 2060, the equivalent of three percent of GDP per year. However, sources of fund, areas of investment and investment efficiency are all questions that need the academic circle of finance to figure out in detail.

How to calculate China's social cost of carbon emissions? What are the cost–benefit differences under different policy and technology scenarios? How to set up and optimize a carbon trading mechanism? Carbon neutrality is not only a technical topic but also calls for an incentive mechanism that motivates firms, individuals and local governments to adjust their acts in accordance with the carbon neutrality goal. Efforts could be made to steer bond issuance and equity financing in favor of carbon neutrality by means of carbon sink and carbon finance. Meanwhile, new challenges such as how to create a market mechanism and set tax rates also require attention. For instance, it will be very difficult to create a uniform carbon pricing standard across the country since the economic impact of CO2 emissions per unit varies greatly among different regions. If it is necessary for some industries to cut capacities in order to meet the national goal, local governments will face another challenge to strike a balance between stabilizing employment and keeping emissions under control.

Still, the academic circle need to ponder more questions. How to lay down an industrial path and a regional coordination mechanism for carbon neutrality? How to determine the order of priority for the development of various industries based on input-output analysis? How to determine productivity distribution, economic layout and fiscal transfers based on regional economic differences? Efforts should be made to study carbon neutrality-related business scenarios and innovations, such as innovations focused on energy production and technology as well as the trend of energy production and consumption structures and consumers' changing lifestyles and preferences. Other research topics include microeconomic commercial scenarios and business modes in key industries in key regions as well as the relations between the digital economy and carbon neutrality — such as how big data can reduce cost and boost the benefit of using clean energy technology and how blockchain technology can boost carbon emissions transparency. The impact of carbon pricing on the currency system in the future is also worth looking into. Last but not least, international cooperation in carbon neutrality should be enhanced.