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Social & Environmental Transition

Shielding transition policies from political turmoil

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Transforming our economies towards a more sustainable model is a tremendous endeavour that requires both a long-term perspective and a view on how to get there. The 2015 Paris Agreement has provided the framework defining the ambition, reaching carbon neutrality by 2050. In order to meet that target, Nationally Determined Contributions (NDC) and Long-Term Strategies (LTS) have been or are currently adopted by the parties to the Agreement. These documents detail how each country intends to contribute to the overall carbon neutrality objectives and the related plans.

The concept of transition pathway is at the core of this radical transformation that will be spanning across decades. Given the magnitude of the industrial, organisational, and societal challenges, a roadmap has to be determined, providing guidance to all stakeholders of the economy.

Basics of policy design

A public policy can be broken down into three main dimensions: scope, intensity and continuity. A broad policy will affect various sectors of the economy. This is useful when targeting an economy-wide effect and when the effort needs to be spread over vast arrays of different actors. It creates however inequity as not all sectors and actors are impacted in the same way. An illustration of this is the introduction of indiscriminate carbon taxes. Without adaptation measures, the industries that have hard-to-abate emissions will be disproportionately penalised and may move their operations offshore.

Intensity describes the level of ambition the policy is aiming for. An ambitious policy design will set targets that are significantly different from the current situation and allocate little time to achieve them. While inspiring change and creating a sense of urgency, it runs the risk of political backlash. At the other end of the spectrum, low targets are safer in terms of enforceability but may significantly delay the desired outcome or drown out the initial political impetus. The difficulty of this arbitrage has been illustrated by the European Emissions Trading System (EU-ETS). During its initial stages, the allocation of emissions allowances was too generous, which led to a collapse in carbon prices and defeated the whole purpose of having a carbon market. Later adjustments to the allowance allocation methodology led to significant price increases and hence to a price signal more consistent with the pursued policy objective.

Continuity is the most complex variable as it partially results from the two previous ones. Most policies are designed and implemented with little consideration for their continuity beyond the current political cycle. However, when dealing with long-term investments such as infrastructures or heavy industries, the decision cycles are not synchronised with the political calendar. Building a battery or electric vehicle factory from scratch takes anywhere from 3 to 5 years and they will have a commercial life of 10 to 20 years and will be depreciated over the same time.

The importance of intertemporal consistency

These assets are an illustration of the importance of the intertemporal consistency that is required by economic actors. The situation is even worse for utilities investing in traditional or renewable power plants or even nuclear plants which have economic lives well beyond half a century. Intertemporal consistency of policy choices means that the decisions made in the present need to be consistent with what came before and that the future will be bound by these decisions. This is what economists describe as path dependence: decisions reinforce each other over time and the cost of deviation becomes astronomical.

For example, the European Parliament has introduced a ban on the commercialisation of new internal combustion engine (ICE) vehicles in the Union from 2035 on. This decision has very important and cascading effects on the whole automotive value chain in Europe and abroad. Most factories will need to be transformed, staff and technicians need to be trained, suppliers need to make very significant adjustments to their business models, etc. The whole ecosystem is experiencing a tectonic shift following this “broad” and “high-intensity” policy decision that is only tempered by a 12-year delay before it comes into force.

However, for industrial actors, the worst possible outcome would be a policy reversal once the initial decision has been made. They would incur extremely important sunk costs as the investments they already made would lose their value. This is the reason why French automakers, although overall at a disadvantage on the EV market, have opposed changes to the 2035 objective.

It is also one of the many reasons why the nuclear industry has experienced severe losses in skills as many investment decisions have been postponed. Turning around on the decision announced in 2022 to build six new nuclear reactors would also generate significant costs as initial investments have already been made.

Issues with path dependency

The continuity of policy decisions is a double-edged sword. It is a safeguard for ambitious long-term policies but it is also a democratic and economic challenge. As Christian Gollier’s work explores, there is an arbitrage to be made between present and future generations as to who is going to bear the cost of adjustment to climate change. Ambitious policy decisions tie down future generations without prior knowledge of their situation and capabilities. They rest on implicit assumptions about technological progress as it is impossible to forecast changes that would radically disrupt the equilibrium they are trying to reach. When it comes to climate change, it means that either we constrain future evolutions by setting our economies on a specific track or that we push down the costs of adaptation onto future generations.

Currently, the best way to make this arbitrage is to use a carbon price trajectory based on the implied destructions and costs of unabated emissions. This entails questions about the value we are giving to the future and to which extent we should consider it in our decision-making process. These discussions are catalysed through the discount rate that is to be used to discount future value streams.

Means of insuring policy continuity

There are nonetheless ways to break from this approach that concentrates the decisions at single points in time while protecting the desired outcome. Instead of making irreversibly committing decisions, the adaptative decision making approach favours smaller, consecutive decisions that can be modified at a reasonable cost. This approach changes the way we perceive decision-making but requires developing a comprehensive view of the different pathways that lead to the desired outcome, so that a map can be charted.

At the other end of the spectrum, ways are explored to protect vital decisions from future changes in political majorities. One way to achieve it is to increase the cost of deviation from the path through policy design. One stunning example is the recent introduction of Japan’s Green Transformation (GX). The Japanese government decided to turn around the decarbonisation logic by raising very large amounts of debt that will be used to finance R&D measures and investments in decarbonisation technologies. The idea is to provide as much impetus as possible for private investments to follow suit. The debt will then be repaid by the introduction of an ETS market and carbon tax that will raise revenues from the actors that have not sufficiently reduced their emissions. In this logic, the benefits come before the taxation and future decision makers have reduced room for manoeuvre as they are bound to introduce the carbon pricing measures in order to repay the debt.

In conclusion, as Europe is confronted with profound evolutions in its political landscape, it might be useful to start thinking about environmental policies as decision pathways and to provide the private sector with enough visibility and stability to make its investment decisions.