Climate Change and Development Series
DIVERSIFICATION Climate
Strategies for
AND COOPERATION Fossil Fuel-
IN A Dependent
DECARBONIZING Countries
WORLD
Grzegorz Peszko
Dominique van der Mensbrugghe
Alexander Golub
John Ward
Dimitri Zenghelis
Cor Marijs
Anne Schopp
John A. Rogers
Amelia Midgley
Diversification and
Cooperation in a
Decarbonizing World
Diversification and
Cooperation in a
Decarbonizing World
Climate Strategies for Fossil
Fuel–Dependent Countries
Grzegorz Peszko
Dominique van der Mensbrugghe
Alexander Golub
John Ward
Dimitri Zenghelis
Cor Marijs
Anne Schopp
John A. Rogers
Amelia Midgley
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Diversification and Cooperation in a Decarbonizing World: Climate Strategies for Fossil Fuel–Dependent Countries.
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Climate Change and Development
The Climate Change and Development Series was created in 2015 to showcase economic
and scientific research that explores the interactions between climate change, climate
policies, and development. The series aims to promote debate and broaden understanding
of current and emerging questions about the climate-development nexus through
evidence-based analysis.
The series is sponsored by the World Bank Group’s Climate Change Cross-Cutting
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v
Titles in the Series
Diversification and Cooperation in a Decarbonizing World: Climate Strategies for
Fossil Fuel–Dependent Countries (2020) by Grzegorz Peszko, Dominique van der
Mensbrugghe, Alexander Golub, John Ward, Dimitri Zenghelis, Cor Marijs, Anne
Schopp, John A. Rogers, and Amelia Midgley.
Unbreakable: Building the Resilience of the Poor in the Face of Natural Disasters (2017) by
Stephane Hallegatte, Adrien Vogt-Schilb, Mook Bangalore, and Julie Rozenberg.
Shock Waves: Managing the Impacts of Climate Change on Poverty (2016) by Stephane
Hallegatte, Mook Bangalore, Laura Bonzanigo, Marianne Fay, Tamaro Kane, Ulf
Narloch, Julie Rozenberg, David Treguer, and Adrien Vogt-Schilb.
Decarbonizing Development: Three Steps to a Zero-Carbon Future (2015) by Marianne
Fay, Stephane Hallegatte, Adrien Vogt-Schilb, Julie Rozenberg, Ulf Narloch, and
Tom Kerr.
vii
Contents
Acknowledgments.......................................................................................................... xiii
Executive Summary..........................................................................................................xv
Abbreviations...................................................................................................................xxv
Chapter 1. Introduction...................................................................................................... 1
Notes................................................................................................................6
References........................................................................................................6
Chapter 2. Challenges, Risks, and Opportunities of a Low-Carbon Transition..... 11
Existing Challenges for FFDCs....................................................................11
New Risks for FFDCs....................................................................................14
An LCT: Smooth Sailing or Tipping Points?...............................................16
Notes..............................................................................................................28
References......................................................................................................29
Chapter 3. Potential Impacts on Different Sectors and Countries ......................... 37
Coal Sector....................................................................................................37
Oil and Gas Sectors.......................................................................................40
Refineries ......................................................................................................46
Carbon-Intensive Manufacturing: Steel and Cement.................................47
Why Focus on Sovereigns and State-Owned Enterprises?..........................48
Notes..............................................................................................................51
References......................................................................................................52
Chapter 4. Strategic Framework for Dealing with the Potential Impacts
of a Low-Carbon Transition......................................................................... 55
Diversification Options for FFDCs..............................................................55
Options for Climate Action and Cooperation............................................65
Notes..............................................................................................................73
References......................................................................................................73
ix
Contents
Chapter 5. Preparedness for a Low-Carbon Transition............................................. 79
Measuring Preparedness for an LCT...........................................................79
Exposure........................................................................................................83
Resilience ......................................................................................................86
Notes..............................................................................................................95
References......................................................................................................95
Chapter 6. Charting the Future....................................................................................... 97
Assessing Uncertain Impacts and Preparedness for Managing a
Low-Carbon Transition................................................................................98
Developing Strategies to Manage an LCT...................................................99
Strategies for Cooperation in International Climate Initiatives ..............114
Notes............................................................................................................115
References....................................................................................................115
Chapter 7. Conclusions................................................................................................. 119
Boxes
1.1 Climate Response Measures in the UNFCCC Documents........................................2
2.1 The Oil Price Collapse and the “Reverse Resource Curse”.......................................13
2.2 Climate-Related Risks to Financial and Economic Stability....................................14
3.1 Coal Transport Infrastructure: Risk of Stranded Assets in Mozambique...............40
4.1 Empirical Evidence for Export Diversification.........................................................57
4.2 Classification of Assets and Capital...........................................................................60
4.3 Traditional View on Price-Based Cooperative Policy Instruments under
the Paris Agreement...................................................................................................68
4.4 Wellhead Carbon Tax.................................................................................................69
5.1 Principal Component Analysis (PCA)......................................................................80
5.2 Indicator of Economic Complexity...........................................................................93
5.3 Significance of Technological Openness...................................................................94
6.1 Tools to Aid Decision-Making under Uncertainty...................................................99
6.2 Harrigan’s Model of Firms’ Strategies in Declining Industries..............................101
6.3 Statoil (Now Equinor) Strategic Framework..........................................................107
6.4 The Decline of the UK Coal Industry.....................................................................113
x
Contents
Figures
ES.1 How a Low-Carbon Transition Could Unfold and How FFDCs Could
Prepare for It..............................................................................................................xvi
ES.2 Two Broad Diversification Strategies.......................................................................xvii
ES.3 Fossil Fuel Rents as a Share of GDP for 10 Top Fuel Producers, 2013–17........... xviii
ES.4 Countries’ Preparedness for a Low-Carbon Transition...........................................xix
2.1 How a Low-Carbon Transition Could Unfold and How FFDCs Could
Prepare for It...............................................................................................................16
2.2 Nonhydro Renewables Share of Power Generation by Region................................20
3.1 Coal Reserves-to-Production Ratios.........................................................................38
3.2 Fossil Fuel Rents as a Share of GDP for 10 Top Fuel Producers, 2013–17...............39
3.3 Breakdown of Coal Sector Cash Flow, 2011–50.......................................................41
3.4 Oil Reserves-to-Production Ratios............................................................................42
3.5 Gas Reserves-to-Production Ratios...........................................................................43
3.6 Room for New Oil and Gas Field Development in 2-Degree Celsius
IEA Scenarios..............................................................................................................44
3.7 Global Oil Supply Cost Curve and Break-Even Prices.............................................45
3.8 Domestic Consumption of Cement in China and India..........................................48
3.9 Shares in Expected Revenue from Oil and Gas between 2013 and 2050.................49
3.10 Export Revenues from Fossil Fuels as a Share of Total Export Revenues
for the Top 10 Most Dependent Countries (2013–17).............................................50
4.1 Two Broad Diversification Strategies.........................................................................56
B4.1.1 Relationship between Export Concentration and GDP per Capita
Growth (1961–2000)..................................................................................................57
4.2 Importance of Public Institutions for the Asset Index.............................................62
4.3 Long-Term Impact of Different Strategies on GDP in FFDCs under
Different Climate and Trade Policy Scenarios..........................................................72
5.1 Countries’ Preparedness for a Low-Carbon Transition............................................81
5.2 Resource Rents as a Share of GNI, 2016....................................................................83
5.3 Ratio of Committed Emissions from Power Generation (to 2020) to
Current Generation Capacity....................................................................................87
B5.2.1 Economic Complexity and Variance in GDP per Capita.........................................93
6.1 More than Divestment: Multiple Strategies Will Help Fossil
Fuel–Dependent Countries Navigate the Risks and Harness the
Opportunities of a Low-Carbon Transition..............................................................98
6.2 Strategy-Development Process for Countries and Fossil Fuel–Dependent SOEs.......108
xi
Contents
Tables
4.1 Choices of Possible Instruments of Climate Cooperation Strategies.....................66
B5.1.1 Structure of Index of Preparedness for Climate Response Measure......................80
5.1 Exposure Indicators for Selected Fossil Fuel–Dependent Countries.....................85
5.2 Economic Resilience Indicators................................................................................88
5.3 Indicators of Resilience to External Shocks for Fossil Fuel–Dependent
Countries and Other Selected Countries.................................................................89
B6.2.1 Matrix of External Determinants of Successful Strategies of Firms in
Declining Industries................................................................................................102
6.1 Matrix of Determinants of Success of the Strategies of Fossil
Fuel–Dependent Firms...........................................................................................106
xii
Acknowledgments
This book was written by a team, led by Grzegorz Peszko of the World Bank, composed
of Alexander Golub of American University, Cor Marijs and John Ward of Vivid
Economics, Dimitri Zenghelis of the London School of Economics, and Dominique
van der Mensbrugghe of the Center for Global Trade Analysis at Purdue University, as
well as Amelia Midgley, John A. Rogers, and Anne Schopp of the World Bank. The
computable general equilibrium modeling that supports the analysis, published in an
accompanying background paper, was led by Dominique van der Mensbrugghe with
the help of Erwin Corong, also with Purdue University. Other contributions were made
by Roger Fouquet and Ralph Hippe of the London School of Economics and Christopher
Beauman of the European Bank for Reconstruction and Development.
The work was carried out under the supervision of Jane Ebinger, Stephen Hammer,
and Marcelo Mena of the World Bank and overall oversight of John Roome, then Senior
Director of the Climate Change Group at the World Bank. Benoit Blarel, Kevin Carey,
Marianne Fay, Stephane Hallegatte, Michael Stanley, and Hans Timmer of the World
Bank, and Sam Fankhauser of the London School of Economics and Vivid Economics,
reviewed the manuscript several times and provided valuable advice to the team
throughout the process of conceptualizing and writing. Elisabeth Jane Mealey of the
World Bank offered valuable coaching on messaging and communications.
The authors extend special thanks to peer reviewers for helping to shape the book at
its many stages. Internal World Bank peer review was performed by Rabah Arezki,
Andrew Burns, Vivien Foster, Ejaz Ghani, and Michael Toman. Additional peer review
was performed by Ben Caldecott of the Oxford Sustainable Finance Programme, Laura
Cozzi of the International Energy Agency, Ottmar Edenhofer of the Potsdam Institute
for Climate Impact Research, Christiana Figueres and Kirk Hamilton of the World Bank,
Helen Mountford of the World Resources Institute, Sergey Paltsev of Massachussetts
Institute of Technology, Massimo Tavoni of Fondazione Eni Enrico Mattei and the
Intergovernmental Panel on Climate Change, and experts from Carbon Tracker. Stuart
Evans, Maarten Hage, and Thomas Kansy of Vivid Economics also supported the
endeavor through peer review.
The team would like to acknowledge invaluable analytical contributions from many
colleagues at the World Bank, including Rubaina Anjum, Neha Mukhi, and Tom Witt,
as well as operational support from Ekta Dudani, Elaine Feister, Paula Garcia, and
Barbara Machado. The World Bank’s formal publishing program managed the editorial
xiii
Acknowledgments
services, design, production, and printing of the book, with Susan Mandel and Jewel
McFadden anchoring the process. The book was skillfully edited by Thomas Steven
Cohen and Inge Pakulski. Others assisting with the book’s publication included Bruno
Bonansea (maps), Sherrie Brown (copyediting), Datapage Digital Services (typesetting),
Zuzana Johansen (proofreading), and Debra Naylor (cover design).
The authors are grateful to members of the leadership of the Climate Change Group
at the World Bank, especially Stephane Hallegatte, for their feedback and support
throughout this venture. The team thanks others who have helped in preparing and
writing the book and apologizes to anyone inadvertently overlooked in these
acknowledgments.
xiv
Executive Summary
Introduction
Fossil fuel–dependent countries (FFDCs) face the conundrum of being both highly
vulnerable to climate change and exposed to the global efforts to mitigate it. FFDCs
that rely on oil, gas, and coal are at greatest risk of upheaval from a low-carbon transition
(LCT). Stakeholders in these countries know that an LCT will cause a global decline in
fossil fuel industries and related value chains on which their economies depend and
find themselves at a crossroads due to the uncertainty about whether and when tipping
points will come.
Stakeholders in FFDCs—especially those in emerging market economies facing the
development challenges of poverty and lack of opportunity—are deeply concerned
about the costs of suddenly shifting away from foundational infrastructure and systems
built up over decades on the back of fossil fuels and related industries.
This book provides a road map and proactive strategies that the global community
and FFDCs can use to create the right incentives and enabling environments to
encourage FFDC participation in the LCT, while acknowledging the constraints that
they face. Achieving the objectives of the Paris Agreement requires a realistic assessment
of these challenges and resolute action to tackle them.
A Low-Carbon Transition Brings New Structural Challenges to FFDCs
For FFDCs, the transition to a low-carbon future means welcoming mitigation of climate
change risks while recognizing that those same response measures entail an eventual shift
away from the fossil fuels that power their economies and societies. Although unique in
many ways, these countries as a whole represent almost one-third of the global population,
20 percent of direct global greenhouse gas (GHG) emissions, and more than 80 percent of
emissions embodied in known oil and gas reserves.
Some stakeholders in FFDCs regard the LCT as an opportunity to deepen
diversification, but most consider it a risk to their narrow revenue and employment
base in carbon-intensive activities, such as oil, gas, and coal extraction; downstream
processing; and fossil fuel–intensive manufacturing including refineries, petrochemicals,
steel, cement, and thermal power.
xv
Diversification and Cooperation in a Decarbonizing World
Pursuing their own economic imperatives, FFDCs have universally articulated
aspirations to diversify away from a dependence on fossil fuel income and contributed
to the objectives of the Paris Agreement by submitting their nationally determined
contributions (NDCs). However, it is likely that their existing national strategies do not
sufficiently prepare their economies for the many possible impacts of a global LCT.
In addition, the uncertainty of the pace and scope of the LCT hinders the ability of
governments, businesses, and other stakeholders to make timely, effective decisions. The
uncertainty is particularly deep with respect to policy developments by the largest
economies, consumption choices of the growing middle class in developing countries, and
structural disruptions in transport, energy, land use, and carbon capture and sequestration.
Uncertainty is not, however, a good excuse for inaction. Successful decisions under
deep uncertainty require consideration of multiple plausible futures and being prepared
for best-case and worst-case scenarios. This book suggests a framework for action for
FFDCs and their partners based on an analysis of two broad strategies—one concerning
economic diversification, and the other concerning cooperating on global efforts to
stabilize the climate (figure ES.1).
FIGURE ES.1 How a Low-Carbon Transition Could Unfold and How FFDCs Could
Prepare for It
External drivers
Border
adjustment
measures
ns log nd
Un ies i tries
po co
tra no a
ch ial
lic un
ila n o
fe y
te anc
te th
rs
ra er
Fin
l
Fossil fuel–dependent
Diversify? Cooperate?
country
s d
tit rm g
ion an
ins l no ngin
Di hno
te
sru log
ut s
cia a
c
so Ch
pt ies
ive
New market
opportunities
External drivers
Source: World Bank.
xvi
Executive Summary
Economic Diversification during a Low-Carbon Transition
Broader approaches to diversification are better fitted to manage the impacts of a global
LCT. FFDCs have long grappled with commodity price volatility using macro-fiscal
policies that counterbalance the impacts of commodity price cycles and traditional
diversification through vertical, energy-intensive industrialization that branches out
from fossil fuel extraction to add value in domestic fuel processing and fuel-intensive
manufacturing. Although such diversification strategies help to hedge against cyclical
risks in commodity markets, they also increase exposure to the structural impacts of an
LCT by deepening economic dependence on traditional emissions-intensive industries.
Rather than focusing on diversifying tradable products in the traditional fossil fuel
product space, the diversification strategy today may need to focus more on diversifying
the underlying wealth—the portfolio of assets used by an economy, including human
capital and renewable natural capital, along with underground assets and produced
capital. Such asset diversification (figure ES.2) leads to more productive and competitive
economies that are also more flexible and resilient to external shocks, especially if
supported by strong institutions and good governance.
Macroeconomic simulations carried out for this book show that asset diversification
is the best long-term economic strategy for FFDCs. By reducing knowledge and
FIGURE ES.2 Two Broad Diversification Strategies
• Diversifies the portfolio of national assets
(inputs): natural capital and intangible
assets (knowledge, innovation, institutions)
• Discovers new comparative advantage and
Asset diversification hedges structural risks
• Increases flexibility, resilience, productivity,
and climate mitigation co-benefits
• Relies on knowledge and efficiency;
increases productivity over time
• Diversifies outputs and exports through
energy- or carbon-intensive industrialization
on the back of fossil fuel value chains
• Builds on current comparative advantage
Traditional
and hedges cyclical risks
diversification
• Increases greenhouse gas emissions and exposure
through
to low-greenhouse-gas transition
industrialization
• Relies on energy subsidies to industry;
maintains low productivity
Source: World Bank.
xvii
Diversification and Cooperation in a Decarbonizing World
productivity gaps with the most advanced countries, it is the only growth model that
can push consumption and growth above business as usual in the long term.
Asset diversification falls victim to a “tragedy of the horizon,” however. Changing the
comparative advantage held by traditional fossil fuel industries unsettles current sources of
revenue and requires building new skills, capabilities, and innovation systems from scratch.
It carries economic and policy risks because of the need for large upfront investments with
delayed returns that appear uncertain and elusive in a time frame that is relevant for current
policy makers and business leaders. The upfront investments can also be challenging to
justify socially because they compete with short-term consumption aspirations.
Mobilizing investments in asset diversification requires long-term revenue visibility.
FFDCs are concerned that an LCT will drain current fossil fuel–related revenues before
a critical mass of new capital and capabilities can generate new sources of sustainable
income. This book suggests that fuel-related revenues in FFDCs can be lower than
expected, but the impact will differ by fuel. Many oil and gas exporters can expect
significant revenue flows in the next two to three decades. At the same time, any LCT
will quickly erode coal revenues, but the associated systemic risk is negligible because
coal is a small part of even the most coal-dominated economies (figure ES.3). Locally
stranded labor and regional economic impacts are more challenging for coal countries
to deal with than stranded assets on a national level.
FIGURE ES.3 Fossil Fuel Rents as a Share of GDP for 10 Top Fuel Producers, 2013–17
a. Oil rents (% of GDP) b. Gas rents (% of GDP) c. Coal rents (% of GDP)
for top 10 producers for top 10 producers for top 10 producers
60 60 60
50 50 50
40 40 40
30 30 30
20 20 20
10 10 10
0 0 0
de p.
ra .
Un Ca ina
Ind Ind a
de p
d A di raq
Ru , Is mira a
ian i s
Br n
Un C da
d S na
s
Ru n, Is Al tar
ian mi ia
Sa No ion
Au rabia
Ch a
d S da
s
on ia
ia
str a
K lo ia
ss ite hs a
Fe Sta n
de tes
rm n
i A ay
Po ny
ite Sau I it
Ca il
d
c
ss lam te
te
te
Fe c Re
Fe c Re
Ira ab E rabi
tio
ali
Au Chin
Ru Un azak mbi
ian d ta
Ge atio
az
ss la ger
es
Co al
wa
fri
lan
na
ite hi
ite na
ud rw
a
Qa
ta
t
ta
str
ra
hA
Ku
r A
r
ut
So
n
Ira
Un
2013 2014 2015 2016
Source: World Bank World Development Indicators.
Note: GDP = gross domestic product.
xviii
Executive Summary
The impacts of an LCT will vary from country to country. Competition between all
fuel producers will increase as demand shrinks and disruptive clean technologies
capture more markets. Producers with low extraction costs, lower upfront capital
needs, better access to investors and developers, higher accumulated financial strength,
lower leverage, and more highly developed export infrastructure will be in a privileged
position for maintaining their revenues.
Although low fuel prices can mean limited resources and financial and social
challenges for asset diversification, high fuel prices can unleash countervailing
economic forces. Interestingly, high extractive export revenues can make asset
diversification more, not less, difficult. Windfall profits from exports of oil and gas
inflate exchange rates and feed a Dutch disease and a resource curse that crowd out
non–fuel related economic activities, deteriorate governance, and increase the
power of incumbents to resist change. An LCT could reverse the resource curse and
make diversification easier because lower commodity prices and revenues would
depreciate local currencies and make manufacturing exports cheaper and imports
FIGURE ES.4 Countries’ Preparedness for a Low-Carbon Transition
Iraq
1.0 Libya
High exposure
Qatar Brunei Darussalam Kazakhstan
Kuwait
Saudi Arabia
Oman Nigeria
Vietnam
Iran, Islamic Rep. Venezuela, RB
Azerbaijan
Guyana
Equatorial Guinea
Algeria
Botswana
Russian Federation Congo, Rep.
South Africa Cambodia
0.5 Ukraine
United Arab Emirates China Ghana
Indonesia India
Norway Malaysia Bolivia Egypt, Arab Rep. Angola
Australia Colombia Côte d’Ivoire Bangladesh Mozambique
Canada Poland Thailand Turkey Namibia Argentina
Korea, Rep. United States Mexico Malawi
Chile
Germany Japan Philippines Brazil Mongolia Pakistan
Sweden France Italy Uganda
United Tanzania
Kenya
Kingdom
Low exposure
0 0.5 1.0
High resilience Low resilience
Source: Based on several databases.
Note: Some likely poorly prepared countries are not in the figure because the full data sets were not available to the authors. Examples include
Turkmenistan and Papua New Guinea.
xix
Diversification and Cooperation in a Decarbonizing World
more expensive, triggering increased localization of production of non–fuel related
activities in FFDCs.
The countries best prepared for an LCT are those least exposed to its impacts and
most resilient to them, able to swiftly adapt to changing external conditions and harness
emerging opportunities (figure ES.4). The index of preparedness developed in this
study suggests that the least prepared countries, including Iraq and Libya, are
exceptionally vulnerable to external shocks from the LCT, given that long-term conflicts
have destroyed almost all non-oil tradable industries and tarnished already weak
institutions. Equatorial Guinea, Nigeria, and República Bolivariana de Venezuela are
among the countries that are both the most exposed and the least resilient, given their
poor governance records. Cambodia is vulnerable mainly because of the large share of
young coal power plants in the generation mix, as is Guyana because of its recently
discovered large oil reserves. Azerbaijan, Botswana, and Kazakhstan share high exposure
and relatively weak resilience. Some Gulf Cooperation Council countries can be
considered borderline cases–although significantly exposed, they also enjoy relatively
high resilience. On the other hand, Norway is more exposed than some less-prepared
countries, such as Angola, but nonetheless is well prepared for an LCT thanks to its
resilience, in particular its economic flexibility, diversification, and high quality of
human capital and institutions.
The Paris Agreement Opens Room to Align Incentives and Ignite Broad
Coalitions for Climate Action
Asset diversification alone may not be enough to stabilize GHG emissions in many
FFDCs, because their comparative advantage in emission-intensive industries is strong.
Simulations realized for this book suggest that even ambitious asset diversification
policies may not be able to trigger the major structural shift toward a low-emissions
economy. Paradoxically, ambitious unilateral climate policies in the rest of the world
can further entrench fuel-intensive economic structures in FFDCs. Rapid unilateral
decarbonization in other countries would increase the costs for their energy-intensive
industries while depressing global fuel prices and reducing the opportunity cost of
using fossil fuels in FFDCs. As a result, industries in FFDCs could expand market share
in the globally declining emissions-intensive products, partly offsetting climate
mitigation co-benefits of asset diversification. Cooperative domestic climate policies
need to complement asset diversification to engage FFDCs in global climate action.
FFDCs have some self-interest in domestic cooperative climate policies. A comparable
level of effort of climate policy—for example, in setting carbon prices—can help diversify
away from products linked to fossil fuels and prevent possible trade sanctions from being
implemented by other countries, enhancing the long-term upside of asset diversification.
However, domestic climate policies remain costly for FFDCs over the short term,
unless there is a credible threat that other countries may impose trade sanctions on
xx
Executive Summary
noncooperative countries. Otherwise, FFDCs have short-term incentives to postpone
policies that increase domestic energy costs and to continue prioritizing traditional,
pollution-intensive industries, because it is their familiar product space and skill set,
even if it exposes them to possible future external LCT impacts and a long-term middle-
income trap.
In contrast, net fuel importers and those countries that use relatively less fuel
have a fundamental advantage over FFDCs in harnessing opportunities from an
LCT. Many have already accumulated skills and capabilities in diversified, clean,
and knowledge-intensive economic activities and have an established competitive
edge in those market segments that gives them stronger incentives to lead on cli-
mate action. FFDCs could be negatively affected by climate policies in these coun-
tries. In particular, carbon prices applied by fuel importers—cooperative or not—
extract a portion of resource rents from FFDCs, leaving them with less revenues
available for risky long-term investments in asset diversification. But these effects
do not create an incentive for FFDCs to cooperate on climate action, unless it helps
slow down the transition away from fossil fuels (especially oil, which is highly
dependent on demand from the transport sector and has more limited domestic
uses than coal and gas).
Incentives to implement cooperative climate policies in FFDCs can be strengthened
by the international community. The Paris Agreement acknowledged the primacy of
domestic self-interest in climate policy and achieved universal participation (at least
initially), but at the cost of not allocating any mitigation commitments to individual
countries. The architecture of the Paris Agreement (Article 6.1) offers a conducive
space for willing parties to form bottom-up clubs to unilaterally ignite ambitious
climate action. For such clubs to be effective and comprehensive, their founders would
need to complement their individual NDCs with collectively determined contributions,
and apply an enforcement mechanism based on reciprocity (“I will if you will”) to
build trust, prevent existing club members from defecting, and induce the cooperation
of reluctant parties.
New, unconventional international incentives can help overcome weak short-
term incentives and capabilities to cooperate on climate action. Among positive
incentives, strategic, conditional financial and technology transfers could be an
effective alternative to the current retail, project-by-project climate finance that
involves large transaction costs and weak incentive effects. Other promising
cooperative instruments are bilateral or multilateral technology and policy
cooperation agreements between fuel exporters and importers, such as harmonized
carbon prices with revenue-sharing agreements implemented through multilateral
wellhead carbon tax agreements. Wellhead tax agreements, if designed to prevent
negative outcomes on low-income countries, would align international incentives to
cooperate, reduce global emissions, and provide FFDCs with the resources necessary
for diversification while addressing the social and political impacts of an LCT.
xxi
Diversification and Cooperation in a Decarbonizing World
Among the negative incentives are different possible forms of border tax adjustments.
Traditional border tax adjustments based on the carbon content of imports from
FFDCs may not be enough to encourage cooperative climate policies in many FFDCs.
The credible threat of “incentive-based” trade sanctions, such as those proposed by
Nobel Prize winner William Nordhaus, could prompt FFDCs to seek cooperative deals,
but this is a risky path for all.
Resource-rich, lower-income, and conflict-affected countries (many of them in
Africa and the Middle East) pose development and ethical dilemmas. They have not yet
converted resource rents into alternative assets and may find it relatively more difficult
to attract investors. Other challenging cases include middle-income coal exporters that
may also lack the financial and political capital to address local social challenges of the
LCT because of sticky, stranded labor.
Simulations suggest that the incentives needed for the most vulnerable FFDCs to
participate in a global LCT would cost only one-eighth of the savings that their
participation would generate in other countries. The required transfers would still
reach a total of $663 billion between 2015 and 2050, and would meet significant
practical and political challenges.
A Road Map to the Low-Carbon Transition for FFDCs
Successful economic strategies in FFDCs will need to strike a balance between (1)
managing traditional carbon-intensive assets and their revenue volatility and (2)
managing the transition to knowledge-intensive growth models relying on much
broader portfolios of assets. Ultimately, sustainable and resilient development implies
an economy that is less exposed and more adaptable to external shocks.
Traditional, emissions-intensive diversification may be a necessary, but temporary
enabler of an LCT. It hedges against the volatility of commodity prices and builds on
existing strengths and capabilities to allow FFDCs to maintain adequate levels of
current revenue and to enable long-term and high-risk investments in innovation
systems outside of current comfort zones. Predictable revenue flows help FFDCs
establish a new place in the global economic geography and alleviate political economy
and social challenges associated with the transition to new asset classes.
But traditional diversification carries a risk of locking FFDCs in a vicious cycle of
low productivity, poor governance, and high emissions, thereby increasing vulnerability
to impacts of an LCT. Changing the established national comparative advantage
requires bold and consistent policy efforts, high-quality institutions, a skilled and
motivated workforce, external incentives, and predictable access to finance.
xxii
Executive Summary
This book makes a case for international recognition that the contributions of
FFDCs to the goals of the Paris Agreement can and should be different from the
contributions of net fuel importers. Efforts to pursue asset diversification with
mitigation co-benefits could form a core of their NDCs.
However, because the comparative advantage of FFDCs in energy and emissions-
intensive products is so entrenched, additional domestic policy efforts would be needed
to break away from their dependence on the fossil fuel–intensive value chain. Such
policies would include removing resource price distortions and implementing
environmental fiscal reforms, mission-oriented research and development (R&D), and
innovation systems, as well as regulatory frameworks and a business environment that
encourages new, low-carbon private entrants to challenge the entrenched positions of
emissions-intensive incumbents, especially those that are state owned.
The international community may need to find ways to encourage and enable
structural policy reforms as FFDC contributions to the goals of the Paris Agreement.
This book identifies no silver bullet but provides new insights about effective pathways
of global cooperation toward the goals of the Paris Agreement, in line with fair and
sustainable development for all.
One of the key conclusions of this study is that asset diversification represents a fun-
damental shift toward a dematerialized long-term growth model, in which fewer mate-
rial inputs generate higher economic output and welfare. Therefore, the risk of stranded
assets is not a helpful focus for dialogue on climate action in the fossil fuel–dependent
economies. Changes in the value of underground and produced assets are less relevant
indicators of economic performance during an LCT than changes in asset structure, and
in income and welfare flows. A low-carbon transition triggers a transition from a tradi-
tional capital-intensive growth model to a more labor- and k nowledge-intensive growth
model, in which human and renewable natural capital, as well as intangibles, increas-
ingly substitute for produced and natural (exhaustible) assets in driving prosperity.
xxiii
Abbreviations
AOSIS Alliance of Small Island States
BAT border adjustment tax
BAU business as usual
BCA border carbon adjustment
BCAT border carbon adjustment tax
BOF basic oxygen furnace
BP British Petroleum
C Celsius
CGE computable general equilibrium
CO2 carbon dioxide
COP Conference of the Parties
CPI Climate Policy Initiative
CPLC Carbon Pricing Leadership Coalition
EAF electric arc furnace
EBRD European Bank for Reconstruction and Development
ECI Economic Complexity Index
ESRB European Systemic Risk Board
EU European Union
FFDC fossil fuel–dependent country
GCC Gulf Cooperation Council
GDP gross domestic product
GHG greenhouse gas
GJ gigajoule
GNI gross national income
GTAP Global Trade Analysis Project
GtCO2 (metric) gigatons of carbon dioxide
HHI Herfindahl–Hirschman index
HT high growth rate of low-carbon technologies
IDDRI Institute for Sustainable Development and International Relations
IEA International Energy Agency
IIGCC International Investors Group on Climate Change
IMF International Monetary Fund
IPCC Intergovernmental Panel on Climate Change
IPCC AR5 Fifth Assessment Report of the United Nations Intergovernmental Panel
on Climate Change
xxv
Abbreviations
IRENA International Renewable Energy Agency
LCT low-carbon transition
LNG liquefied natural gas
LSE London School of Economics
NDC nationally determined contribution
NEA Nuclear Energy Agency
NES new energy solutions
NPV net present value
OECD Organisation for Economic Co-operation and Development
OGCI oil and gas climate investments
OPEC Organization of the Petroleum Exporting Countries
PCA principal component analysis
PIK Potsdam Institut für Klimafolgenforschung
PV photovoltaic
R&D research and development
SI International System of Units
SOE state-owned enterprise
TCFD Task Force on Climate-Related Financial Disclosures
tCO2e tonne of carbon dioxide equivalent
UCISL University of Cambridge Institute for Sustainability Leadership
UNFCCC United Nations Framework Convention on Climate Change
WSA World Steel Association
All dollar amounts are US dollars unless otherwise indicated.
xxvi
1. Introduction
This book provides a stocktaking of what the global low-carbon t ransition (LCT) may
mean for fossil fuel–dependent countries (FFDCs) and how they can manage it. FFDCs
are most exposed to the impacts of a global LCT and, at the same time, are often least
prepared to manage it. Their economies depend on the export of oil, gas, or coal, on the
use of carbon-intensive infrastructure (for example, refineries, petrochemicals, coal
power plants), or both. These countries face at least two climate-related risks. The first-
order risk arises from weather-related events induced by climate change. The second-
order risk is financial, fiscal, and macrostructural. It arises from the potentially
accelerated transition of the global economy away from carbon-intensive fuels (Carney
2015). This book focuses on managing this transition risk and harnessing its related
opportunities.
Although FFDCs significantly differ from one another in many respects, they jointly
account for almost 30 percent of the world’s population, 15 percent of gross domestic
product (GDP), and 20 percent of global direct greenhouse gas (GHG) emissions. On
average, their direct emissions per capita are lower than those of the rest of the world,
but the emissions intensity of their GDP is higher than the world’s average. They hold
the key to the globe’s remaining fossil fuel reserves: their share in the global value of
underground proven reserves of oil and gas amounts to 82 and 85 percent respectively.1
In 2016 they produced 67 percent of the world’s oil and 55 percent of the world’s gas
(BP 2018).
The primary audience for this study is decision-makers in FFDCs. By focusing on
FFDCs, this book complements previous World Bank Group reports (CPLC 2017; Fay
et al. 2015; Kossoy et al. 2015; World Bank, Ecofys, and Vivid Economics 2016, 2017).
However, decision-makers in the rest of the world may also find this book useful in
managing the transition of their own fuel-extractive and carbon-intensive sectors as
well as in developing their climate policies to encourage global efforts toward climate
goals.
This book analyzes the strategies available to FFDCs for managing the risks and
apping into the opportunities of an LCT. For these countries, the risk associated with
t
being an early LCT mover is arguably higher than it is for countries that are more
diversified and have a comparative advantage in knowledge-intensive economic
activities. Many stakeholders in FFDCs understandably find it risky to abandon the
1
Diversification and Cooperation in a Decarbonizing World
growth drivers that have served them well so far. But they also realize that holding on
to the same growth drivers in the face of significant global change is itself a source of
risk. This book provides guidance on how to navigate this dual challenge. It identifies
welfare-enhancing pathways for FFDCs to deepen diversification, hedge risks, and
potentially discover new sources of comparative advantage. It also explores new
instruments that the international community can apply to encourage comprehensive
cooperation toward the mitigation goal included in the Paris Agreement, while
acknowledging the special circumstances of the countries that are less prepared to
decarbonize.
Many FFDCs have long been concerned with the negative impacts of policy
m
easures of other countries responding to climate change. Their special circumstances
were recognized in the United Nations Framework Convention on Climate Change
(UNFCCC) in 1992 (UNFCCC 2018), the Kyoto Protocol (Barnetta and Dessaib
2002), and the Paris Agreement (box 1.1). The UNFCCC documents call on all parties
to take full consideration of the specific needs and concerns of developing-country
parties arising from the impact of the implementation of response measures when
addressing climate change (UNFCCC 2018). This book provides guidance on how to
operationalize the Paris Agreement, while directly addressing the concerns and dilem-
mas of the countries that are less prepared to decarbonize. In addition, this analysis
helps identify new design elements and incentives that can be built into future
BOX 1.1 Climate Response Measures in the UNFCCC Documents
■ Article 4.8 of the Convention and Articles 2.3 and 3.14 of the Kyoto Protocol provide a
basis for addressing the impact of the implementation of response measures.
■ Article 4.8(h) in the Climate Convention commits the parties to consider the specific needs
and concerns of developing-country parties arising from the impact of the implementation
of response measures, including on “Countries whose economies are highly dependent on
income generated from the production, processing and export, and/or on consumption of
fossil fuels and associated energy-intensive products” (UNFCCC 1992).
■ When addressing climate change concerns, the Kyoto Protocol commits parties to strive
to minimize adverse economic, social, and environmental impacts on other parties, espe-
cially developing-country parties, and in particular, those identified in Articles 4.8 and 4.9
of the Convention, taking into account Article 3 of the Convention.
■ The Paris Agreement states that parties shall take into consideration in the implementa-
tion of the agreement the concern of parties with economies most affected by the impacts
of response measures, particularly developing-country parties.
■ Response measures are being further addressed in the context of the Bali Road Map
process, the Cancun Agreements, and the Durban Outcome.
Source: https://unfccc.int/topics/mitigation/workstreams/response-measures.
2
Introduction
strategies of coalitions and clubs involved in the implementation of the Paris
Agreement, potentially reducing roadblocks to a mutually beneficial cooperative
outcome.
FFDCs developed a comparative economic advantage in fossil fuel–intensive sectors
in the period when climate change was not yet recognized as a global risk. These
sectors—whether extractive, energy related, or manufacturing—are engines of growth
and welfare. They often employ a significant share of a country’s capital and labor and
generate the bulk of export revenues. In cases in which extraction of resources was
accompanied by sound macro-fiscal frameworks and good governance, FFDCs accu-
mulated physical and financial capital as well as skills and capabilities in running busi-
nesses and institutions. Accordingly, millions of people were pulled out of poverty and
leapfrogged to a middle- or high-income level within a single generation. Several low-
income FFDCs in Africa, Latin America, and South Asia that have discovered, though
not yet tapped, large underground fossil fuel reserves hope it will drive similar prosper-
ity for their economies.
FFDCs were already grappling with the downsides of dependency on narrow sources
of income well before the impacts of climate change were widely understood. Prices in
fossil fuel markets can be volatile; fossil fuel exports can lead to an appreciation of their
currency, which may undermine the competitiveness of the rest of the economy; and
the riches on offer can lead to rent-seeking and corruption rather than dynamism and
entrepreneurship (Ross 2013). FFDCs have adopted a variety of responses—including
countercyclical macro-fiscal policies, forced savings in stabilization and sovereign
wealth funds, and exchange rate flexibility (IMF 2012; Ossowski and Halland 2016).
This book explores whether the same policy responses can hedge the potential impacts
of an LCT.
Several countries and regions have already revealed an-interest in pursuing some
aspects of an LCT independently of efforts to achieve the goals of the Paris Agreement.
Most European Union member states, California and a few other US states, British
Columbia and Quebec in Canada, Chile, China, India, the Republic of Korea,
New Zealand, and, more recently, Morocco have invested in exploiting their first-mover
advantage in low-carbon, knowledge-intensive technologies and products. What all
these countries and regions have in common is that they are net importers of fossil
fuels and usually have already accumulated capital, skills, and capabilities in
knowledge-intensive rather than energy-intensive economic activities. Literature on
carbon pricing is still dominated by the perspective of net importers of fossil fuels,
where win-win opportunities are relatively easy to identify.
To date, surprisingly little consideration has been given to the implications of an LCT
for FFDCs, especially the developing countries among them (Manley, Cust, and Cecchinato
2017). Yet as early as 2012, Cramton and Stoft observed that any global climate agreement
would probably make countries that export a significant amount of fossil fuels worse off,
3
Diversification and Cooperation in a Decarbonizing World
at least over the short term, and hence unwilling to voluntarily cooperate in the absence
of additional incentives. The more popular literature has predominantly focused on how
large, listed international oil and gas companies may or may not be affected (Carbon Tracker
2015, 2017), while central banks in Europe have begun research on the implications for
financial sector stability in Organisation for Economic Co-operation and Development
(OECD) countries and large emerging market economies (Bank of England 2015; Carbon
Tracker 2017; Carney 2015; Cleveland, Schuwerk, and Weber 2015; FSB 2017; Regelink
et al. 2017; Weyzig et al. 2014). The authors who recognized that a global LCT poses a
challenge to sovereigns (Caldecott et al. 2016; CPI 2016; Lange, Wodon, and Cust and
Manley in Carey 2018) paved the way for this book.
The perspective of fossil fuel exporters on climate policy is not a new issue in the
economic literature, and although underresearched, its influence on the policy debate,
and hence its impact on climate cooperation, has been limited. As early as 1982,
Bergstrom showed that if the main oil-consuming nations cooperated with each other
they could extract significant rents from oil-producing nations through national excise
taxes, counterbalancing Organization of the Petroleum Exporting Countries (OPEC)
cartel goals. Dong and Whalley (2009); Johansson et al. (2009); and Liski and Tahvonen
(2004) confirm that OECD countries’ traditional demand-side climate policies would
capture OPEC oil rents. Bauer et al. (2016) apply the REMIND model2 to show that
carbon prices introduced by importers of fossil fuels capture a portion of resource
rents from fuel exporters, while Strand (2008, 2013) and Karp, Siddiqui, and Strand
(2015) find through the use of a theoretical model that a carbon tax extracts higher
rents from exporters than does a cap-and-trade scheme. Franks, Edenhofer, and
Lessmann (2015) and Edenhofer and Ockenfels (2015) move the debate further by
demonstrating that, for fuel importers, carbon taxes are superior to capital taxes
because they capture part of the resource rent that is held initially by the owners and
exporters of fossil fuels. They show that this result holds regardless of whether fuel
importers cooperate, and that fuel exporters are worse off even if they can strategically
influence prices with an export tax. Elliott et al. (2010); Erickson et al. (2015); and Seto
et al. (2016) all explore further why carbon lock-in makes fossil fuel producers reluc-
tant to undertake climate action. Stiglitz (2015) notes that fossil fuel exporters may not
have the incentive to implement traditional demand-side domestic carbon pricing
under the pressure of moral suasion alone.
Wirl (1995) finds that the best strategy for oil exporters is to preempt importers’
carbon taxes at the wellhead. Dullieux, Ragot, and Schubert (2011) suggest that in
anticipation of a consumers’ carbon tax, OPEC could respond by increasing producer
prices to postpone extraction and reduce consumption, and thereby diminish the
impact of the carbon tax. In this way, they argue that OPEC can reap a part of the
climate rent.” Similarly, Böhringer, Rosendahl, and Schneider (2018) argue that OPEC
“
may want to retain resource rents by increasing the oil price as a response to European
Union climate policy, thereby reversing leakage, although the coalition or cartel size
4
Introduction
critically affects the scope for rent-seeking and leakage reduction. A particular stream
of the literature proposes supply-side climate policies for major fossil fuel producers
(mainly coal) as a way to solve the “green paradox” challenge (Sinn 2008, 2012). The
examples include Asheim (2012); Collier and Venables (2014); Day and Day (2017);
Eichner and Pethig (2017); Fæhn et al. (2017); Gerarden, Reeder, and Stock (2016);
Harstad (2012); Lazarus, Erickson, and Tempest (2015); Muttitt et al. (2016); Piggot
et al. (2018); and Richter, Mendelevitch, and Jotzo (2018).
This book proposes framing the LCT as a risk-management and development chal-
lenge to FFDCs; it analyzes the risks and opportunities a global LCT presents to FFDCs.
It identifies ways these could be managed and tapped. It identifies welfare-enhancing
pathways for FFDCs to deepen diversification, enhance future growth, and cooperate in
international initiatives to stabilize the Earth’s climate consistent with the mitigation
goal adopted in the Paris Agreement. It also explores new instruments that the interna-
tional community can apply to turn the contributions of individual countries into
cooperative actions on the ground.
This book acknowledges that the predicament of an LCT is its deep uncertainty.
The timing and forms of tipping points are unknowable because they depend on
multiple sovereign decisions not yet made by key players or accepted by stakeholders
because of conflicting visions of a preferred future. The LCT could take place as a
smooth and regular transition or as a brutal shift in incentives and policies later on.
Different scenarios are more or less disruptive, including for FFDCs. So far, climate
policies have brought about marginal rather than disruptive changes. Yet the future
is not a linear extension of the past. It took 150 years for coal in Europe to displace
biomass as the primary energy source, but only about 30 years for coal to give way to
oil and gas. No one knows for sure what the dynamics of a future energy transition
will look like and whether the global transition to zero-carbon fuels will happen
faster than previous transformations.
There’s an abundance of hydrocarbons in the world (…) more hydrocarbons than
the world needs, possibly… I don’t know how those [factors shaping the future of
energy] are going to play out... Nobody does. But I think it would be very unwise to
ignore them.
Bernard Looney, BP’s head of exploration and production
(Financial Times 2017)
This book relies on qualitative analysis underpinned by quantitative modeling.
The World Bank and the Purdue University teams have developed a new version
of a global, dynamic, recursive general equilibrium model (GTAP-ENVISAGE),
which has been integrated with extractive models for the oil and gas sectors
(from Rystad UCube) and coal mining (from Wood Mackenzie). The model simu-
lates an array of exploratory scenarios designed through combinations of
5
Diversification and Cooperation in a Decarbonizing World
uncertain but plausible external impacts over which FFDCs have little control
(Peszko, van der Mensbrugghe, and Golub 2020). They can, however, make strate-
gic choices to manage uncertainty and the possible impacts of an LCT.
dependent
The main objectives of this book are to help decision-makers in fossil fuel–
countries do the following:
■ Better understand their exposure and vulnerability to the uncertain impacts of a
possible LCT
■ Better manage their national wealth, including fossil fuel reserves and carbon-
intensive infrastructure
■ Identify policy and asset allocation strategies that are robust; can serve as new
engines of growth and wealth creation under uncertain future economic,
technology, social, and policy trends; and contribute to the global objective of
decarbonizing the world economy.
The book is structured as follows: Chapter 2 discusses the challenges, risks, and
opportunities an LCT could pose for FFDCs. Chapter 3 reviews the varying impacts
such a transition could have on different sectors and countries. Chapter 4 introduces
a conceptual framework for the strategic options FFDCs have to hedge against transi-
tion risks. Chapter 5 focuses on benchmarking the preparedness of various countries
to an LCT, and chapter 6 outlines practical diversification and climate negotiation
strategies that can be used to increase resilience to transition impacts and harness
associated opportunities.
Notes
1. Calculated as expected resource rents.
2. REMIND is a hybrid model that links an optimal economic growth model with a detailed energy
system model. It is developed and used by Potsdam Institut für Klimafolgenforschung (PIK).
Unlike the computable general equilibrium model used in this study, REMIND has a relatively
aggregated structure of the economy and performs intertemporal optimization with perfect
foresight.
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Kossoy, A., G. Peszko, K. Oppermann, N. Prytz, N. Klein, K. Blok, L. Lam, L. Wong, and B. Borkent.
2015. “Competitiveness and Carbon Leakage.” In State and Trends of Carbon Pricing 2015.
Washington, DC: World Bank Group.
Lazarus, M., P. Erickson, and K. Tempest. 2015. “Supply-Side Climate Policy: The Road Less Taken.”
Working Paper 2015–13, Stockholm Environment Institute, Stockholm.
Liski, Matti, and Olli Tahvonen. 2004. “Can Carbon Tax Eat OPEC’s Rents?” Journal of Environmental
Economics and Management 47 (1): 1–12.
Manley, David, James Cust, and Giorgia Cecchinato. 2017. “Stranded Nations? The Climate Policy
Implications for Fossil Fuel-Rich Developing Countries.” OxCarre Policy Paper 34, Oxford
Centre for the Analysis of Resource Rich Economies, Oxford, UK.
Muttitt, G., H. McKinnon, L. Stockman, S. Kretzmann, A. Scott, and D. Turnbull. 2016. The Sky’s
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Washington, DC: Oil Change International.
Ossowski, Rolando, and Havard Halland. 2016. Fiscal Management in Resource-Rich Countries:
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Washington, DC: World Bank.
Peszko, G., D. van der Mensbrugghe, and A. Golub. 2020. “Diversification and Climate Cooperation
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Washington, DC.
8
Introduction
Piggot, G., P. Erickson, H. van Asselt, and M. Lazarus. 2018. “Swimming Upstream: Addressing Fossil
Fuel Supply under the UNFCCC.” Climate Policy 18 (9). https://doi.org/10.1080/14693062.2018
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Regelink, Martijn, Henk Jan Reinders, Maarten Vleeschhouwer, and Iris van de Wiel. 2017. Waterproof?
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Nederlandsche Bank.
Richter, Philipp M., Roman Mendelevitch, and Frank Jotzo. 2018. “Coal Taxes as Supply-Side Climate
Policy: A Rationale for Major Exporters.” Climatic Change 150 (1–2): 43–56. https://doi
.org/10.1007/s10584-018-2163-9.
Ross, Michael L. 2013. The Oil Curse. How Petroleum Wealth Shapes the Development of Nations.
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Types, Causes, and Policy Implications.” Annual Review of Environment and Resources 41: 425–52.
https://doi.org/10.1146/annurev-environ-110615-085934.
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DC: World Bank.
9
Challenges, Risks, and
2.
Opportunities of a Low-Carbon
Transition
Existing Challenges for FFDCs
Fossil fuel–dependent countries (FFDCs), especially those that rely heavily on fossil
fuel exports, face many challenges, even before considering the prospect of a low-
carbon transition (LCT). A significant body of research addresses the question of
whether resource-rich economies are “cursed” or “blessed” by their endowments
(Auty 2001; Badeeb, Lean, and Clark 2017; Gelb 1988, 2010; Ross 2013; van der Ploeg
2011). Studies using measures of resource dependence generally find a negative
relationship between economic growth and resource endowments (Auty 2001;
Gylfason, Herbertsson, and Zoega 1999). Similarly, Hidalgo et al. (2007) and Hausmann
et al. (2013) show that economic complexity and diverse capabilities pave the way to
prosperity. Lederman and Maloney (2007) find that annual gross domestic product
(GDP) growth per capita of net exporters of natural resources was only 0.6 percent, on
average, in the period 1980–2005, while the figure for net importers was 2.2 percent.
They also argue, h owever, that the resource curse can be avoided, because how goods
are produced is more important than what goods are produced.
Three major channels have been identified for the adverse effects of resource
endowments:
■ Dependence on natural resource exports exposes countries to volatile commod-
ity markets that generate macroeconomic instability. Volatile resource prices can,
without careful planning, significantly lower the government’s resource-based
revenues. In Nigeria, for instance, the difference between $50 and $150 per bar-
rel of oil represented 50 percent of GDP (Gelb 2010). The pressures this creates
became evident in the wake of the oil price declines earlier this decade but also
have historical precedents. For example, Mexico and República Bolivariana de
Venezuela experienced sharp declines in government revenues in the 1980s fol-
lowing oil price volatility, with associated slumps in economic activity and a sig-
nificant drop in government spending. Going back further, in the late nineteenth
and early twentieth century, Chile’s specialization in exports of primary goods
11
Diversification and Cooperation in a Decarbonizing World
was beneficial in the period of global economic expansion, but led to severe
domestic economic problems when World War I and the subsequent Great
Depression triggered a significant drop in prices. Citing these cases, Willebald,
Badia-Miró, and Pinilla (2015) identify a so-called staple trap, in which export
dependence creates lock-in effects that block structural change and impede
long-term growth. Even before extracting resource rents, some emerging FFDCs
fell victim to a presource curse (Cust and Mihalyi 2017) in which, following dis-
coveries of resources, usually oil, the inflated expectations of immediate richness
led to unaffordable consumption, unsustainable borrowing, and growth disap-
pointments, as recently experienced by Ghana (Bawumia and Halland 2017),
Mozambique (IMF 2018), Sierra Leone, and Mongolia (Cust and Mihalyi 2017).
■ The capital inflows typically associated with fossil fuel extraction raise the
real exchange rate and reduce the competitiveness of the rest of the economy.
Significant increases in fossil fuel extraction will result in higher exports, but often
require foreign direct investment. If these flows are large enough, they will lead to
an appreciation of the nominal exchange rate, making the domestic production
of other tradables less competitive. This is precisely what happened in the wake of
the discovery of natural gas fields in the Netherlands in 1959, and the subsequent
gas boom hence is often known as the Dutch disease. This term became widely
used in economics (Economist 1977) to describe the paradoxical situation in which
seemingly good news, such as the discovery of large oil reserves, turns out to have a
negative impact on a country’s broader economy as a result of the sharp apprecia-
tion of the country’s currency (Corden and Neary 1982; Gelb 1988). Conversely,
one could expect that a decline in the price and value of fossil fuel exports (like
we have seen since 2014) will heal Dutch disease automatically and improve the
competitiveness of other tradables, although this is not always the case (box 2.1).
■ The concentration of large resource rents1 in one sector of the economy can
result in poor governance, which undermines longer-term growth. Van der
Ploeg (2011) finds that the resource curse is not inevitable for resource-rich
countries and depends critically on the quality of institutions. Often, the sig-
nificant rents derived from fossil fuel exports benefit elites rather than finan-
cially supporting pro-growth policies (Haber and Menaldo 2011). Rents can end
up being allocated politically via patronage, such as highly paid public sector
jobs, rather than through markets. Resource rents are often either quickly spent
by the elite on imported consumer goods or invested inefficiently in “white
elephant” projects (Robinson and Torvik 2005). Governments in resource-rich
countries are less accountable for public expenditure, which leads to ineffi-
cient spending. This results in dominance of “extractive” over “inclusive” insti-
tutions, as Acemoglu and Robinson (2012) put it. Extractive institutions also
distort the economy, reducing the efficiency of investment, hindering struc-
tural change, and hence lowering GDP growth (Auty 2012). Devarajan (2018)
concludes that “oil-rich countries systematically misallocate public expendi-
tures relative to non-oil countries—by favoring consumption over capital, and
12
Challenges, Risks, and Opportunities of a Low-Carbon Transition
BOX 2.1 The Oil Price Collapse and the “Reverse Resource Curse”
The oil price collapse of 2013–15 was a mixed blessing for noncommodity sectors in oil-exporting
countries.
The IMF (2016) concludes that, while noncommodity tradable sectors suffer during commodity
booms, busts generally do not lead to a rapid reversal process. The IMF’s cross-country analysis
finds that in commodity-exporting countries, manufactured exports respond less quickly to a real
depreciation during periods of falling commodity prices than to a real depreciation in periods of
stable commodity prices. This may be because a deterioration in the terms of trade leads to the
perception that the external economic environment is volatile or because it is typically associated
with a downturn in global demand.
The Russian Federation shows these dynamics at work. The noncommodity sectors’ response
to the near 30 percent depreciation during 2014–16 was weak and unevenly distributed across
sectors. Diversification of exports toward non-energy tradable sectors was hampered by structural
factors, including rigid product and labor markets, the lack of a financial system that could rapidly
shift credit to new sectors, burdensome customs procedures, and restricted access to markets
beyond neighboring countries (through trade agreements) (IMF 2017b).
Norway is something of an exception, given that the real depreciation that occurred in the
period 2013–15, coupled with relatively low wage growth, boosted domestic tourism and helped
traditional manufacturing exports recover somewhat. However, this was a relatively modest,
short-lived rebound. Over a longer time frame, structural issues such as stagnant productivity and
wage inflation may hold back the further expansion of non-oil sectors (IMF 2017a).
within consumption, inefficient subsidies and public-sector wages over targeted
transfers. Furthermore, for given levels of expenditure, value-for-money is con-
siderably less in oil-rich countries.” This challenge has been keenly felt in, for
example, República Bolivariana de Venezuela and Gulf Cooperation Council2
countries, where the private sector is often unable to attract talent because its
pay is uncompetitive compared with readily available, well-paid government
positions financed by resource rents (IMF 2016). Empirical analysis of the Arab
world by Hoda and Zaki (2014) confirms that the curse is largely institutional
and can be rectified by reforms of political and economic institutions.
Fortunately, successful risk management strategies are feasible even for countries
with significant resource endowments. Experience has shown that primary specializa-
tion need not block structural change or hamper economic growth in FFDCs. Countries
as diverse as Malaysia and Norway would have experienced relative economic decline if
they had failed to restructure their economies and diversify their assets. In fact, in
Malaysia, the important increases in GDP per capita occurred only after the country
had diversified. As Willebald, Badia-Miró, and Pinilla (2015, 18) note,
History teaches us that “curses” and “blessings” are constructions—they are the
result of the socioeconomic system… Thus, successful experiences of economic
development in countries like Australia and Canada highlight the fact that institu-
tions promoting interaction between enabling and receiving sectors are
13
Diversification and Cooperation in a Decarbonizing World
fundamental to science-based and innovation-driven growth in resource-based
economies. It is crucial, therefore, to develop institutional structures to support
knowledge capabilities in the growth of natural resource–based industries.
New Risks for FFDCs
FFDCs face two different climate-related risks. First, along with all countries, they face
the risk of the physical impacts of climate change associated with weather-related
events. Second, they face the macrostructural risk of a transition to a global low-carbon
economy. This distinction between different climate-related risks was popularized in
2015 by the Governor of the Bank of England in his speech to Lloyd’s, the leading
United Kingdom insurance company (box 2.2).
This book only addresses the transition risk. The physical risk associated with weather-
related events is broadly covered in the literature, including several World Bank publica-
tions (for example, World Bank 2012; Hallegatte et al. 2017; Rigaud et al. 2018). This
study uses a broad approach to transition risk—it covers not only financial risks, but also
fiscal, economic, and social risks. Liability risk is not covered here because it is largely a
specific legal issue, although it may become systemic if the concept of “loss and damage”
introduced into United Nations Framework Convention on Climate Change (UNFCCC)
negotiations becomes an enforceable economic reality.
The systemic nature of LCT transition risk is well recognized by financial system regu-
lators. For example, several central banks in the European Union (in particular, those in
France, the Netherlands, and the United Kingdom) have identified the LCT risk as one of
the potential systemic risks to the financial sector and are conducting extensive research
to establish how the exposed financial institutions are prepared to manage this risk
BOX 2.2 Climate-Related Risks to Financial and Economic Stability
■ Physical risks: the first-order risks that arise from weather-related events, such as floods
and storms. They comprise impacts directly resulting from such events, such as damage
to property, and also those that may arise indirectly through subsequent events, such as
disruption of global supply chains or resource scarcity.
■ Transition risks: the financial risks that could arise from the transition to a low-carbon
economy. This risk factor is mainly about the potential repricing of carbon-intensive finan-
cial assets, and the speed at which any such repricing may occur.
■ Liability risks: the risks that could arise from parties who have suffered loss and damage
from climate change, and then seek to recover losses from others who they believe may
have been responsible.
Source: Carney 2015.
14
Challenges, Risks, and Opportunities of a Low-Carbon Transition
(Bank of England 2015, 2018; French Treasury, Banque de France, and Autorité de
Contrôle Prudentiel et de Résolution 2016; Regelink et al. 2017; Schotten et al. 2016). The
Bank of Canada has also recognized the issue (Lane 2017). The European Systemic Risk
Board found that a transition to a low-carbon economy that occurs late and abruptly
could affect systemic risk via three main channels: (1) the macroeconomic impact of sud-
den changes in energy use, (2) the revaluation of carbon-intensive assets, and (3) a rise in
the incidence of natural catastrophes (ESRB 2016). However, most central banks are still
cautious about supporting sustainable finance by lowering capital requirements for green
lending and penalizing fuel-dependent assets at this stage. They are focused on research-
ing the risks and exploring the macroprudential policy responses.
Anticipating a formal move by financial sector regulators, several commercial banks
and insurance companies have begun conducting systematic assessments of their asset
portfolios’ exposure to an LCT (Redmond and Wilkins 2013; TCFD 2016). Many
international and national companies that rely heavily on fossil fuels or carbon-related
activities are also assessing future business plans in light of possible developments
under a transition (for example, BP, E.ON, RWE, Shell, and Vattenfall), often prompted
by concerned institutional investors.
The LCT can take different forms and can affect FFDCs through several intertwined
channels (figure 2.1). Some of these impacts are perceived by FFDCs as external shocks
or threats, others as external opportunities. Rarely can FFDCs influence the drivers or
the pathways of these impacts. The first channel is the emergence of disruptive
technologies—partly driven by market forces, and partly facilitated by supportive
policies and infrastructure investments in other countries. The second channel involves
the deliberate efforts of climate leaders to pursue greenhouse gas emissions reduction
through domestic policies, through, for example, administrative measures, price-based
policies (removal of fossil fuel subsidies, cap-and-trade systems, carbon and energy
taxes), and sectoral policies (especially in energy, transport, industry, and agriculture).
Furthermore, the pioneers of climate action can use trade policies to prevent leakage of
heavy industry and emissions to “pollution havens” and to make climate action a more
comprehensive global endeavor. Eventually the growth of new institutions, sudden
shifts in investors’ preferences, and changes in social norms may lead to tipping points
that fundamentally alter the competitiveness of carbon-intensive activities. An LCT
also brings new opportunities. New opportunities for value creation are opening
outside of the fossil fuel value chain. The growth of influential new business lobbies can
make the transition self-perpetuating (Arbib and Seba 2017; Financial Times 2017).
Finally, international climate policies may involve financial, technology, and knowledge
transfers.
FFDCs can manage LCT risks and tap into emerging opportunities with two broad
strategic choices: (1) whether and how to diversify their economies and (2) whether
and how to cooperate on global efforts to stabilize the climate (figure 2.1).
15
Diversification and Cooperation in a Decarbonizing World
FIGURE 2.1 How a Low-Carbon Transition Could Unfold and How FFDCs Could
Prepare for It
External drivers
Border
adjustment
measures
ns log nd
Un s i tries
po
tra no a
ch ial
lic oun
ila n o
fe y
i
te anc
te th
e
c
rs
ra er
Fin
l
Fossil fuel–dependent
Diversify? Cooperate?
country
s d
tit rm g
ion an
ins l no ngin
Di hno
te
sru log
ut s
cia a
c
so Ch
pt ies
ive
New market
opportunities
External drivers
Source: World Bank.
An LCT: Smooth Sailing or Tipping Points?
The external impact of an LCT would be very different in scale and nature from the
historically familiar cyclical volatility of commodity markets. An LCT would lead to a
structural decline in fossil fuel–based industries and linked value chains, with associ-
ated systemic risks to the countries and communities that depend on them. It would
entail a permanent decline in the value of FFDCs’ underground and produced assets,
and hence their ability to maintain income to finance diversification and meet the
needs of their populations. The impact of an LCT could be protracted, especially if
coalitions of countries representing FFDCs’ major export markets introduce incentive
trade restrictions on countries that do not take climate action, as previously studied by
Lessman, Marschinski, and Edenhofer (2009) and Nordhaus (2015) in the context of
international climate agreements. In recent years, many low-carbon-technology costs
have fallen rapidly (Kittner, Lill, and Kammen 2017; Louw 2018), policy ambition has
(on the whole) increased (World Bank, Ecofys, and Vivid Economics 2017; IRENA
2017), new low-carbon industrial lobbies and institutions have emerged, and, as
shown by pressure on institutional investors to divest their fossil fuel holdings (IIGCC
16
Challenges, Risks, and Opportunities of a Low-Carbon Transition
2017), the social acceptability of emissions-intensive activity is declining (KPMG
2017). These trends are discussed in this section.
Managing the LCT is made more difficult by the uncertainty over the pathways and
lead time of structural shifts. The predicament of an LCT is that associated uncertainties
are deep. The speed and form of such a fundamental economic and societal change are
unknowable because they depend on multiple sovereign decisions not yet made by key
players with conflicting visions of the preferred future. Therefore, planning is based on
diverging beliefs and wishes involving an LCT, rather than converging probabilities,
especially with respect to structural disruptions in transport, energy, land use, and car-
bon capture and sequestration, as well as future generations’ lifestyle choices. Convergence
exists in integrated assessment models about what should be done to achieve 1.5-degree
and 2-degree Celsius (C) climate goals (Clarke et al. 2014), in which researchers assume
similar binding global carbon budget constraints on their models and use backcasting
(Robinson 1988) or backward induction (von Neumann and Morgenstern 1953) to
identify various pathways to meet these common constraints. Decision-makers, how-
ever, must rely on forward induction in their planning, that is, rationalizing the past
behavior of other players and pursuing individually preferred futures (Stalnaker 1998).
Multiple possible impacts complicate decisions about how to plan for an LCT amid
doubt about whether tipping points will materialize within a relevant time frame.
On one side of the spectrum of expected futures, the combination of sunk investments,
old networks, entrenched institutions and policies, and opposition from vested interests
can put a drag on the pace of transition. Many commentators contrast the bold aspirational
objectives of the Paris Agreement with the current trajectory of global emissions and the
aspirations of an emerging middle class in developing countries (BP 2017; IEA 2018).
They note the limited level of ambition in the first round of submitted nationally
determined contributions (NDCs) (UNFCCC 2016) and point to the dependence of
many countries on high-carbon infrastructure and the challenges inherent in decarbonizing
sectors as diverse as cement, steel, maritime transport, and aviation (Dale and Fattouh
2017; ExxonMobil 2018; IEA 2016). Electrification of transport faces constraints because
of charging infrastructure and congestion (KPMG 2017). IEA (2018) forecasts continuous
growth of oil demand through the entire forecasting period until 2023, despite market
penetration of electric vehicles. Nontransport use of oil is seen by industry as the key
demand driver going forward. For example, the 2018 BP Energy Outlook suggests that the
noncombusted use of fuels, such as feedstocks for petrochemicals, lubricants, and bitumen,
will become an increasingly important component of overall industrial demand by 2040,
although the forecasted volumes are a small fraction of the oil used in transport.
Canada, Saudi Arabia, and other countries invest significant research and develop-
ment (R&D) sums on carbon capture, storage, and use in enhanced oil recovery and in
materials, hoping to achieve breakthroughs in technology-driven solutions to climate
change. If commercially scalable, these technologies could decouple the growth
17
Diversification and Cooperation in a Decarbonizing World
of demand for fossil fuels from the growth of emissions. On the policy side, OECD
et al. (2015) point at the misalignment between existing policy frameworks and climate
objectives, which hinders low-carbon investment and consumption choices. Some
climate policy reversals and stalls—such as those of Australia in 2013; Poland in 2016;
the United States in 2017; Ontario, Canada in 2018; and France in 2018—have added
to the confusion about where the world is heading.
Different factors can slow the diffusion of low-carbon technologies. Acemoglu et al.
(2012) provide empirical evidence for geographical knowledge spillovers (a firm’s
choice about whether to innovate clean or dirty is influenced by the p ractice of the
countries where its researchers and inventors are located) and for path dependence
(firms tend to direct innovation toward what they are already good at). It is intuitive
that innovation activity tends to focus on the dominant technologies, for which returns
on incremental improvements are easily observed and u nderstood. Hausmann and
Hidalgo (2010) identify a strong quiescence trap in the world, that is, countries with few
capabilities have negligible or no return on the accumulation of more capabilities, while
at the same time countries with many capabilities will experience large returns—that is,
increased diversification—to the accumulation of additional capabilities. This suggests
that relatively less diversified FFDCs will find it more challenging to start diversifying
their economies than already more diversified countries.
On the other end of the spectrum of expectations, an LCT could gather momentum
exponentially, catching FFDCs off guard. The future is unlikely to be a linear extension
of the past. Key sectors can reach a tipping point abruptly, creating potentially systemic
risk via a macroeconomic “hard landing” and the unexpected revaluation of carbon-
intensive assets (ESRB 2016). Tang et al. (2018) and many others argue that China’s
structural reforms shifting from a labor- and energy-intensive growth model to one
that is capital and technology intensive will permanently and structurally reduce coal
consumption in the future. As the largest coal, oil, and gas consumer in the world,
China is driving the fluctuations in the global market for fossil fuels. Therefore, the
effects of a transition are likely to spill across borders because decarbonization policies
in other countries are bound to affect global markets (Acemoglu et al. 2012; Cherif,
Hasanov, and Pande 2017), especially if other countries apply “carrots and sticks” to
encourage a large coalition toward climate action.
There are precedents from the deep structural transformations of the past. Examples
from history show how change can happen quickly (Wilson 2012), from the reduced
acceptability of smoking in many countries to the rapid emergence of mobile tele-
phony, which has largely displaced (or leapfrogged, in the case of many developing
countries) fixed-line telephony. The formative phases of new technologies in the energy
sector usually took two to three decades (Wilson 2012), but can be accelerated by poli-
cies that break dependency on historical paths and create new market opportunities
(Geels 2005; Pearson and Foxon 2012).
18
Challenges, Risks, and Opportunities of a Low-Carbon Transition
The emergence of tipping points can be ignited by feedback loops that interact
across the economy, accelerating institutional and behavioral change. The role of tip-
ping points is crucial in this context (Heal and Kunreuther 2012).3 The trigger of a
tipping point could be a specific climate or energy policy, or a breakthrough technology
(such as cheap and effective energy storage); the point is that policies, institutions, and
technologies reinforce each other in a positive feedback loop. Indeed, each of these
events makes the others more likely to happen, driving expectations and reinforcing
the dynamics of transition, potentially leading to rapid and permanent structural mar-
ket shifts. However, this means that if a tipping point is reached, innovation activity can
quickly be redirected elsewhere. Investments in enabling infrastructure (Grübler,
Nakićenović, and Victor 1999) can further spur technology tipping points through
positive network externalities and increasing returns for the deployment of new dis-
ruptive technologies. This can be intertwined with sudden shifts in investor and con-
sumer preferences that accelerate new technology penetration rates. The development
of new skills and integrated technologies as well as supportive institutions and con-
sumer behaviors could further facilitate technology cost reductions and policies across
the economy (Dechezleprêtre, Neumayer, and Perkins 2015). As more players start to
move, expectations of new opportunities can become self-fulfilling.
This book argues that falling costs of new technologies, accelerating policy action,
the emergence of new institutions, and changing social norms and investors’ prefer-
ences are the key drivers of possible tipping points. These and their interlinkages are
elaborated in the next subsections.
Falling Costs of New Technologies
The falling cost of key low-carbon technologies has proved to be game-changing by
driving the exponential growth of their application (figure 2.2). The unit costs of low-
carbon technologies have huge potential to continue to fall as these new technologies
are developed and deployed and engineers learn how to cheaply connect and service
them. This potential is far higher for new technologies than it is for long-established,
high-carbon incumbents.4 Falling costs have already allowed solar photovoltaic (PV)
and onshore wind technologies to become competitive with gas and coal for power
generation in a number of locations, even without a high carbon price. The cost of
solar PV modules fell by 60 percent in the two years to the first half of 2017 and by a
factor of five in the five years after 2008 (Louw 2018). Energy storage prices are falling
even faster than solar PV and wind technologies: a recent study finds that R&D invest-
ments for energy storage projects have lowered lithium ion battery costs from $10,000/
kWh in the early 1990s to an estimated $100/ kWh in 2018 (Kittner, Lill, and Kammen
2017). Lower prices and accumulated skills will allow new combinations of solar, wind,
and energy storage to outcompete coal and gas on cost in several locations. Policy
options identified by Massachusetts Institute of Technology (Hart, Bonvillian, and
Austin 2018) could further bolster innovation and grid penetration.
19
Diversification and Cooperation in a Decarbonizing World
FIGURE 2.2 Nonhydro Renewables Share of Power Generation by Region
percent
12
11
10
9
8
7
6
5
4
3
2
1
0
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
World Middle East North America
Asia Pacific Europe and Eurasia
Africa South and Central America
Source: BP 2017, © BP p.l.c. 2017. Reproduced with permission from BP; further permission required for reuse.
At a certain threshold of the penetration of nonhydro renewables in electricity
generation, the cost of integrating their variable supply into the grid rises steeply,
possibly slowing their further expansion. The share of variable renewable energy
sources in power generation is still very small—less than 8 percent on average in the
world, and much less in developing countries where the grids and institutions that
manage them are weaker. For example, grid integration of variable renewables
includes costs of grid connection, expansion, and upgrading, plus system operation
costs, such as the balancing costs and the costs incurred from reduced utilization
rates of existing conventional plants. In less flexible power systems, these costs could
reach up to $30/MWh with variable sources’ penetration rates of 30 to 40 percent
(IRENA 2015). Although these costs should not be entirely attributed to variable
renewables, especially when the system is not flexible enough to deal with normal
variability (in the short term), nonetheless, they pose an additional challenge
system operation when the penetration rates of variable renewables exceed
for
10 to 20 percent of total power generation. Rapidly falling costs of electricity storage
20
Challenges, Risks, and Opportunities of a Low-Carbon Transition
and progress with smart grid technologies can be a game changer, but the entrenched
behavior of consumers and system operators can be more difficult to change, espe-
cially in countries with vertically integrated state-owned power utilities where ther-
mal generation and system operation are managed by the same entity.
The success of new technologies depends not only on their costs but also on net-
works and infrastructure that can lock them in or push them out to the technology
“valley of death” (a term used to describe the phase in which a proven technology gets
stuck between prototypes and commercialization). Public policies and investments in
networks and infrastructure steer the initial course of penetration of future technolo-
gies. But once established, successful networks and infrastructure rapidly spread with
private investment and creativity. Once publicly funded (Mazzucato 2013), Internet-
based networks are already disrupting traditional business models in energy, transport,
and tourism, dramatically reducing the transaction costs associated with the market
penetration of new low-carbon technologies and b ehaviors—from roof-top solar pan-
els through energy-intelligent buildings, energy storage to car sharing. The spread of
the “Internet of Things” and the near-zero marginal cost of production and distribu-
tion technologies (Ashton 2009) can revolutionize manufacturing, boost resource effi-
ciency, and digitalize much of transport and trade (Aguzzi et al. 2014). A 2017 KPMG
survey of executives in the automotive industry notes that “the auto industry is lost in
transition between evolutionary, revolutionary, and disruptive trends that all need to be
managed at the same time” (KPMG 2017, 2).
The energy sector is not the only sector to benefit from productivity improvements
associated with an LCT. Data suggest that potential spillovers from low-carbon innova-
tion to other sectors may be higher than for higher-carbon sectors. Using data
on 1 million patents and 3 million citations, Dechezleprêtre, Neumayer, and Perkins
(2015) suggest that spillovers from low-carbon innovation are more than 40 percent
greater than from conventional technologies (in the energy production and transpor-
tation sectors). Acemoglu et al. (2012) also make a powerful theoretical case to suggest
that once the “clean innovation machine” has been “switched on and is running,” it can
be more innovative and productive than the conventional alternative. In this scenario,
carbon prices may only need to be temporary (necessary for several decades) because
the energy and economic system will, over time, become locked into a low-carbon
product technology base.
Policy Action Gathers Momentum
Although the UNFCCC negotiations are often seen as moving slowly, explicit or implicit
climate policies are being continuously enacted. In 2017 about 67 national and subna-
tional jurisdictions implemented or were scheduled to implement 47 carbon pricing ini-
tiatives (World Bank, Ecofys, and Vivid Economics 2017). Yet explicit carbon pricing still
21
Diversification and Cooperation in a Decarbonizing World
covers only 15 percent of global greenhouse gas emissions. The observed carbon prices
are low, ranging from less than $1 up to $140 per tonne of carbon dioxide equivalent
(tCO2e), with about three-quarters of emissions covered by carbon pricing priced at less
than $10/tCO2e. This is substantially lower than the price levels that are consistent with
achieving the temperature goal of the Paris Agreement, in the range of $40–$80/tCO2e in
2020 (CPLC 2017). Furthermore, Edenhofer (2015) argues that because of widespread
subsidies to fossil fuels around the world, the average net global carbon price was negative
(even as low as minus $150/tCO2). According to the International Energy Agency (IEA),
in 2016 fossil fuel subsidies were equal to $40 per barrel of oil, which is equivalent to an
emissions subsidy of $93/tCO2e (IEA 2017, 84). The estimated value of global fossil fuel
consumption subsidies decreased by 18 percent to $260 billion in 2016, due in part to
lower prices for main fuels but also to continued efforts at reform (IEA 2017).
Nonpricing climate policy instruments are more widespread than carbon pricing.
According to the latest Global Climate Legislation Study, which covers 99 jurisdictions
that collectively account for 93 percent of global emissions, the number of climate laws
(pricing and nonpricing) has approximately doubled every four to five years: there were
50 laws at the time of the Kyoto Agreement in 1997, about 100 in 2002, about 200 in 2005,
400 at the time of the Copenhagen Accord in 2009, and 850 laws in 2016 (LSE 2016).
The policy-led nature of climate action and its role in driving climate innovation
makes the emergence of tipping points more likely. Policy decisions build on each
other, and on their consequences. The anticipated payoff to a business or political
leader considering investments in renewables and resource efficiency depends on what
they expect others to do. If a critical mass of businesses (for example, GM, Tesla, or
Volvo), countries (for example, China, or the members of Organisation for Economic
Co-operation and Development), or regions (for example, US states and Canadian
provinces) are expected to move at scale, the cost of the underlying technologies would
be expected to fall faster, niche finance would become mainstream, and new global
markets would be expected to expand rapidly.
Many of the policy drivers reflect domestic incentives to mitigate emissions. For
example, moving away from burning coal near populated areas and making dense cities
more livable through investments in extensive public transport reduce the impact of
pollution on health and productivity. The European Environment Agency (2015) esti-
mates that premature deaths resulting from just one particulate pollutant, PM2.5, were
about 428,000 in 2014 in Europe alone, with an additional 78,000 people dying each
year from exposure to NO2 (nitrogen dioxide) air pollution. Another study by the
Global Commission on the Economy and Climate, led by the World Resources Institute,
suggests that the health impacts of PM2.5 exposure (including premature deaths) are
between 10 and 13 percent of annual GDP in China (Global Commission on the
Economy and Climate 2015). Urban planning can also help relieve traffic congestion,
which can lead to significant losses of time and output. Recognizing these
22
Challenges, Risks, and Opportunities of a Low-Carbon Transition
opportunities is important in driving change because having domestic incentives to
mitigate emissions fosters international cooperation.
At the same time policy reversals can slow down the LCT. Many observers believe
that the repeal of the Clean Power Plan in the United States may not be able to turn the
clean technology tide in the US energy sector; however, like the repeal of the emissions
trading system in Australia, while it did not stop renewable energy penetration, it
slowed the transition. A series of regulatory changes implemented by Poland in 2016
were able to effectively freeze the previously buoyant development of wind energy and
pushed several existing wind farms to bankruptcy, with negative spillovers to the finan-
cial sector, where at least one exposed bank had to make large write-offs to cover losses
on wind loans that became stranded assets (wnp.pl 2017). The social unrest of the “yel-
low vests” in France in 2018–19 over the environmentally motivated fuel price increases
casts doubt on the social acceptance of an LCT even among climate policy leaders.
These events underscore the importance of smart design and implementation of
reforms. In several developing countries, in particular in Asia and Africa, capacity pay-
ments and long-term power purchase agreements are locking in large fleets of new
thermal, often coal, power plants for decades. Take-or-pay clauses in these contracts
already inhibit new renewable energy entrants and lead to the curtailment of existing
renewable plants even if their electricity is cheaper to generate than that generated by
thermal incumbents. System reforms to enhance flexibility and efficiency and open the
generation market to new entrants are often blocked by state-owned, vertically inte-
grated utilities supported by vocal coal mining interest groups.
Emergence of New Institutions
Increased development and deployment of clean technologies can give rise to new
industrial lobbies and constituencies, which can help drive green policies and the for-
mation of new regulatory institutions (Lockwood 2013). For example, city mayors
promising more bicycle lanes, congestion charging, and pedestrianization garner more
public support in dense, resource-efficient cities than in sprawling, car-based ones,
whose citizens may instead prefer highways to be expanded and the lowering of fuel
costs, which further lock in carbon-intensive infrastructure (Rode, Stern, and Zenghelis
2012). On the other hand, as discussed later, current lobbies’ resistance to change can
decelerate the transition to a low-carbon economy.
Institutional change can help overcome infrastructural lock-in. As long as one par-
ticular technology remains dominant, innovation efforts will focus on products and
services linked to the use of that technology, and fewer efforts will be directed at devel-
opment of an alternative technology and its associated network. However, if institu-
tional change results in a new technology becoming dominant by allowing
technology-related tipping points to be reached, innovation activity can shift quickly.
A good example is the challenge of developing electric vehicle infrastructure (Eberle
23
Diversification and Cooperation in a Decarbonizing World
and von Helmolt 2010). If electric vehicle infrastructure becomes established, the
incentives to conduct R&D on electric cars will increase substantially relative to fuel cell
or combustion engine vehicles. There are some signs this may happen—Volvo
announced it would stop designing combustion engine–only cars in 2019 and start
focusing its R&D on electric vehicles; others have followed suit with their own
announcements. Several countries have even announced plans to ban the sale of ther-
mal vehicles (for example, Norway starting in 2025, the United Kingdom in 2035,
France and Canada in 2040, and Costa Rica in 2050). Since the Industrial Revolution,
firms have been routinely exploiting this path dependence in technology adoption and
the network effects to diffuse their innovations and create new markets (Bessen 2014).
For instance, realizing that fossil fuel–driven networks are hard to dislodge, in June
2014 Tesla Motors announced it would “not initiate patent lawsuits against” parties
who use its technology “in good faith.” Some companies have already begun to use
Tesla’s patented technology. At the same time, Tesla is slow to share its charging infra-
structure with other brands and the clause “in good faith” regarding its patents entails
following a patent pledge.5 Toyota also announced royalty-free use of 5,680 fuel cell–
related patents.
Changing Social Norms
Changes in social norms can interact with institutional, policy, and technological changes.
Social norms can be defined as the predominant behavior within a society, supported by
a shared understanding of acceptable actions and sustained through social interactions
(Ostrom 2000). Social feedback helps make norms self-reinforcing and therefore stable.
However, because people prefer to behave like others, social feedback also makes people
vulnerable to abrupt changes resulting from policy changes or elsewhere. For example,
regulations on smoking in public places, bans on asbestos, various taxes and subsidies to
support R&D in green technologies, and investments in cycling infrastructure and public
transport have accelerated the process of shifting norms. Thus, policies can play a signifi-
cant role by giving people reasons to change their expectations (Young 2015).
Emitting carbon with full knowledge of the damage it causes is increasingly seen in
a negative light (Green 2018). This applies in particular to fossil fuels (especially coal
and unconventional oil and gas) and particular activities in fossil fuel supply chains
(for example, investment, production, and large-scale consumption in coal-fired power
stations). The wave of popular lawsuits against US oil companies for health damages
caused by climate change has triggered threats of legal action against European oil
majors. The concept of “unburnable carbon” (Carbon Tracker Initiative 2011; Griffin
et al. 2015) has become widely acknowledged, and civil society actions have started
targeting the exploration and development of new fossil fuel deposits. Anti–fossil fuel
norms are already concentrating moral pressure on the largest emitters (Collier and
Venables 2014). A total of 34 member states of the Organisation for Economic
24
Challenges, Risks, and Opportunities of a Low-Carbon Transition
Co-operation and Development have agreed to end state subsidies that finance the
export of technologies to build coal-fired power plants. In 2016, the Chinese central
government also imposed a three-year moratorium on the construction of new coal
mines and coal-fired power stations, although the government and development banks
actively support expansion of Chinese-built coal power plants abroad. Although indi-
vidual leaders may reverse the policies of their predecessors, the global trend toward
greater action is clear. Three-fourths of auto executives surveyed by KPMG (2017)
believe that traditional internal combustion engines will remain technologically rele-
vant, but socially unacceptable in five to ten years.
Shifting social norms play a role in increasing the traction of calls for fossil fuel
divestment aimed at major institutional investors (Ansar, Caldecott, and Tilbury 2013).
Norway’s sovereign wealth fund has recently declared its intention to entirely divest
from coal, while divestment of US coal has also gathered pace.6 A number of long-term
institutional investors (for example, university pension funds) are under pressure to
divest fossil fuel assets. Share prices of sectors that rely heavily on fossil fuels have
lagged the S&P 500 average (see “stranded assets total return swap” in Roston [2017]).
On the other hand, climate skeptics also step up efforts to influence public opinion.
Brulle (2013) finds that donations to organizations that deny global warming are
financed by fossil fuel or conservative interest groups and often funneled through
third-party pass-through organizations that conceal the original funder.
The Paris Agreement and Global Cooperation to Decarbonize the World Economy
The Paris Agreement is the first fully inclusive international climate agreement.
established a global goal to keep the world’s temperature rise this century below
It
2 degrees C above pre-industrial levels and to pursue efforts to limit the temperature
increase even further to 1.5 degrees C. Each country can determine its own national
contribution to that global temperature stabilization objective, recognizing individual
circumstances and capabilities. This was different than its predecessor—the Kyoto
Protocol—which established a target on greenhouse gas emissions, and broke down the
total emissions cap to individual, legally binding commitments, albeit only on a subset
of countries deemed developed at that time.
The freedom to choose one’s own level of ambition and the nonbinding nature of
individual commitments under the Paris Agreement helped achieve universal partici-
pation (at least initially). It successfully drew all countries into submitting their
nationally determined contributions (NDCs). Several studies showed, however, that
the initially submitted NDCs together do not add up to the global effort needed to
achieve the global 2-degree C objective (OECD 2018). However, the Paris Agreement is
a multistage strategic game. In the following stages a pledge-and-review process is
expected to prompt countries to renew their commitments in five-year cycles. Each
25
Diversification and Cooperation in a Decarbonizing World
country’s decision to increase its level of ambition is voluntary and no benchmarks for
how much to increase the ambition are defined, to say nothing of sanctions. In the
absence of enforcement mechanisms, countries are often expected to be willing to
increase their level of ambition of climate mitigation action because of “naming and
shaming” (Falkner 2016) and moral pressure (Figueres 2016) supported by financial
and technology transfers through climate finance and carbon markets from developed
to developing countries (Cramton and Stoft 2012; Gollier and Tirole 2015; Jakob,
Steckel, and Edenhofer 2014).
Despite its nonbinding nature, the open, bottom-up, flexible architecture of the
Paris Agreement provides new opportunities to foster climate cooperation. In contrast
to the Kyoto Protocol, where any cooperative climate action had to be negotiated
between all parties and agreed upon by consensus, the Paris Agreement opens up room
for collaborative, bottom-up, and unilateral initiatives of clubs of countries to launch
ambitious climate mitigation actions. The flexibility granted in Article 6 could create
an enabling environment to break the impasse in the efforts to establish comprehensive
and stable cooperation toward the mitigation goal. Article 6.1 explicitly acknowledges
that a group of parties can form a club of the parties to pursue voluntary cooperation
to allow for higher ambition in their mitigation and adaptation actions, and Articles
6.2, 6.4, and 6.8 identify market and nonmarket approaches that could operationalize
international climate cooperation. Like-minded countries can jointly pursue their own
sustainable development objectives—through energy, technology, and climate policies
that reduce the use of fossil fuels and push down the costs of low-carbon technologies
and infrastructure. They are constrained only by other acts of international law, such as
the World Trade Organization, in their choices of the application of “carrots and sticks,”
including trade sanctions targeted at nonparticipating parties.
Economists argue that in the absence of a global government with coercive powers, any
effective and stable international environmental agreement needs to be bound by aligning
the self-interests of the participants, hence rendering it self-enforcing (Barrett 1994, 2003;
Diamantoudi and Sartzetakis 2006; Hoel 1992; Hoel and Schneider 1997). For a climate
action club to be stable, its members should enjoy exclusive benefits and privileges that
prevent them from defecting or free-riding on the efforts of other members. Nobel
Prize-winning economist Elinor Ostrom, after studying how communities make decisions
about their common goods, concluded that two conditions are essential to maintaining
cooperation (Ostrom 2000, 2009). One is trust based on a common commitment, and
another—enforcement—is based on the principle of reciprocity (“I will if you will”).
The Paris Agreement explicitly acknowledges the primacy of domestic self-interest in
climate policy by allowing the countries to determine their own NDCs (Cramton et al.
2017; Gollier and Tirole 2015; MacKay et al. 2015). MacKay et al. (2015) argue that indi-
vidual commitments cannot be meaningfully enforced with reciprocal actions. The
pledge and review process built into the Paris Agreement provides some transparency,
26
Challenges, Risks, and Opportunities of a Low-Carbon Transition
but not the incentives to ratchet up the level of ambition toward the mitigation objec-
tive. Additional incentives may emerge from bottom-up club initiatives outside the
legal UNFCCC instruments. Stiglitz (2015, 33) argues that the Paris Agreement cannot
rely on public pressure alone to implement existing NDCs because “there is simply
insufficient ‘solidarity’ at the global level.”
Once integrated by a common commitment and reciprocity, a club of climate action
leaders could start playing a multistage strategic game to entice more reluctant non-
members to join the club. The menu of incentives a club can apply include financial
and technology transfers, carbon markets, and border adjustment taxes (Böhringer,
Rosendahl, and Schneider 2018; Cosbey et al. 2012; Kortum and Weisbach 2016;
Nordhaus 2015), or other sanctions (Dannenberg 2016). Several authors (Falkner
2016; Keohane, Petsonk, and Hanafi 2017; Victor and Jones 2018) explore various ways
to increase the size of the climate action coalition, usually through different forms of
pricing and transfer mechanisms (Hovi et al. 2016, 2; Victor 2011). Steckel et al. (2017)
propose that climate finance be redesigned as strategic incentives to establish national
climate policies, rather than a merely project-by-project incremental financing mecha-
nism. Many other economic and political issues can also be linked to cooperative
behavior in international climate games (Barrett and Dannenberg 2016; Carraro 2016;
Carraro and Marchiori 2004).
The literature on incentives for climate cooperation is dominated by the old
d
eveloped-developing countries divide and the assumption that the level of ambition
of mitigation action is inversely related to income. Recently, however, several low-
income countries that are vulnerable to climate change (such as the Alliance of Small
Island States [AOSIS] group) have become global leaders of climate mitigation without
waiting for massive foreign financial transfers, although their ability to act is con-
strained by their lack of resources. This engagement proves that the willingness to
cooperate on climate action is no longer determined primarily by income level.
Countries most reluctant to cooperate include those that depend on fossil fuel reve-
nues and energy-intensive power and manufacturing sectors. Many FFDCs—whether
low or high income—have been reluctant to implement domestic climate mitigation
actions amid concerns that doing so would disrupt their (often narrow) revenue sources
and established comparative advantage. Without addressing these concerns, an interna-
tional coalition may not be comprehensive and stable enough to achieve the mitigation
goal of the Paris Agreement. But the architecture of the agreement makes it more diffi-
cult for FFDCs to delay or derail proactive action by climate pioneers.
So far, few efforts have been made toward establishing clubs of climate action
under the Paris Agreement. The European Union, with its climate-energy policy
package, is one example. Other efforts include technology-focused initiatives, such
as the Renewable Energy Club established by Germany and nine other countries in
2013, the REDD+ mechanism for forestry, and the Powering Past Coal Alliance
27
Diversification and Cooperation in a Decarbonizing World
launched by Canada, the United Kingdom, and several other countries and stake-
holders at COP 23 (Conference of the Parties) in Bonn/Fiji in 2017. The Carbon
Pricing Leadership Coalition is another attempt to initiate dialogue between parties
that may have aligned interests to harmonize prices of carbon across jurisdictions.
The narrow focus, limited participation, and modus operandi of these clubs have
not yet achieved a critical mass of market and political power to increase the global
level of ambition. The pursuit of scaling up climate finance encounters persistent
difficulties (OECD et al. 2015; Westphal et al. 2015). The project-by-project archi-
tecture of climate finance generates low flows, high transaction costs, and weak stra-
tegic incentives to cooperate (Steckel et al. 2017). Carbon markets are stalled by the
prolonged absence of buyers.
In today’s interconnected world, tipping point dynamics in any large market or set
of large markets will affect the activities of other markets. While those involved in pro-
ducing and exporting low-carbon goods and services stand to profit, those producing
and exporting carbon-intensive goods and services could see their markets shrink and
the prices of their outputs fall. Policy actions taken by one country affect other coun-
tries as well. The impacts of policies can be propagated through trade, cross-border
investment flows, and increasingly also knowledge and information flows—the latter
often being truly global: available anywhere, anytime.
Notes
1. Resource rent is the difference between the price at which an output from a resource is sold and its
extraction and production costs, including normal return. Resource rents are shared in different
proportions between the host government and the extractive industry. These proportions
depend on the fiscal “take” by the government—through royalties and tax or profit-sharing
instruments.
2. The Gulf Cooperation Council countries are Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the
United Arab Emirates.
3. A tipping set is a set of agents that, by changing their strategies, can tip the rest of the agents from
one equilibrium point to another. If there is a small tipping set, not everyone has to agree to change
their behavior: agreement by a small subset will suffice (Heal and Kunreuther 2012).
4. Although the so-called sailing ship effect—whereby the introduction of steamships induced a leap
forward in efficiency and design of sailing ships—suggests that incumbent industries can “brush
up their act” through competitive innovation when faced with existential competition. The effec-
tive development and deployment of fracking technologies illustrates this effect.
5. Tesla’s patent pledge can be found at https://www.tesla.com/about/legal#patent-pledge.
6. See “Inside the War on Coal” at the Politico website: http://www.politico.com/agenda/story
/2015/05/inside-war-on-coal-000002?utm_term=0_876aab4fd7-d7a965efd7-303449629&utm
_ con te n t = b u f f e r b a e a b & ut m _ m e d i u m = s o c i a l & u t m _ s o u rce = f a ce b o o k . com & u t m
_campaign=buffer.
28
Challenges, Risks, and Opportunities of a Low-Carbon Transition
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35
Potential Impacts on Different
3.
Sectors and Countries
As chapter 2 discusses, a low-carbon transition (LCT) can occur through several inter-
twined channels, such as disruptive clean technologies, networks that lock in these
technologies, shifts in consumer and investor preferences, changes in policies and insti-
tutions, and the growth of influential new business lobbies. The combination of these
pressures is likely to manifest in different ways across different carbon-intensive activi-
ties. Market dynamics and background technological and demand conditions vary sig-
nificantly across different fossil fuels and carbon-intensive activities. This means that
the same underlying drivers can have very different impacts on different activities and
hence, on different fossil fuel–dependent countries (FFDCs).
Coal Sector
Coal is the most abundant fossil fuel and arguably the most vulnerable to the impacts
of a transition. Known coal reserves are vast; they would suffice for more than 160 years
at the current production rate (figure 3.1). In fact, the International Energy Agency
(IEA) noted that global coal reserves are far larger than the amounts required even
under very long-term business-as-usual scenarios. The notion that reserves will be left
in the ground is, therefore, uncontroversial for the coal industry, regardless of climate
policies (IEA 2015d, 275). The largest reserves are located in North America, Europe,
and Eurasia (figure 3.1).
Coal is also the most carbon intensive of the fossil fuels and all scenarios consistent
with a 2-degree Celsius (C) goal show a rapid exit from coal-generated electricity. In
addition, coal produces high levels of local air pollution, and it requires large amounts
of water when used as a fuel for power generation. Partly as a result of these challenges,
confidence in the future of the global coal industry has dropped in recent years. In
particular, in relatively wealthy regions of the United States and the European Union
(EU), increasing extraction costs and social and regulatory pressure to control local
environmental impacts will mean that most of the coal reserves will remain unmined,
even without the impact of climate policies. Many of the world’s coal assets in the
United States and the EU are held by companies already in financial distress: Alpha
Natural Resources, a leading US coal producer, filed for bankruptcy in 2015. Peabody
Energy, once the largest private sector coal company, went bankrupt in April 2016.
37
Diversification and Cooperation in a Decarbonizing World
FIGURE 3.1 Coal Reserves-to-Production Ratios
years
a. 2017 by region b. History
400 700
350 600
300
500
250
400
200
300
150
200
100
50 100
0 0
1997 2002 2007 2012 2017
ica
ric d
pe
Ea ate f
ca
ic
St o
me an
cif
fri
ro
idd ent alth
er
a
s
Pa
lA h
Eu
dA
Am
ra out
e
ia
en nw
an
S
rth
As
ep mo
st
No
d
Ind om
nt
le
Ce
C
M
North America Europe Middle East and Africa World
South and Central America Commonwealth of Independent States Asia Pacific
Source: BP 2018, © BP p.l.c. 2018. Reproduced with permission from BP; further permission required for reuse.
China and the EU, together comprising seven-tenths of the global market for coal, are
already signaling shifts away from coal in the power sector, while the largest growing
market, India, is seeking domestic self-sufficiency (IEA 2015b).
Market conditions in the coal industry raise the possibility of a “disorderly exit” in
the face of decarbonization challenges. Both thermal and metallurgical coal have rela-
tively flat supply curves, in contrast, for example, to oil. This means that a large amount
of coal is offered at a similar price level; in other words, if demand declines, no clear
merit order suggests which producers will reduce output. Instead they may compete on
their short-term operating costs, which is not financially viable in the long term and
may impose fiscal and debt burdens on host countries, especially if mines are state
owned. Large swaths of the industry could simply close. Mines in North America and
Europe may be particularly exposed—not only do they face increasing costs but they
are also located far from the growing markets of Southeast Asia and Africa. The trans-
portation costs per unit of energy content of coal are higher than for oil and gas, and
lignite is de facto nontradable, although the cheapest coal (for example, that from
Columbia and South Africa) can still be competitive in distant markets.
38
Potential Impacts on Different Sectors and Countries
The pressures created by a decline in demand for coal are geographically concentrated
and may be severe—especially when local upstream and downstream links are
considered—although localized in relatively few places. But coal mining contraction is
not likely to cause systemic economic disruption in any country because, unlike the case
of oil and gas, even the largest coal exporters do not generate large tax revenues from
coal, and rents are generally small (figure 3.2). But locally it can have a major impact. In
Poland, for example, coal exports account for an insignificant proportion of total
exports. However, the coal-dependent power sector is likely to face serious challenges,
especially as new coal power plants are being added with government support, despite
the clear decarbonization objectives of the EU energy and climate policy. Sometimes it
is not only the coal mining but also coal-dependent transport infrastructure that may be
affected by an LCT. For example, Mozambique is contemplating the construction of
major new infrastructure to allow the export of its coal reserves. If new railways and
ports are designed with a single function in mind, they may generate lower-than-
expected income if export markets accelerate the phasing out of coal in their power
sectors (box 3.1).
The largest challenge in the coal industry relates to the risk of stranded miners
(IEA 2015c). Coal mining is labor intensive compared with oil and gas extraction, with an
estimated global workforce of between 7 million and 9.5 million (depending on
estimates), 5.3 million of whom are in China (Sartor 2018). Revenue per employee tends
FIGURE 3.2 Fossil Fuel Rents as a Share of GDP for 10 Top Fuel Producers, 2013–17
a. Oil rents (% of GDP) b. Gas rents (% of GDP) c. Coal rents (% of GDP)
for top 10 producers for top 10 producers for top 10 producers
60 60 60
50 50 50
40 40 40
30 30 30
20 20 20
10 10 10
0 0 0
de p.
ra .
Un Ca ina
Ind Ind a
de p
d A di raq
Ru n, Is mira a
ian i s
Br n
Un C da
d S na
s
Ru n, Is Al tar
ian mi ia
Sa No ion
Au rabia
Ch a
d S da
s
on ia
ia
str a
K olo lia
ss ite hs a
Fe Sta n
de tes
rm n
i A ay
Po ny
ite au I it
Ca il
d
c
ss lam te
te
te
Fe c Re
Fe c Re
Ira ab E rabi
tio
ali
Au Chin
Ru Un azak mbi
ian d ta
Ge atio
az
ss la ger
es
wa
fri
lan
na
ite hi
ite na
C a
ud rw
a
Qa
ta
t
ta
str
ra
hA
Ku
r A
r
ut
So
S
Ira
Un
2013 2014 2015 2016
Source: World Bank World Development Indicators.
Note: GDP = gross domestic product.
39
Diversification and Cooperation in a Decarbonizing World
BOX 3.1 Coal Transport Infrastructure: Risk of Stranded Assets in
Mozambique
Mozambique intends to develop its remote reserves of coal and build a major railway to bring coal
to domestic markets. Its coal reserves are located in sparsely populated rural areas, far from trans-
port routes that could bring coal to the international market. For several years the government has
been trying to raise funds for the construction of a railway route that would connect mines with
ports, but so far without success.
Mozambique continues to have a hard time finding lenders willing to finance the planned railway.
The country has insufficient fiscal space for such a large loan. Additionally, the drop in international
demand for coal and the resulting drop in its price have made it harder to attract direct investors.
Two Indian companies have bought extraction and operation licenses in two large mines but have
frozen their capital expenditures, and not a single investor has expressed interest in coal exploration.
Even if short-term market dynamics were to reverse, significant uncertainties surround coal
demand that may lead to these transport assets becoming stranded in the long term if constructed.
In the medium to long term, global demand for coal may either rebound or continue contracting
because of the low-carbon transition in other countries. Thus, under some of the future scenarios
(marked by high uncertainty), today’s investments in this sector—both in exploration and in upstream
infrastructure—may yield lower returns than expected, or may even entail the decommissioning of
certain facilities before they reach the end of their economic lifetime. The railway infrastructure, in
particular, could be exposed to the risk of capacity underutilization if built for the freight transport of
coal. Instead, a more expensive, multifunctional railway system could be built to stimulate regional
development and the export of agricultural products from currently isolated communities.
to be about 70 percent lower than in the oil and gas industry, with a much higher
proportion of revenues accounting for operating costs, predominately labor (figure 3.3).
Because labor is the least mobile factor of coal production (given the geographic and skill
constraints of a coal workforce), the coal industry’s decline puts greater social and political
pressure on affected mining regions than the decline of other sectors potentially affected
by an LCT, as discussed in several papers produced under the Climate Strategies
and IDDRI (Institute for Sustainable Development and International Relations) Coal
Transition Initiative (Sartor 2018).
Oil and Gas Sectors
Currently, the oil and gas sectors are experiencing less immediate pressure from an LCT
than coal, but future stakes are more significant in economic terms. Both oil and gas are
still expected to play major roles in future energy even as the world is moving toward
an LCT, providing between 45 and 50 percent of global primary energy in 2040 in the
IEA Sustainable Development Scenario (IEA 2017). This reflects the expected contin-
ued role for hydrocarbons as a transport fuel and in many industrial applications, and
the flexibility of gas as a fuel for electricity generation. Global oil reserves are sufficient
40
Potential Impacts on Different Sectors and Countries
FIGURE 3.3 Breakdown of Coal Sector Cash Flow, 2011–50
US$/tonne
120
100
80
60
40
20
0
–20
20 1
50
20 1
20 9
20 1
20 6
20 8
20 1
20 3
20 4
20 6
20 8
19
20 0
20 2
20 3
24
20 6
20 8
30
32
20 3
34
20 9
20 0
42
20 3
20 4
20 6
20 8
20 9
20 2
20 5
20 7
20 5
27
20 5
37
20 5
20 7
1
2
2
3
3
3
4
1
1
1
1
2
2
2
2
2
3
3
4
4
4
4
4
4
1
1
1
2
3
4
4
20
20
20
20
20
20
20
20
20
Royalty Government take Capital costs Operating costs Total asset cash flow
/
Source: Analysis based on Wood Mackenzie (accessed May 31, 2016), https://www.woodmac.com/research/products/upstreamglobal
-economic-model/.
for about 50 years with current consumption rates and are higher than 30 years ago
figure 3.4). The reserves-to-production ratio has been relatively flat or increasing dur-
(
ing the past 30 years because of the exploration for and discovery of new reserves and
improvements in extraction efficiency. In effect, the world is not running out of oil
soon, and without exogenous policy or market forces to reduce demand, an LCT will
not be driven by supply constraints. The growth of reserves was mainly driven by new
discoveries in South and Central America, where the largest global reserves are located,
followed by discoveries in the Middle East.
At the same time, the competitive dynamics of the sectors have changed drastically
as the result of a technological revolution. The combination of horizontal drilling and
hydraulic fracking techniques have enabled oil and gas to be extracted in vast quantities
from shale reserves in the United States at a cost as low as $60 per barrel of oil, with
costs continuing to fall and significant efforts being made to extract oil and gas from
shale in other countries. Shale production introduces competitive pressure into the
sector because extraction is less capital intensive and has shorter lead times than other
marginal sources of supply (Wang et al. 2014; Kilian 2016). The fall in oil prices since
mid-2014 was due in large part to conventional producers, particularly Saudi Arabia,
responding to this pressure (Behar and Ritz 2017). On the demand side, the tightening
of vehicle fuel efficiency standards, new battery technologies, and infrastructure sup-
porting electric vehicles create uncertainty about the peak demand for oil, while the
switch to renewable energy in power systems and demand-side energy management
make future demand for gas uncertain.
41
Diversification and Cooperation in a Decarbonizing World
FIGURE 3.4 Oil Reserves-to-Production Ratios
years
a. 2017 by region b. History
150 150
120 120
90 90
60 60
30 30
0 0
1987 1992 1997 2002 2007 2012 2017
ica
pe
a
st
ic
ric d
a f
ric
St o
me an
cif
Ea
ro
er
nt lth
Af
a
M tes
u
Pa
Am
lA h
le
E
de ea
ra Sout
idd
ia
en nw
rth
As
ep mo
No
Ind m
nt
Co
Ce
North America Europe Middle East Asia Pacific
South and Central America Commonwealth of Independent States Africa World
Source: BP 2018, © BP p.l.c. 2018. Reproduced with permission from BP; further permission required for reuse.
The competitive pressures from shale may also feed into global gas markets via
liquefied natural gas (LNG) exports. LNG provided 60 percent of interregional gas
trade in 2014, and the IEA expects LNG volumes to increase by 50 percent by 2020
(IEA 2015a). This boom has been driven by high gas prices outside the United States,
but the start of LNG exports linked to US gas prices in 2016 exposes international
markets to the competitive pressures of US shale gas. Even when US gas prices are not
used as a benchmark for global LNG trade, the growth in LNG means that regional
gas markets are likely to become more competitive in the future because LNG can
connect them all. Moreover, cost reduction and higher flexibility thanks to floating
offshore gas terminals could further disrupt the energy sector. Nonetheless, with the
current production-to-consumption ratio, the current known gas reserves are vast—
enough for more than 60 years. The largest gas reserves are located in the Middle
East, followed by the Commonwealth of Independent States and Africa ( figure 3.5).
The global reserves-to-production ratio has been relatively stable for the past 30
years, suggesting that, as with oil, gas scarcity is not imminent.
42
Potential Impacts on Different Sectors and Countries
Shale oil is expected to provide most of the new oil supply in the coming decades.
Figure 3.6 shows the expected sources of oil supply to 2050, based on an analysis of
Rystad’s Ucube database. Current sources will continue providing 60 percent of total
supply in 2025, whereas conventional sources currently under development will sup-
ply only 10 percent. Shale oil production in the United States has already surpassed
that in Saudi Arabia or the Russian Federation, and new developments, largely from
shale, may provide 30 percent of oil supply in 2025.
Uncertain demand and competitive supply pressures are likely to make investors much
more selective when developing new resources with large capital needs, long lead times,
and high break-even prices. The resilience of US shale oil producers to the oil price shock
of 2014 proved that supply-side efficiency through technology progress and management
changes can be very responsive to prices, even in a relatively short time. Several analysts
agree that the oil reserves that are probably most exposed to competitive pressure are oil
fields in the Arctic, tar sands in Canada, and some not-yet-developed deepwater and
ultra-deepwater reserves (figure 3.7). In 2017, for example, Shell decided to divest its
Canadian oil sand interests, which is one of the highest-cost sources of crude oil.
FIGURE 3.5 Gas Reserves-to-Production Ratios
years
a. 2017 by region b. History
150 600
500
120
400
90
300
60
200
30
100
0 0
1987 1992 1997 2002 2007 2012 2017
a
pe
a
c
a f
st
ric d
ric
ric
ifi
St o
me an
ro
Ea
c
nt lth
e
Af
M tes
a
Pa
Eu
Am
lA h
le
de ea
ra Sout
ia
idd
en nw
rth
As
ep mo
No
Ind om
nt
C
Ce
North America Europe Africa Asia Pacific
South and Central America Commonwealth of Independent States Middle East World
Source: BP 2018, © BP p.l.c. 2018. Reproduced with permission from BP; further permission required for reuse.
43
Diversification and Cooperation in a Decarbonizing World
FIGURE 3.6 Room for New Oil and Gas Field Development in 2-Degree Celsius IEA Scenarios
120
100
80
Thousand barrels of oil per day
World crude oil demand in the IEA SD scenario (WEO 2017)
60
40
20
0
20 1
20 3
20 1
20 1
20 2
20 6
20 8
20 9
20 0
22
23
20 6
20 8
29
30
20 2
20 3
20 6
20 8
20 9
40
42
20 3
20 8
20 9
50
14
24
20 5
27
20 4
44
20 6
20 5
17
20 5
37
20 5
47
4
1
2
3
1
1
1
1
2
2
2
3
3
3
3
3
4
4
4
2
3
4
1
3
4
20
20
20
20
20
20
20
20
20
20
20
20
20
20
Undiscovered Discovery Oil demand under IEA SDS Under development Producing Abandoned
Sources: Based on Rystad Ucube, March 2019; IEA WEO 2017 Sustainable Development Scenario.
Note: IEA = International Energy Agency; SD = sustainable development; SDS = sustainable development scenario; WEO = World Energy Outlook.
Figure shows global liquids supply to 2050 split by life cycle category. Crude oil, condensate, and natural gas liquids are included.
These technological changes mean that “peak oil” is much more likely to be driven by
demand-side pressures—in other words, decarbonization—than supply-side constraints.
Historically, there has been huge concern about global oil production becoming con-
strained by limited availability. These demand-side decarbonization pressures will play
out in increasingly competitive and fragmented oil and gas markets, most likely domi-
nated by low-cost existing producers and a competitive fringe of shale producers. By con-
trast, the development of high-cost, conventional reserves may become increasingly
uncompetitive, especially given their high capital needs and long lead times.
For instance, Brandt (2007) analyzed 139 potentially overlapping oil-producing
regions throughout the world and argued that production in 123 regions could be
reasonably modeled as single-peaked and that production in 74 of these regions had,
in fact, already peaked. The potential political, social, and economic repercussions of
peak oil resulting from supply-side constraints were a major focus of other studies
(Hirsch, Bezdek, and Wendling 2005; Heinburg 2005). By contrast, the shale revolu-
tion means that most industry observers now consider demand-side constraints far
more likely to lead to peak consumption, with some studies supported by oil majors
44
Potential Impacts on Different Sectors and Countries
FIGURE 3.7 Global Oil Supply Cost Curve and Break-Even Prices
Cost curve
120
Average breakeven
Oil sands
100 75%
break-even
price
Onshore Russia confidence
Extra-heavy oil 88 interval for
80 Onshore ROW
Deepwater each category
Offshore shelf
US$ per barrel
62
55 57
60 53 54
North American
48
shale
Onshore
Middle East 40 Ultra-deepwater
40
25
Total production in
20 2020 from category
as share of the total
cumulative production
0
0 10 20 30 40 50 60 70 80 90 100
Oil production, million barrels a day
Sources: Rystad Energy research and analysis; IMF staff calculations (Arezki and Matsumoto 2017).
Note: The break-even price is the Brent oil price at which the net present value equals zero, considering all future cash flows, using a real discount
rate of 7.5 percent. Oil refers to crude oil, condensate, and natural gas liquids. ROW = rest of world.
suggesting this peak consumption could be reached in the 2020s or 2030s (Financial
Times 2017). Similarly, Helm (2017) argues that technology innovation and the global
move toward the Internet of Things will inexorably reduce the demand for oil, gas,
and renewables—and prove more effective than current efforts to avert climate
change. He argues that both oil companies and fossil fuel–exporting nations will need
to adjust to the permanence of low demand for, and low prices of, oil.
Oil is responsible for most of the economic dependence on fossil fuel rents and
exports. The importance of oil rents and export revenue for the total output of the
economy (for the period 2013–17) dwarfs that of gas and coal for major exporters of
each fuel (figure 3.2).
Depending on assumptions made about future technologies and policies to generate
negative emissions after 2050 (that is, to remove carbon from the atmosphere and
sequester it in the ground or in a forest), there may still be room for limited new explora-
tion and new oil and gas field development in the face of an LCT that is consistent with
45
Diversification and Cooperation in a Decarbonizing World
the 2-degree C goal, although supply competition would be tighter, as discussed earlier
in this chapter. The decline in production of the fields currently in operation—estimated
at 6 percent per year (Statoil 2017)—is higher than the decline in global demand for oil
and gas in the scenarios consistent with the 2-degree C goal. This is illustrated in figure
3.6, in which the global oil supply split by life-cycle category from Rystad is overlaid with
world primary energy demand from the IEA Sustainable Development Scenario (IEA
2017), which is compatible with the 2-degree C target. Other analysts confirm this
observation, for example, Statoil (2017). Even Carbon Tracker (2017) argues that only
one-third of new oil development projects are “not needed” in a 2-degree C constrained
future.1 However, this fraction is dependent on many uncertain factors, including the
sensitivity of the climate system and the ability to remove carbon from the atmosphere
after 2050. In many scenarios, though, FFDCs have access to increasing revenues from
oil and gas sales to finance diversification, although an LCT will increase competition
and cause revenues to grow more slowly than many in the industry currently expect
(Peszko, van der Mensbrugghe, and Golub 2020).
Refineries
Refineries are likely to face the same pressures as oil, but amplified. Refineries take
crude oil as an input and transform it into refined products, such as gasoline and diesel
and jet fuel. They therefore would face declines in demand as refined products are
taxed, biofuels displace refined products, and consumers switch to electric vehicles and
more efficient modes of transportation. This is the same pressure that oil production
faces, but refineries tend to have thinner margins because they are more competitive
than crude extraction given their relatively similar cost structures.
Refineries differ in their complexity, with more complex refineries typically enjoy-
ing higher margins. Complexity describes a refinery’s capability to convert lower-
quality crude oil into higher-value refined products. Complex refineries have
historically been more competitive on an operating basis because lower-quality
crudes—those that are heavier (with longer hydrocarbons) and sour (with a higher
sulphur content)—have been more abundant and therefore cheaper. This has gener-
ally led to a higher margin on an operating cost basis (the net cash margin). This
higher net cash margin has tended to compensate for the higher capital costs of more
complex refineries.2
The availability of higher-quality crude from shale may erode the competitive
advantage of complex refineries. Crude oil from shale tends to be lighter and sweeter
than conventional crude oil. The large amount of shale oil that has become available
in recent years has lowered the cost of light, sweet crude, and in parallel reduced the
cost advantage that more complex refineries used to enjoy thanks to their use of heavy,
sour crudes.
46
Potential Impacts on Different Sectors and Countries
Moreover, the relatively complex refineries tend to be more energy intensive, which
will most likely lead to a disadvantage in a low-carbon world. The 41 lowest-complexity
refineries use, on average, 1.75 gigajoules (GJ) of energy per ton of crude processed,
while the 40 highest-complexity refineries (with an index of greater than 10.5) use, on
average, 4.64 GJ of energy per ton of crude. Han et al. (2015) find a similar result across
61 refineries in the United States and the EU. Because an LCT is expected to increase
energy costs, the margins of the more complex, and thus more energy intensive, refin-
eries will come under pressure.
The extent to which complexity will improve refineries’ resilience or represent a
liability for them in a low-carbon world remains unclear. The outcome depends on the
extent to which energy costs increase, the extent to which shale oil reduces the relative
competitiveness of complex refineries, and the pace at which new refineries are opened
in non-OECD countries, as well as their level of trade with OECD countries. Refineries
often seek protection from competitive pressure through vertical integration with fuel
suppliers. This structure may prompt parent oil companies with deep pockets to inject
liquidity in bad times for refineries. In the long run, however, constraints in competi-
tive sourcing of crude supplies may also be a source of risk for refineries.
Carbon-Intensive Manufacturing: Steel and Cement
The importance of steel is likely to remain unchallenged as economies develop, with
production expected to increase from 1.6 million tonnes3 in 2015 to 2.8–3.6 million
tonnes by 2050. Concerns in the industry seem less focused on the impact of an LCT
than on the unequal levels of climate policy ambition across countries, which could
jeopardize fair competition in the sector (WSA 2019). Steel can be produced in two
ways: through the more emissions-intensive, basic oxygen furnace (BOF) process,
which uses iron ore and coking coal; or the less emissions-intensive electric arc furnace
(EAF) process, which primarily uses scrap steel and electricity. The share of BOF in
global steel production in 2014 was 74 percent, while the share of EAF was only
26 percent. Estimates of current steel-related emissions range from about 2.5 billion
tonnes (WSA 2019) to up to 2.9 billion tonnes (McKinsey & Company 2018), not
counting mining and transportation, with BOF accounting for 90 percent of these
emissions. Coal is difficult to substitute for in the BOF process, while the EAF process
is constrained by the availability of scrap metal, particularly in developing countries
with limited scrapping and recycling (given their relatively new infrastructure).
Cement is less internationally traded (except over relatively short cross-border dis-
tances), and very carbon intensive. Production is concentrated in countries with the
highest level of construction activity, particularly China, which accounts for more than
half of the world’s cement (Reuters 2018). Cement accounts for 34 percent of industrial
direct emissions (IEA 2015b) and for 5 percent of total global emissions. Nearly
47
Diversification and Cooperation in a Decarbonizing World
two-thirds of cement emissions come directly from the production process, with the
remaining third from energy use. With China’s change in its growth model, global
demand for cement is already stabilizing and may peak soon in other countries
(figure 3.8).
Overall, the emergence of fundamentally different technologies and materials is dif-
ficult to foresee in the short to medium term; the largest pressures will probably be
concentrated in specific regions as a result of asymmetric carbon intensities. No other
materials currently provide sufficient strength and flexibility at the cost of steel, while
there are significant interdependencies between the use of cement as a bonding agent
and other building materials in the construction sector.
An LCT would mean that the most carbon-efficient producers would stand to gain
market share. Competitive positions can still be disrupted in the transition to a low-
carbon world if faced with global cooperative action or border carbon adjustment
measures, particularly for steel and cement manufacturers with significantly higher
carbon intensities than others. In the steel sector, plants exhibit major differences in
energy intensity, while in the cement sector, there are differences in energy efficiency,
fuels used, and levels of clinker use. In both sectors, carbon capture, use, and storage
could become a crucially important technology.
Why Focus on Sovereigns and State-Owned Enterprises?
Much attention has been given to the impact of an LCT on international extractive
companies.4 Less attention has been paid to the impact on FFDCs and state-owned
enterprises (SOEs)—to what extent they may be affected, and what economic growth
FIGURE 3.8 Domestic Consumption of Cement in China and India
a. China b. India
2,500 2,500
2,000 2,000
Million tonnes/year
Million tonnes/year
1,500 1,500
1,000 1,000
500 500
0 0
2010 2011 2012 2013 2014 2015 2016 FY11 FY12 FY13 FY14 FY15 FY16E FY17E
Sources: China: based on, for 2010–14: BDZ, Cembureau, taken from Statista.com; for 2015–16: Calculated using per capita consumption from
Statista.com and population from UNDESA. India: India Brand Equity Forum based on CMA, CMIE Database, TechSci Research.
Note: E = estimated; FY = fiscal year.
48
Potential Impacts on Different Sectors and Countries
and development strategies they should adopt in anticipation (CPI 2016; Helm 2017).
Previous analysis (Nelson et al. 2014) suggests that governments rather than corpora-
tions bear the brunt of transition risks. And this book’s analysis suggests that govern-
ments can expect to receive almost 80 percent of the net present value of future oil and
gas revenue, with a further 12 percent of future revenue flowing to national oil compa-
nies (figure 3.9). Although these figures are more extreme than for gas and coal extrac-
tion (figure 3.10) or carbon-intensive industries, they demonstrate that there may be
acute direct exposure and impact to governments themselves.
Historically, several countries relied heavily on fossil fuels to generate export reve-
nues (figure 3.10). Most of this export dependency affects oil-rich countries and, rarely,
gas exporters (for example, Qatar). An abundance of coal, as discussed earlier, does not
lead to the Dutch disease.
The Climate Policy Initiative (CPI 2016) designed a methodology to assess the
impact of climate-related policies on national budgets over the medium and long
term, including the fiscal implications of falling natural resource–based revenues.
It recommends that governments model different demand scenarios for their
resources over the next 20 to 30 years to assess the impacts of changes in demand,
costs, and prices on their key assets and cash flows—taking care to separate the
impact on the public sector from that on the private sector.
FIGURE 3.9 Shares in Expected Revenue from Oil and Gas between 2013 and 2050
Independents 1% Others 2%
National oil companies 12%
Integrated 2%
Majors 4%
Government 79%
Source: Analysis based on Rystad UCube database.
Note: Majors = international companies. Net present value calculated using a 6 percent discount rate. Coal revenues are not included
because they are negligible.
49
Diversification and Cooperation in a Decarbonizing World
FIGURE 3.10 Export Revenues from Fossil Fuels as a Share of Total Export Revenues for the
Top 10 Most Dependent Countries (2013–17)
a. Oil b. Gas c. Coal
100 100 100
90 90 90
80 80 80
70 70 70
60 60 60
Percent
Percent
Percent
50 50 50
40 40 40
30 30 30
20 20 20
10 10 10
0 0 0
ud ge n
Ka O p.
A via
ela q
Az Kuw la
o, ia
kh n
n
Bo m
an ia
Ye Tob ay
n, o
M Nig p.
am ia
ue
lom ia
a
sn ss ou bi ia
er era ca
go n
Po via
Co i Ar ria
s ia
La a
ba t
d a No mar
an F A e
An RB
ss r
d
Sa Ni ija
er ai
ru ta
zu Ira
za ma
sta
me ag
M do bi
ze tio
vin
ia ian th qu
Re
lan
go
ng ab
ala
M lger
Re
oz er
Co tral
Bo Ru S zam nes
Au gol
nd rw
d H ed fri
biq
li
t
Da Qa
,
on
y
M
I n
ne
o
Ve
ei
da
un
ini
Br
Tr
Source: Based on World Development Indicators database.
Moreover, SOEs face institutional constraints that make it harder for them to
respond to transition risks. SOEs often have other important mandates aside from
those related to their core business—providing employment and investing in infra-
structure, for instance. These additional, noncommercial mandates may limit their
flexibility to respond to risks. In addition, because SOEs’ financial capital is often
concentrated in their home markets and their access to international sources of capi-
tal is limited, they are also less flexible than private companies with regard to sources
of capital. Human capital likewise tends to be concentrated in the SOE’s home coun-
try and often lacks the technical know-how required for the use of state-of-the-art
fracking and deep-sea exploration technologies. Finally, SOEs often vehemently
defend their vested interests, successfully preserving the status quo and thus frustrat-
ing government efforts to prepare for a transition (see the section “Traditional
Diversification” in chapter 4).
The resource rents of many FFDCs finance a range of essential expenditures.
The development plans of middle- and low-income countries—such as Angola,
Cameroon, Kazakhstan, Mozambique, Myanmar, Tanzania, and Uganda—often
rely on realizing direct rents from carbon-intensive activities to invest in the health,
education, and infrastructure needed for continued development and to lift the
remainder of their populations out of poverty. The indirect tax revenues derived
from the multiplied impact on wages, salaries, and profits distributed through, and
spent in, the rest of the economy will also affect public finances through a lower tax
50
Potential Impacts on Different Sectors and Countries
take. Countries with histories of conflict, such as Iraq and Libya, have few alterna-
tives to fossil fuel revenues to finance the reconstruction of their economies and
restore prosperity.
An emerging qualitative literature studies the risk of stranded assets in countries
that depend on fossil fuel resources. For example, Caldecott et al. (2016) discuss the
challenges and opportunities facing lower-income and emerging market economies in
Latin America and the Caribbean if their fossil fuel resources become “unburnable”
given carbon budget constraints. In a similar vein, Manley, Cust, and Cecchinato (2017)
qualitatively discuss the challenges to stranded nations under constraints of “unburn-
able carbon.” They conclude that these fossil fuel–rich countries are exposed to the risk
of permanent loss of value of their underground wealth, and that they may be pursuing
policies that increase their exposure and result in them being less able to manage the
related risks. Cust and Manley in Lange, Wodon, and Carey (2018) use the wealth
accounting framework to estimate and discuss the carbon wealth of nations—the value
of fossil fuel reserves—and the risks that advances in technology and climate policies
may pose to the value of this wealth.
Formal models are beginning to be applied to support analytical work on stranded
assets. Makarov, Chen, and Paltsev (2017) applied the Massachusetts Institute of
Technology (MIT) Economic Projection and Policy Analysis model to assess the
impacts of the Paris Agreement on the Russian economy. The study simulates the
impacts of alternative global emissions constraints, some based on the Paris
Agreement nationally determined contribution pledges and others in which mitiga-
tion efforts are increased after 2030 to be on a 2-degree C trajectory. Interestingly, the
study also simulates three simple diversification scenarios with which Russia can pre-
pare for these impacts. The authors find that Russia could best mitigate the adverse
impact of climate policies by diversification of the economy, moving to low-carbon
energy sources, and investing in human capital development. Climate Policy Initiative
(Nelson et al. 2014) explores the impact an LCT would have on the value of investor
portfolios when fossil fuel assets lose value because they are left in the ground or
produce lower returns from declining demand and price. They apply regional and
global economic single sector models for coal, oil, natural gas, and power to examine
how the decline in value would be spread between governments and investors and
among various countries, and how both the level of stranded assets and their distri-
bution would depend on policy. They conclude that governments, rather than private
investors and corporations, face the majority of stranding risk.
Notes
1. The Paris Agreement has another aspirational goal of 1.5 degrees C, in which case additional new
oil development projects “would not be needed.”
2. World Bank analysis of Wood Mackenzie data, 2014.
51
Diversification and Cooperation in a Decarbonizing World
3. The tonne, commonly referred to as the metric ton in the United States, is a non-SI (International
System of Units) metric unit of mass equal to 1,000 kilograms. For practical reasons, this book uses
the term tonne rather than metric ton.
4. See, for example, the work of the Carbon Tracker Initiative (www.carbontracker.org) and the Task
Force on Climate-Related Financial Disclosures (www.fsb-tcfd.org).
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/publications/freepublications/publication/WEO2015.pdf.
IEA (International Energy Agency). 2017. World Energy Outlook 2017. Paris: IEA. http://www.iea.org
/media/weowebsite/2017/Chap1_WEO2017.pdf.
Kilian, L. 2016. “The Impact of the Shale Oil Revolution on U.S. Oil and Gasoline Prices.” Review of
Environmental Economics and Policy 10 (2): 185–205.
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Lange, G.-M., Q. Wodon, and K. Carey. 2018. The Changing Wealth of Nations 2018: Building a
Sustainable Future. Washington, DC: World Bank.
Makarov, I., Y. -H. H. Chen, and S. Paltsev. 2017. “Finding Itself in the Post-Paris World: Russia in the
New Global Energy Landscape.” Report 324, MIT Joint Program on the Science and Policy of
Global Change, MIT, Cambridge, MA. http://globalchange.mit.edu/publication/16859.
Manley, David, James Cust, and Giorgia Cecchinato. 2017. “Stranded Nations? The Climate Policy
Implications for Fossil Fuel–Rich Developing Countries.” OxCarre Policy Paper 34. Oxford
Centre for the Analysis of Resource Rich Economies, Oxford, UK.
McKinsey & Company. 2018. Decarbonization of Industrial Sectors: The Next Frontier. Amsterdam:
McKinsey & Company. https://www.mckinsey.com/~/media/mckinsey/business%20functions
/s ustainability/our%20insights/how%20industry%20can%20move%20toward%20a%20
low%20carbon%20future/decarbonization-of-industrial-sectors-the-next-frontier.ashx.
Nelson, David, Morgan Hervé-Mignucci, Andrew Goggins, Sarah Jo Szambelan, Thomas Vladeck,
and Julia Zuckerman. 2014. “Moving to a Low-Carbon Economy: The Impact of Policy Pathways
on Fossil Fuel Asset Values.” Energy Transition Series, Climate Policy Initiative.
Peszko, G., D. van der Mensbrugghe, and A. Golub. 2020. “Diversification and Climate Cooperation
Strategies of Fossil Fuel Dependent Countries.” Policy Research Working Paper. World Bank,
Washington, DC
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https://www.reuters.com/article/us-cement-forecast/global-cement-demand-forecast-to
-grow-1-5-percent-in-2019-idUSKBN1O425Z.
Sartor, O. 2018. “Implementing Coal Transitions: Insights from Case Studies of Major Coal-
Consuming Economies.” A summary report of the Coal Transitions Project. IDDRI and Climate
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-perspectives-2017-v2.pdf.
Wang, Q., X. Chen, A. N. Jha, and H. Rogers. 2014. “Natural Gas from Shale Formation—The
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Sustainable Energy Reviews 30: 1–28.
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53
Strategic Framework for
4.
Dealing with the Potential Impacts
of a Low-Carbon Transition
Although we have established that deep uncertainty is a predicament of a low-carbon
transition (LCT), this book argues that this uncertainty is not a good excuse for inaction.
Pasteur’s (1854) observation that “fortune favors the prepared mind” is more relevant than
ever for an LCT because surprise impacts can be systemically disruptive. Financial institu-
tions, insurance companies, and financial system regulators are already taking measures to
manage this risk. Successful decisions under deep uncertainty require the consideration of
many possible futures and being prepared for plausible best-case and worst-case scenarios.
This chapter analyzes different strategic options that FFDCs could use to adequately
prepare for, and respond to, a global LCT, whether the transition is driven by technology
or policy. This study focuses on two key sets of strategic choices to manage its impacts:
1. Diversification strategies can take one or both of the following forms:
■ Downstream industrialization within the fossil-fuel product space through tra-
ditional diversification of outputs and exports, for example, through supporting
domestic use of fossil fuels
■ Diversification of the broader economic asset base, including investment in
renewable natural capital and intangible assets, such as institutions and human
capital, that can drive a transition toward a productivity-driven, knowledge-
based economy.
2. International cooperation strategies involve the following:
■ Commitments to domestic climate policy instruments that are aligned with a club
of countries committed to emissions-mitigation actions, with benefits linked to
climate club–exclusive privileges (for example, in the domains of trade or financial
and technology transfers)
■ Abstention from such internationally coordinated policy actions (free-riding).
These two strategic choices are unpacked in the remainder of this chapter.
Diversification Options for FFDCs
The broad diversification strategies analyzed here are not alternatives, and can be pur-
sued jointly, depending on a country’s existing strengths, market position, and
55
Diversification and Cooperation in a Decarbonizing World
accumulated skills and capabilities. Asset diversification can be seen as an extension of
traditional export diversification (figure 4.1). The balancing act involves resource allo-
cation decisions that harmonize short-term cash-flow requirements with long-term
sustainable development needs.
Traditional Diversification
Fossil fuels and their related industrial value chains have become FFDCs’ natural com-
parative advantage, providing energy security and a source of revenues. The prevailing
growth model in many FFDCs (for example, the Gulf Cooperation Council [GCC]
countries), consisting of extracting oil and gas and producing related products and
nontradables while importing most of the tradable consumption goods, have also con-
strained their economic performance (Cherif and Hasanov 2014).
Many FFDCs have already expressed their aspirations to achieve more diversified
economies in their development plans. For instance, Saudi Arabia’s Vision 2030 states
that “diversifying our economy is vital for its sustainability. Although oil and gas are
essential pillars of our economy, we have begun expanding our investments into addi-
tional sectors.”1 Qatar is making progress toward its diversification goals contained in its
Vision 2030 (Alagos 2017). In the Russian Federation, the “Concept of Long-Term Socio-
Economic Development of Russia until 2020” calls for modernization and innovation as
FIGURE 4.1 Two Broad Diversification Strategies
• Diversifies the portfolio of national assets
(inputs): natural capital and intangible
assets (knowledge, innovation, institutions)
• Discovers new comparative advantage and
Asset diversification hedges structural risks
• Increases flexibility, resilience, productivity,
and climate mitigation co-benefits
• Relies on knowledge and efficiency;
increases productivity over time
• Diversifies outputs and exports through
energy- or carbon-intensive industrialization
on the back of fossil fuel value chains
• Builds on current comparative advantage
Traditional
and hedges cyclical risks
diversification
• Increases greenhouse gas emissions and exposure
through
to low-greenhouse-gas transition
industrialization
• Relies on energy subsidies to industry;
maintains low productivity
Source: World Bank.
56
Strategic Framework for Dealing with the Potential Impacts of a Low-Carbon Transition
an important goal to secure the development of its economy.2 Additionally, the May
Decree 2018 of the President lays the groundwork for national priority projects.3
Traditionally, FFDCs have put diversification efforts into products and exports
closely related to hydrocarbons (box 4.1). This strategy is typically associated with
identifying sectors that are closely linked to areas in which the economy has an existing
comparative advantage and that offer additional opportunities for value creation.
In FFDCs, this approach often implies keeping domestic fuel prices low and pursuing
BOX 4.1 Empirical Evidence for Export Diversification
Some studies find a positive relationship between export diversification and welfare. For instance,
Hesse (2008) reviews the literature on the benefits of export diversification and finds strong evidence
of a negative correlation between export concentration (measured by a Herfindahl index) and cumula-
tive gross domestic product (GDP) per capita growth over five-year intervals in the period 1961–2000.
The Herfindahl index (also known as the Herfindahl–Hirschman index, HHI, or sometimes HHI-score) is
a measure of the size of firms in relation to the industry and is an indicator of the degree of competition
among them. The results are presented in figure B4.1.1. Many of the successful East Asian countries
are located in the lower right corner of the figure, with relatively low levels of export concentration. Poor
growth in Sub-Saharan African economies is correlated with a very strong concentration in exports.
FIGURE B4.1.1 Relationship between Export Concentration and GDP per
Capita Growth (1961–2000)
0.8
Chad Nigeria
Zambia
Uganda
0.6 Niger
Burundi
Guinea
Mauritania
Rwanda
(mean) HHI
Gabon
Mali Mauritius
0.4 Congo, Rep. Algeria
The Gambia Ethiopia
Central African Republic Suriname Malawi
Somalia
Liberia Burkina Faso
Togo Ecuador
Congo, Dem. Rep. Sierra Leone Ghana Benin Colombia
Sudan Jamaica Chile Papua New Guinea
Bolivia Guinea-Bissau Barbados
0.2 Bahamas, The
Nicaragua Costa Rica
Trinidad and Tobago Sri Lanka
Cameroon Indonesia
Jordan Kenya Côte d’Ivoire Malta
Guatemala Paraguay Iceland
Zimbabwe Tanzania Dominican Republic Malaysia
Madagascar Morocco Panama
Senegal Haiti Bangladesh Mexico Israel Tunisia Hong Kong SAR, China
Mozambique Peru Uruguay Brazil
New Zealand Philippines Turkey Pakistan Norway Thailand Singapore
Argentina South AfricaCanada
Australia India Greece Ireland Cyprus Korea, Rep.
Switzerland Poland Finland Japan
Belgium Spain China
0 Germany
Sweden Hungary
Austria
Italy Portugal Taiwan, China
United Kingdom Netherlands France
Denmark United States
–0.2 –0.1 0 0.1 0.2 0.3
(mean) rgdpchg
Source: Hesse 2008.
Note: HHI = Herfindahl index; rgdpchg = real GDP per capita growth rate (chain-weighted index).
(Box continues on the following page.)
57
Diversification and Cooperation in a Decarbonizing World
BOX 4.1 Empirical Evidence for Export Diversification (continued)
Yet these results are controversial. Gill et al. (2014) question the utility of metrics such as
export and production diversification. Exports can be concentrated for many reasons, among oth-
ers, underdevelopment or the size of the economy. Furthermore, production and export concentra-
tion metrics are highly sensitive to the level of sectoral aggregation, and the authors show that
using different levels of aggregation in an analysis can yield opposing outcomes.
More fundamentally, whether export diversification is either necessary or sufficient to achieve
economic development is unclear. The World Bank (2014a) suggests that the optimal level of diver-
sification is context specific, and that export diversification alone is not sufficient to deliver strong
growth. For instance, while diversification away from fossil fuel exports helped create flourishing
economies in the United Kingdom and the United States, in countries such as Australia, Canada,
Norway, and the United Arab Emirates, heavy reliance on fossil fuel exports occurred alongside
strong economic growth. On the other hand, both Argentina and Brazil sought to diversify their
export base but have arguably not succeeded in achieving their development goals.
vertical industrial policies that strengthen downstream, carbon-intensive capabilities.
A classic example would be to move from oil, gas, and coal extraction to refining the oil
and producing petrochemicals, steel, cement, and fertilizers, or fueling airlines and
thermal power plants. In GCC countries, recent diversification into manufacturing has
been highly concentrated in the chemicals sector, which is largely oil related (Callen
et al. 2014), although steel and aluminum attracted significant government-led invest-
ments in Saudi Arabia and Qatar. Similarly, in Kazakhstan, carbon-intensive industries
such as metallurgy and chemicals have long been central to diversification efforts
(Felipe and Hidalgo 2015).
Traditional export diversification has borne fruit when successfully accomplished.
As highlighted in box 4.1, traditional diversification has often been associated with
higher levels and stronger resilience of GDP growth. This success is due to a wider
range of higher-value-added products that provide a hedge against resource price vola-
tility, as well as the development of sectors that have greater technological spillovers.
A more diversified economy also becomes less susceptible to rent-seeking by providing
a wider range of opportunities and less concentrated power in society.
Yet as evidenced by many stalled attempts, and despite some notable successes, even
traditional diversification can be challenging for commodity exporters. The
International Monetary Fund (IMF) concluded that a key challenge for GCC countries
is to find ways to develop non-oil tradable sectors that support sustainable private sec-
tor employment (Cherif, Hasanov, and Zhu 2016). Some analysts (for example, Cherif
and Hasanov 2014) argue that GCC countries’ inability to diversify away from oil stems
mainly from market failures associated with Dutch disease. They suggest that govern-
ment policies should target high-value-added sectors with large spillovers and
58
Strategic Framework for Dealing with the Potential Impacts of a Low-Carbon Transition
productivity gains. Few countries have succeeded in overcoming the dominance of
natural resources and primary commodities (in particular oil). Policy makers’ focus on
short-term rents from resources and their allocation of these rents to ensure political
survival has tended to undermine institution building and distracted from policies and
investments necessary to sustain growth in the long term (World Bank 2017).
Furthermore, vested domestic interests must often be overcome for economic trans-
formation to happen. State-owned enterprises lobby forcefully against diversification
that could undermine their position and influence. Moe (2007) explores the role of
governments in influencing long-run economic growth since the Industrial Revolution
by looking at France, Germany, Japan, the United Kingdom, and the United States.
Combining the Schumpeterian (Schumpeter 1943) process of creative destruction with
Olson’s (1982) theory of vested interests, he argues that the most successful economies
were those in which the governments did not excessively prioritize the demands of
powerful incumbent interest groups. He concludes that, “What matters is the state[’s]…
ability and willingness to pursue policies of structural change. And hence, what matters
is whether or not the state is in possession of sufficient political consensus and social
cohesion for political elites to be able to go against powerful vested interests resisting
change” (Moe 2007, 268).
Although traditional diversification has helped to hedge against cyclical risks, this
study poses a question as to its effectiveness in managing a possible structural decline
in fossil fuel–dependent markets. Heavy industrialization usually increases domestic
emissions of greenhouse gases and local pollutants. Diversifying away from oil and gas
by investing downstream in production of higher-value-added products that use
hydrocarbons as feedstock will only get riskier if the importers and domestic consum-
ers are increasingly concerned about the carbon content of final goods. Such diversifi-
cation can increase exposure to LCT risks, especially if other countries adopt border
carbon adjustment (BCA) measures. Policies and trade measures can translate these
concerns into higher prices for final consumers, lower producer prices, and structurally
declining export demand.
Asset Diversification
LCT risks underscore the urgency of broader approaches to diversification, not so
much focused on what a country makes at home and sells abroad, but on how it goes
about making those goods and services (Gill et al. 2014). That is, rather than being
focused on diversifying outputs, the focus is on diversifying inputs—the assets being
utilized by an economy (hence the term asset diversification).4 These assets are human
(people and their skills [Lange, Wodon, and Carey 2018]), naturally delivered ecosys-
tem services (Helm 2015), produced (for example, factories and infrastructure) and, of
crucial importance, intangible assets, including human and knowledge capital as well
as institutions that organize societies (Lange, Wodon, and Carey 2018; Hamilton and
59
Diversification and Cooperation in a Decarbonizing World
Hepburn 2014, 2017). (See box 4.2.) They contribute to creating a more productive
economy, with intangible assets also particularly important in building competitive
knowledge economies that are more flexible, adaptable, and resilient to a wide range of
external shocks. This type of diversification can coexist with traditional (vertical)
industrial policies, building on existing comparative advantage and investing in new
capabilities. Both types of diversification contribute to economic complexity.
Rapid progress has been made in the development of methodologies that account
for the value of natural and intangible assets in the economic performance of nations
(Hamilton and Hepburn 2014; Helm 2015; Lange et al. 2011; Lange, Wodon, and
Carey 2018). However, renewable natural and intangible assets have not yet become
integrated into mainstream economic models and macro-fiscal policy frameworks.
Hence, they are often overlooked, underpriced, and mismanaged by decision-makers,
even if they make a vital contribution to the sustainability of economic growth. But
sustainability is less visible to policy makers focused on year-to-year output growth.
The understanding of the role of intangible and ecosystem assets to an economy is
increasing.
BOX 4.2 Classification of Assets and Capital
Gill et al. (2014) decompose an economy’s assets into three broad categories: natural, produced,
and intangible, defined as follows:
■ Natural assets include resources like subsoil assets, forests, wetlands, rivers, oceans, and
farmland.
■ Produced assets are physical investments, like machinery and infrastructure.
■ Intangible assets represent the contribution of labor, human capital, social capital, institu-
tions, knowledge capital, and the rule of law.
Hamilton and Hepburn (2014) break down the wealth of a nation into various forms of capital,
the most important of which are the following:
■ Physical or produced capital, which includes physical infrastructure, buildings, machinery, and
the like
■ Human capital, which incorporates the education and stock of knowledge embodied in
people
■ Natural capital, which includes underground assets, commercial land, fish stocks, and
natural land, including the ecosystem services that it provides
■ Intellectual property, which includes the value of contracts, leases, patents, software,
databases, and other intangible property
■ Social and institutional capital, which incorporates intangible factors such as the quality
of institutions, the rule of law, and various forms of social capital that enable goods and
services to be produced
■ Net financial assets, which is the measure of the net holdings of financial assets across national
borders; within national borders, financial assets and liabilities cancel each other out
60
Strategic Framework for Dealing with the Potential Impacts of a Low-Carbon Transition
In FFDCs, asset diversification typically implies renewed efforts to bolster economic
flexibility by investing in renewable natural and intangible assets such as human capi-
tal, institutions, and innovation (EBRD 2014; Gill et al. 2014; IMF 2016; McKinsey &
Company 2015). Australia, Canada, Chile, and Norway provide examples of this form
of broad asset diversification, financed by the continued proceeds of resource extrac-
tion (Grunfeld and Moxnes 2003). Whether these investments are made often makes
the difference between the emergence of productive or stagnating economies, fully par-
ticipatory societies or societies that exclude many of their citizens, and countries with
stable or fragile governments (Gill et al. 2014).
Asset diversification has already built competitive and resilient knowledge economies.
Some of the most successful western economies today—including the Netherlands, the
United Kingdom, and the United States—have achieved advanced diversification in both
products and assets, starting from initial reliance on primary products, and become
leading knowledge-based economies. Countries such as Australia, Canada, Chile, Malaysia,
Norway, and to a lesser extent Indonesia, are examples of economies that are still relatively
concentrated on output diversification metrics but have successfully diversified their
portfolio of national assets, developing more knowledge- intensive manufacturing and
services (Gelb 2010; Tijaja and Faisal 2014; World Bank 2014b; Zen 2012).
Asset diversification and associated structural transformation have been strong
drivers of the reduction of the energy and emissions intensity of former industrial
economies. Asset diversification can have important climate mitigation co-benefits.
Many FFDCs and other resource-rich emerging market economies have performed
particularly poorly in investment in intangible assets. Figure 4.2 presents a comparison
of asset endowments across different groups of resource-rich countries. It makes a
striking case for the development of strong institutions. Poor institutions can impede
growth in various ways. For example, Gelb (2010) reports that Algeria’s failure to
diversify away from oil exports was the result of a poor business climate and poor
enforcement of the “rules of the game” for markets—in other words, a result of its
institutions. By contrast, Botswana’s annual growth rate has averaged nearly 8 percent
since the 1970s, and is often at least partly attributed to its meritocratic government
and strong governance of the savings of rents from diamond extraction (World Bank
2014a; Pegg 2010), although a lack of strong institutions in the areas of tax administra-
tion, state-owned enterprises, and the labor market have held back private sector devel-
opment and economic diversification (Harvey 2015; IMF 2017). Further lessons can be
drawn from the experiences of Chile and Mexico, both of which pursued export diver-
sification strategies in the 1980s. Chile’s diversification strategy was accompanied by
investment in strong economic institutions and human capital, leading to sustained
growth and a robust business climate. In contrast, Mexico struggled to implement
institutional reforms and missed out on potential growth, with real wages remaining
stagnant between 1994 and 2012 (Weisbrot, Lefebvre, and Sammut 2014).
61
Diversification and Cooperation in a Decarbonizing World
FIGURE 4.2 Importance of Public Institutions for the Asset Index
2.0
1.8
1.6
Asset index
1.4
1.2
1.0
Developed Successful developing Underperforming
economies economies economies
Natural capital Built capital Institutions
Source: Gill et al. 2014.
Note: The asset index ranges from 1 to 2. The higher the index value, the better the result.
Knowledge and human capital also play a crucial role in supporting development.
Knowledge capital refers to nonphysical (intangible) assets such as skills; intellectual
property such as patents, designs, and trademarks; and economic competencies includ-
ing organizational know-how. Lange, Wodon, and Carey (2018) measure human capi-
tal as the discounted value of earnings over a person’s lifetime, which should reflect the
value of skills, experience, and effort by the working population over their lifetimes
disaggregated by gender and employment status (employed, self-employed). The
amount of productive knowledge contained in an economy can also be approximated
by indexes of years of schooling or quality of education (see the section “Produced and
Intangible Assets”).
Recent work in so-called latent diversification has a broadly similar implication.
Latent diversification looks at a country’s capacity to change the mix of products it
exports as circumstances change over time, rather than focusing on its export share in
a single year. Lederman, Pienknagura, and Rojas (2015) find that the capacity to shift
production factors to other sets of export lines is important for weathering eco-
nomic shocks. This implies that having a flexible set of assets, such as robust institu-
tions, may result in better performance over time than having inflexible inputs such as
a single natural resource.
Institutional development is central to growth (Acemoglu, Johnson, and Robinson
2005; Easterly and Levine 2003). Some economic historians, such as Mokyr (1990),
North (1990), and Rosenberg and Birdzell (1985), have concluded that differences in
governance and institutions are key to explaining economic success. Some even argue
that factors such as a codified rule of law explain why the Industrial Revolution took
62
Strategic Framework for Dealing with the Potential Impacts of a Low-Carbon Transition
place in the western world rather than elsewhere, and why certain countries are more
innovative than others. A growing number of studies also emphasize that the structure
of incentives facing agents in an economy is a crucial determinant of that economy’s
performance.5 Rodrik (2004), for example, emphasizes five institutions important
for growth and innovation—those that protect property rights, provide regulatory
oversight, promote more economic stability, and provide social insurance, and those
that manage conflicts. These studies corroborate the central importance of a country’s
institutions and economic policies in explaining why some developing countries
(especially in Southeast Asia) have broken out of the middle-income trap and grown
faster than rich countries. At the same time, a growing body of institutional economic
literature recognizes the importance of the active role of the well-governed state not
only in creating general framework conditions for markets and entrepreneurship, but
also in actively driving innovation through targeted investments in research
and development (R&D) and commercialization of disruptive technologies
(Mazzucato 2013).
Changing the established national comparative advantage takes time and requires
large, continuous, and risky investments. Cherif and Hasanov (2014) note that s everal
decades of preparatory work are required to develop a non-oil tradable sector. It is
easier to temporarily leapfrog several income levels by consuming resource rents
than permanently shifting the core productive strengths of an economy. Experience
with innovation policies in Southeast Asia and Latin America suggests that accumu-
lating new skills and capabilities to innovate outside of the natural comparative
advantage requires a specific set of favorable conditions and opportunities, as well as
a large and sustainable flow of funds (Edquist 1997). To enter the global innovation
race, FFDCs will need to build entire sectoral and national innovation systems
(Malerba 2004). Malerba (2004) lists the three main pillars of successful innovations
systems: knowledge and technologies, actors and networks, and institutions. These
pillars often need to be built from scratch with associated skills and capabilities of
firms, as well as with basic capacity in science. Sophisticated leapfrogging policies are
available—but not always to those who would be able to implement them on the
ground (Lee 2013).
Some FFDCs, such as Russia and GCC countries, have accumulated a critical mass
of capabilities to generate new technologies, but many others still need to build capa-
bilities to absorb technologies generated by others. Several FFDCs are concerned that
this lag may lead to a new pattern of economic dependency and could replace one
source of economic vulnerability with another.
Innovation also requires a steady flow of funding for upstream R&D by firms,
universities, and governments, and for commercialization of new technologies (by
venture capitalists, banks, and governments). In the more advanced and diversified
resource-rich economies (Australia, Canada, Norway), the public sector played a
63
Diversification and Cooperation in a Decarbonizing World
large role in financing R&D (although it entailed a set of agency and transaction
costs), while innovations in the most successful sectors in India; Malaysia; Taiwan,
China; and Thailand were mainly privately funded (Malerba 2004). Mazzucato
(2013) provides evidence that most of the large tech firms in Silicon Valley in the
United States were developed on the basis of technologies and networks funded by
government institutions that took risks that venture capitalists were not willing to
bear. Thus, the architecture of cooperative climate agreements would need to
recognize the special circumstances of FFDCs and enable them to access a predictable
flow of funding for innovation and asset diversification with strong mitigation
co-benefits.
Different ways to diversify are not mutually exclusive. This study shows that tradi-
tional export diversification within the fossil fuel product space may become a riskier
and less sustainable proposition amid the possible structural impacts of an LCT. But
asset diversification alone—investing in human capital, better regulations, and
infrastructure—may not be sufficient to ignite a new sustainable tradable production
growth engine, especially among major oil and gas exporters. Cherif and Hasanov
(2014) argue that successful diversification strategies have relied on a policy mix of
promoting vertical diversification in comparative advantage sectors such as oil and gas
and petrochemicals and endeavors into horizontal diversification beyond these sectors
with an emphasis on technological upgrade and competition in international markets.
Therefore, a dynamic, comprehensive “hedging portfolio” of policies and investments,
combining ingredients of traditional and asset diversification, will be needed to pre-
pare for the challenges of an LCT. A flexible mix of diversification approaches will have
to be customized to the country context and be flexible enough to adjust to evolving
external conditions and internal capabilities.
Simulations performed in Peszko, van der Mensbrugghe, and Golub (2020) suggest
that the short-term costs and risks of moving away from areas of historic comparative
advantage, toward asset diversification, are high. By building on accumulated capital,
capabilities, skills, and abundant domestic resources, traditional diversification pro-
vides initially higher and more certain revenue, output, and consumption compared
with asset diversification.
Asset diversification requires upfront investments that do not immediately bear
fruit— productivity improvements in new sectors need time to materialize and dis-
covering new sources of global comparative advantage requires risky efforts and
long-term investment in national and sectoral innovation systems. It is therefore not
surprising that many stakeholders in FFDCs feel safer holding on to their current
strengths in the fossil fuel product space (discussed also by Hidalgo et al. [2007]) even
if this strategy exposes them to higher long-term risks. Pursuing a shift away from
core strengths pushes incumbent economic agents out of their comfort zone and into
the comfort zone of their current foreign competitors.
64
Strategic Framework for Dealing with the Potential Impacts of a Low-Carbon Transition
Options for Climate Action and Cooperation
Willingness to Abate and Cooperate
The next question is how different approaches to diversification interact with the climate
change agenda and international cooperation. As chapter 2 argues, the Paris Agreement
created new opportunities for cooperative bottom-up climate action clubs, but not the
incentives to establish them. Pursuing their own economic imperatives, FFDCs have
universally submitted their nationally defined contributions (NDCs), but many have
been reluctant to implement ambitious domestic climate mitigation policies amid con-
cerns about the “adverse impact of climate response measures” (UNFCCC 2018).
The weak incentives for FFDCs to be leaders of climate action should be no surprise.
Just like climate change, climate policies also have transboundary spillover effects and
relocate wealth across countries. Franks, Edenhofer, and Lessmann (2015) show that
carbon prices introduced by importers of fossil fuels capture a portion of resource
rents, transferring it from exporters (FFDCs) to importers. Similarly, Edenhofer and
Ockenfels (2015) observe that prices on carbon emissions drive a wedge between the
revenues generated by countries supplying fossil fuels and the revenues generated by
those consuming the fuels. Such rent capture by fossil fuels importers leaves FFDCs
with less revenue available for risky long-term investment in asset diversification.
Therefore, Stiglitz (2015) writes that net exporters of fossil fuels may not have the
incentives to implement cooperative domestic carbon pricing without additional
incentives needed to go beyond moral persuasion. 6
Without FFDC participation, other countries may also be less willing to ratchet up
their own levels of effort to stabilize global climate change. Fragmented, unilateral
climate policies of selected countries may lead to relocation of polluting economic activ-
ities to other countries that would free-ride on their efforts by enjoying the benefits of
climate change mitigation without contributing to its costs. In fact, concerns about free-
riding were a key factor that disintegrated the Kyoto Protocol before it even formally
entered into force in 2005. The United States refused to ratify it in 2001, arguing that
many large emerging market economies, including China and India, would free-ride
without emissions caps. Several other large emitters—with greenhouse gas emissions
caps, including Canada and Japan—rescinded their commitments in 2012. Each coun-
try had specific interests for revising their level of ambition, but the common narrative
was that other large emitters that do less would benefit from unilateral mitigation action.
Facing asymmetric climate policies across the world, climate action leaders may
mitigate the negative competitiveness impacts on their industries and emissions leak-
age by offering exemptions and export rebates for exposed, trade-intensive sectors or
by implementing border carbon adjustments (Kossoy et al. 2015). Most literature and
policy initiatives focus on traditional border carbon adjustment taxes (BCATs) on
carbon content in imports (see reviews by Cosbey and Fischer [2014] and Mehling
65
Diversification and Cooperation in a Decarbonizing World
TABLE 4.1 Choices of Possible Instruments of Climate Cooperation Strategies
Free-ride on climate action of the rest of the world Cooperate in global climate action
• Avoid domestic carbon prices void surprise policy actions abroad and BATs
• A
• Face risk of border adjustment taxes (BATs) • Implement domestic climate policies through
○
Traditional border carbon adjustment tax (BCAT) in which a tax is ○ Traditional consumption- or emissions-based
imposed on the carbon content of imported goods and services carbon taxes
○
Nordhaus-type BAT, a flat ad valorem trade sanction on ○ Wellhead or extraction-based carbon taxes
all imports from noncooperating countries
Source: Peszko, van der Mensbrugghe, and Golub 2020.
et al. [2017]). Mattoo et al. (2009) distinguish between border taxes on the carbon con-
tent of imports and the carbon content in domestic production, but Nordhaus (2015)
is the first to discuss a punitive tariff on the import of all goods from noncooperative
countries. Table 4.1 illustrates possible choices of policy instruments of cooperation
strategies, as used in Peszko, van der Mensbrugghe, and Golub (2020).
Price-Based Cooperative Instruments
The Paris Agreement is the first fully inclusive international climate agreement under
which all countries have expressed individual commitments by submitting their NDCs.
The freedom to choose one’s own level of ambition and the nonbinding nature of NDCs
successfully drew countries into the Paris Agreement: 163 out of 197 parties to the conven-
tion had submitted NDCs by November 2017.7 But this is just the first phase of a multi-
stage “climate game.” The Paris Agreement provides a regular pledge-and-review process
through which countries are expected to ratchet up their ambition in five-year cycles.
Countries’ decisions to increase the level of ambition must be voluntary by the nature of
the global political architecture, based on the self-interest of sovereign nation states (Barret
1994; Hoel 1992). This means that individual countries must have an incentive to increase
their level of ambition over time. The pathways to establishing a credible, self-enforcing
mechanism that encourages international cooperation toward the 2-degree (or 1.5-degree)
Celsius (C) target have been discussed for several years (for example, Diamantoudi and
Sartzetakis 2006; Hoel and Schneider 1997), but have yet to materialize.
The bottom-up, flexible nature of the Paris Agreement provides a new opportunity
to foster climate cooperation. In contrast to the Kyoto Protocol, where any cooperative
climate action had to be negotiated between all parties and agreed to by consensus, the
Paris Agreement offers ample room for collaborative, bottom-up, and unilateral initia-
tives of clubs of countries to launch ambitious climate mitigation actions. Like-minded
countries can jointly pursue their own sustainable development objectives—through
energy, technology, and climate policies that reduce the use of fossil fuels and push
down the costs of low-carbon technologies and infrastructure (for example, in trans-
port and electricity). They are constrained only by the World Trade Organization in
their choices of whether to apply carrots or sticks, including trade sanctions targeted at
nonparticipating parties. FFDCs may therefore be caught by surprise (Hovi et al. 2016),
66
Strategic Framework for Dealing with the Potential Impacts of a Low-Carbon Transition
because, compared with the Kyoto Protocol, under which they could exercise veto
power, they now have less control over decisions made by clubs of other countries.
But opportunities to cooperate are not the same as incentives to cooperate. As dis-
cussed in the section “Emergence of New Institutions” in chapter 2, effective incentives
can be established under Article 6 by a club of countries pursuing ambitious actions
toward the mitigation goal on the basis of joint commitment and reciprocity, with
credible “carrots and sticks” offered to nonparticipants.
From the inception of the United Nations Framework Convention on Climate Change
(UNFCCC), the important imperative of the cooperative climate architecture was to
achieve global goals at the least cost to the global economy. The price-based instruments, at
least in theory, offered the flexibility needed to achieve cost-effective global solutions.
Market-based mechanisms of the Kyoto Protocol (Articles 6, 12, and 17) were the promi-
nent examples of an economic approach to climate policy, whereas the Paris Agreement
allows parties to experiment with a greater variety of price-based instruments to facilitate
international cooperation. The menu includes market-based approaches under Articles 6.2
and 6.4 of the Paris Agreement, and nonmarket approaches, such as carbon taxes, under
Article 6.8 (box 4.3). The market-based approaches suffer from the fundamental problem
of an absence of buyers willing to pay for carbon assets to justify the costs of a higher level
of climate policy ambition. The absence of enforceable emissions targets allocated to indi-
vidual countries under the Paris Agreement casts doubt about whether and when interna-
tional carbon markets can reemerge.
Internationally harmonized emissions-based carbon prices are commonly expected
to be combined with climate finance. Once developed countries collect carbon price
revenues from their emissions, it becomes possible to share them through financial
transfers with developing countries to facilitate their participation and address equity
concerns (CPLC 2017; Cramton et al. 2017; Cramton and Stoft 2012; Dion and Laurent
2015; Edenhofer and Ockenfels 2015; Gollier and Tirole 2015).
It may be in the interest of the rest of the world to provide financial transfers to
FFDCs to support their LCT. According to simulations presented in Peszko, van der
Mensbrugghe, and Golub (2020), cooperation by FFDCs to keep climate change below
2 degree C would reduce by $5.5 trillion the losses experienced by other high-income
countries. These countries would need to use only about one-eighth of these savings, or
$663 billion until 2050 (approximately $22 billion per year), to provide the necessary
incentives for the most vulnerable FFDCs to participate, generating massive benefits for
themselves if it led to universal participation. Notwithstanding their importance in
motivating cooperative behavior (World Bank, Ecofys, and Vivid Economics 2016,
2017), efforts to scale up climate finance and
carbon markets encounter persistent dif-
ficulties (Westphal et al. 2015). As discussed earlier, climate finance tends to be frag-
mented, with high transaction costs and weak incentives for increasing the level of
ambition. This study reinforces those voices that call for financial transfers to be
67
Diversification and Cooperation in a Decarbonizing World
BOX 4.3 Traditional View on Price-Based Cooperative Policy Instruments
under the Paris Agreement
Linked carbon markets (Article 6.2 of the Paris Agreement). The Kyoto Protocol was a precursor
to international carbon markets, including three flexible mechanisms: (1) International Emissions
Trading (Article 17), under which Annex I countries that adopted binding emissions caps could
exchange emissions allowances to reduce the overall costs of compliance; (2) Joint Implementation
(Article 6), a project-based baseline-and-credit mechanism available also to Annex I countries; and
(3) Clean Development Mechanism (Article 12), a pure offset baseline-and-credit mechanism that
linked uncapped developing countries’ potential supply of emissions credits with Annex I coun-
tries’ potential demand. After the United States declined to ratify the Kyoto Protocol in 2001, the
largest source of demand (and the main rationale for flexible mechanisms) disappeared and the
carbon markets gradually crumbled. The Paris Agreement, through Article 6.2, introduces flexibility
for bilateral or multilateral arrangements between parties that can rely on mitigation outcomes
that could be generated and transferred under a variety of mechanisms, procedures, and protocols.
The project-based carbon-crediting mechanism (Article 6.4 of the Paris Agreement) is expected
to be similar to the Clean Development Mechanism under the Kyoto Protocol and governed by par-
ties under a United Nations Framework Convention on Climate Change (UNFCCC) process. It will
most likely leave the least flexibility for bottom-up innovation by the climate clubs.
Internationally harmonized emissions-based and consumption-based carbon taxes (Article
6.8). Emissions-based carbon taxes are imposed on the carbon content of fossil fuels consumed
within a country. Such taxes can be collected anywhere in the value chain—from the upstream
point of entry into the economy, to the downstream point of final combustion. International har-
monization of emissions-based carbon taxes can take the form of internationally agreed upon
minimum tax rates (Weitzman 2014). Consumption-based carbon taxes are one specific design
of emissions taxes. They are paid by final consumers of products, irrespective of the origin of
the product or process (Neuhoff et al. 2015). Hence, they extend coverage to the emissions that
occur outside of a country’s borders. It has been argued that if implemented as nondiscrimina-
tory measures, consumption-based carbon taxes would be World Trade Organization–compliant,
although others claim they will fall under Article XX of the General Agreement on Tariffs and
Trade. As a downstream tax, they require an understanding of the carbon intensity of upstream
processes associated with the product, including that which occurs in other jurisdictions from
which a product or its components were imported. This adds to the complexity of the scheme,
though its proponents suggest that the charge could be simply calculated using an assumption of
global best practice carbon efficiency at all stages of production.
policy
strategically designed as conditional incentives for results-based cooperative
efforts rather than project-by-project financing (Steckel et al. 2017).
This book also introduces an alternative design of internationally harmonized car-
bon taxes, collected from producers rather than consumers of fossil fuels (box 4.4).
Unlike the traditional harmonized carbon pricing discussed above, such production-
based carbon taxes are not levied on emissions or the carbon embedded in final prod-
ucts (whether produced domestically or imported), but on the carbon content of fossil
fuels at the point where they are first extracted from the ground (wellhead or mine
mouth, hence wellhead taxes hereafter). Unlike emissions-based carbon taxes, they are
68
Strategic Framework for Dealing with the Potential Impacts of a Low-Carbon Transition
BOX 4.4 Wellhead Carbon Tax
A wellhead carbon tax is defined for the purposes of this study as a uniform tax on carbon e mbedded
in fossil fuels. In the extreme version, the tax is collected only at the point of extraction and
collected from fossil fuel producers, regardless of whether the fuels are consumed d omestically
or exported. In this version, importers agree to not impose an emissions-based carbon tax on the
emissions embedded in the fuel because taxes have already been applied by exporters. In a more
realistic scenario, various revenue-sharing ratios can be bilaterally or multilaterally negotiated
between fossil fuel exporters and importers through agreements on the harmonized tax rates.
This may be more feasible and easier to negotiate than internationally harmonized emissions-
based or consumption-based taxes, which require agreement not only on tax rates but also
on explicit financial transfers between countries.
Wellhead carbon taxes are a variation of internationally coordinated carbon pricing and were
briefly discussed in the early years of the United Nations Framework Convention on Climate
Change (UNFCCC) after the Rio summit (Wirl 1995). They can be designed as joint and contin-
gent commitments needed to operationalize the incentive structure under the Paris Agreement as
argued by Weitzman (2014), Nordhaus (2015), MacKay et al. (2015), and Gollier and Tirole (2015).
They are similar in structure to severance taxes and are sometimes called extraction taxes (Kortum
and Weisbach 2016). Sinn (2008) and recently Richter, Mendelevitch, and Jotzo (2018) propose
coal taxes as part of the package of supply-side climate policies for major coal exporters.
Incentives for FFDCs to cooperate on climate action would increase if carbon tax revenues
were shared through wellhead carbon tax agreements. Shifting the carbon tax base from con-
sumption (or emissions) to production would leave importing countries with the same consumer
prices but lower carbon tax revenues, effectively worsening the welfare of their consumers
(Peszko, Golub, and van der Mensbrugghe 2019). In parallel, wellhead taxes would boost FFDCs’
consumption because of the large influx of new revenues that could be transferred to households.
The implementation of wellhead carbon taxes will not be free of challenges (such as agreeing
on the rates; dealing with fiscal sovereignty, transparency, and dispute resolution; rebates for carbon
capture, utilization, and storage; and so on). Yet these challenges will be no greater than those
involved in negotiating traditional, emissions-based cooperative carbon prices—such as linked emis-
sions trading systems, and harmonized emissions-or consumption-based carbon taxes. The impact
of wellhead carbon taxes on low-income, fuel importing countries would also need to be considered
since it would make energy more expensive in those countries without providing their governments
with a flow of resources to support their populations and smooth the adjustment process. This study
argues that they are nevertheless a promising avenue worth further analysis, including the use of
modeling for further investigation (Peszko, Golub, and van der Mensbrugghe 2019).
not rebated when fuel is exported. They thus would extend carbon prices to domestic
consumers in FFDCs in return for the opportunity to retain revenues that would other-
wise be collected abroad. Under a cooperative deal, an importer would agree not to tax
the carbon embedded in the fuel from the participating country again to avoid double
taxation. Revenue sharing between countries can be negotiated bilaterally or multilater-
ally through agreements on carbon tax rates on both sides of the border. Unlike tradi-
tional carbon prices introduced by importers, wellhead taxes would not extract profits
from fuel exporters, as discussed by Franks, Edenhofer, and Lessmann (2015).
69
Diversification and Cooperation in a Decarbonizing World
Trade Instruments to Facilitate Climate Cooperation
Trade sanctions are among the potential tools for encouraging cooperative behavior,
although they pose a host of challenges. In the absence of, or in addition to “carrots”
(such as financial and technology transfers), a climate action club may try to persuade
nonparticipants by using BCATs or more straightforward trade sanctions. Alternative
measures may include the following:
■ Border carbon adjustment measures impose a carbon price at the border,
based on the carbon content embedded in imported carbon-intensive
goods, or provide a rebate to exporters (Kossoy et al. 2015; Roson and van
der Mensbrugghe 2012). They effectively represent the extension of a car-
bon-pricing regime to entities outside the implementing jurisdiction. BCAs
are typically discussed as a mechanism for protecting against an escape of
emissions-intensive industries from countries with strong decarbonization
policies to those with laxer standards (carbon leakage8). Their objective is to
“level the playing field” between firms that are subject to a carbon price and
those that are not (or not at the same level) and prevent inefficient carbon
leakage (Kossoy et al. 2015).
■ Nordhaus taxes are a unique form of climate-motivated BCAT. Such taxes are
a uniform import tariff on all goods and services originating from a country
that does not cooperate in internationally harmonized climate policy action,
where uniform in this context means irrespective of their embedded carbon
content. The concept was popularized by Nobel Prize winner in economics
William Nordhaus (2015),9 who argued that ambitious, price-based climate
coalitions are unlikely to be stable unless plain trade sanctions are imposed
on nonparticipants. By applying trade penalties on nonparticipants, a club of
climate action leaders would be able to induce the formation of a large, stable
coalition with higher levels of abatement. Even though such tariffs would be
easy to administer, being independent of the carbon content of imports, they
would be less linked to emissions because they would apply to all imports from
the targeted country regardless of the emissions intensity of an imported good.
Thus, the primary aim of such an instrument is to restrict nonparticipating
countries’ market access to overcome free-riding incentives and induce all
countries to cooperate on climate action. A Nordhaus tax is controversial
and, like all other border adjustment measures, would probably be subject to
legal challenges under the World Trade Organization because it is only weakly
linked to the carbon content of imports and can be highly discriminatory.
BCAs have been rarely applied so far, but this may change. Their threat could miti-
gate the risk of carbon leakage and encourage free-riding countries to cooperate and
increase their climate policy ambitions. The credibility and imminence of this threat is
an element of uncertainty that FFDCs face. At least two trends may attract more atten-
tion to the future role of trade instruments in climate policies.
70
Strategic Framework for Dealing with the Potential Impacts of a Low-Carbon Transition
■ Growing concern about the risk of carbon leakage. Growing concern among coun-
tries with carbon-pricing schemes has increased their willingness to implement
policies that avoid (1) saddling domestic industries with competitive disadvan-
tages and (2) the possible relocation of emitting activities to countries without
carbon pricing. As policy ambition increases, such economic, social, and politi-
cal concerns are likely to grow.
■ The growth in the volume of carbon embodied in international trade flows. It is
estimated that the carbon content of traded products has increased to 24 percent
of global emissions of carbon dioxide (Andrew, Davis, and Peters 2013). Many
major developing countries are net exporters of embodied carbon emissions,
while many developed countries are net importers of the same emissions (Peters
et al. 2011). This raises concerns that the apparent decrease in emissions in many
developed countries may simply reflect their “off- shoring” to third parties.
Trade instruments, in different forms, are one of many policy measures to address
competitiveness and carbon leakage concerns (Kossoy et al. 2015). Countries can also
encourage cooperation by adopting softer measures to ensure that benefits of club
membership are exclusive, that is, they accrue only, or at least disproportionally, to the
members of a club. For example, FFDCs may receive incentives to take ambitious emis-
sions-mitigation measures by being excluded from the benefits derived from R&D and
financial transfers implemented by climate leaders (Carraro 2016).
Simulations using an updated ENVISAGE model (Peszko, van der Mensbrugghe,
and Golub 2020) suggest that traditional diversification and noncooperative poli-
cies are the most attractive short-term strategies for FFDCs, assuming the rest of
the world does not impose climate and trade policies and disregarding the climate
change impacts. These results are consistent with past diversification efforts by
FFDCs, which have focused on fossil fuel–related sectors.
According to these simulations, border adjustment policies based on the carbon
content of imports would not change these incentives very much and are unlikely
to lead to broader cooperation by FFDCs. However, the possibility that other
countries introduce unilateral climate policies and Nordhaus-type BCAs against
noncooperating countries can change this assessment. Such measures would have a
strong impact on FFDCs regardless of their efforts to diversify, so that participating in
traditional global climate action to prevent trade sanctions would quickly become an
attractive strategy for most FFDCs, especially the most advanced ones, including
GCC countries, Mexico, Russia, and other large oil and gas exporting countries.
If the rest of world imposes trade sanctions on noncooperative FFDCs, asset diversi-
fication would be the only strategy that sustains growth and welfare into the future (fig-
ure 4.3). Asset diversification (with or without cooperation) becomes a robustly attractive
long-term strategy for FFDCs after the external policy shock occurs and the world moves
more rapidly toward decarbonization. “Robust” means that in the long run, growth and
consumption with asset diversification outperform growth and consumption with
71
Diversification and Cooperation in a Decarbonizing World
FIGURE 4.3 Long-Term Impact of Different Strategies on GDP in FFDCs under Different
Climate and Trade Policy Scenarios
1.5
Real discounted GDP losses as % of BAU 2021–2050
1.0
0.5
0
–0.5
–1.0
–1.5
–2.0
No diversification Traditional diversification Asset diversification
Unilateral climate policy without trade sanctions Cooperative climate policy
Unilateral climate policy, border tax on carbon content Cooperative climate policy with wellhead taxes
Unilateral climate policy, Nordhaus tax
Source: World Bank and Purdue University (ENVISAGE).
Note: BAU = business as usual; FFDCs = fossil fuel–dependent countries; GDP = gross domestic product. The colored bars denote the difference
between the cumulative discounted real GDP in FFDCs under different scenarios (over the period 2021–50) and the corresponding figures under
the BAU scenario (at a 6 percent discount rate), expressed as a percentage of the BAU figures. As is usually the case with computable general
equilibrium models, the percentage differences with respect to BAU are quite small under all scenarios. Asset diversification is the robust long-term
hedge of GDP against low-carbon transition risks and the only no-regret economic strategy for FFDCs. Negative values indicate gain relative to BAU.
traditional diversification under all external policy shocks that have been simulated.
Thus, from FFDCs’ perspective, asset diversification can be considered as a long-term
hedge in the worst-case scenario, as well as a robust strategy for long-term growth.
Finally, lower-income and conflict-affected countries with large proven, but not
yet extracted fossil fuel reserves—many of them in Africa—pose challenges to an
LCT. These FFDCs are less able to develop competitive, knowledge-based econo-
mies and implement ambitious domestic climate policies at present. Although they
could eventually benefit from asset diversification, they might not be able to gener-
ate resource rents quickly enough to mitigate the impacts of an LCT and capture
the opportunities that it creates. This is particularly true due to the increasingly
risky global environment, marked by declining global demand for fossil fuels and
diminishing access to capital for upstream and midstream development projects.
Development finance institutions are also becoming more reluctant to finance fos-
sil fuel activities. Imposing trade sanctions on these countries would have negative
social repercussions without necessarily achieving the intended results because
their emissions are low and the costs of cooperative climate policies relatively high.
72
Strategic Framework for Dealing with the Potential Impacts of a Low-Carbon Transition
Some middle-income coal-exporting countries may also encounter local challenges
to an LCT. Creating cooperative incentive structures may require additional finan-
cial, technology, or knowledge transfers to enable investments in diversification,
ease the socioeconomic implications of a transition, and encourage domestic low-
carbon policy measures.
Notes
1. Saudi Arabia’s Vison 2030 may be found at http://vision2030.gov.sa/en/node.
2. For more information on Russia’s innovation policy, see http://economy.gov.ru/en/home/activity
/sections/innovations/.
3. See http://kremlin.ru/events/president/news/57425.
4. Gill et al. (2014) even argue that output diversification may not be necessary for sustainable devel-
opment. They emphasize that what countries need is sustainable improvements in efficiency and
productivity, and recommend that diversification strategies should focus less on diversifying
export products and more on managing the portfolio of assets from which society derives multiple
forms of robust income and welfare.
5. These include Acemoglu and Robinson (2012); Barro (1998); Clague et al. (1999); Jones (1981);
Knack and Keefer (1995); North (1990); Olson (1996); Olson, Sarna, and Swamy (2000); Sala-i-
Martin, Doppelhofer, and Miller (2004); and Tradico (2008).
6. Some notable exceptions in this context are Mexico, which has implemented a carbon tax;
Kazakhstan, which is considering implementing emissions trading; and South Africa, which is
exploring the introduction of a carbon tax (World Bank, Ecofys, and Vivid Economics 2017).
7. See the NDC registry webpage here: http://www4.unfccc.int/ndcregistry/Pages/Home.aspx.
8. Carbon leakage (also known as emissions leakage) is a situation that may occur if businesses trans-
fer production to other countries with laxer emissions constraints, so as to avoid having to pay for
the costs related to climate policies; the leakage refers to the resulting increase in carbon dioxide
emissions in countries that fail to take domestic mitigation action.
9. This book makes no judgment about the likelihood or desirability of Nordhaus taxes. Neither does
it analyze their legality under international trade law. This report just assumes that the p
robability
that they will be applied is larger than zero. Therefore, FFDCs may perceive them as a credible
threat, especially if the coalition of countries applying these taxes has large market and political
power.
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77
Preparedness for a Low-Carbon
5.
Transition
Some countries are better prepared for a global low-carbon transition (LCT) than oth-
ers. This chapter looks at countries’ varying degrees of preparedness for turning the
risks of an LCT into opportunities for robust growth. Preparedness is a function of the
degree to which they are exposed to climate-related trade measures, the resilience of
their economies and institutions to the external impacts of an LCT, and their ability to
diversify their asset bases and harness the opportunities presented by a transition.
Preparedness is measured here by composite exposure and resilience indexes that
are composed of 4 and 11 indicators, respectively. Table B5.1.1 in box 5.1 presents the
underlying indicators in the two indexes. The results of benchmarking fossil
fuel–dependent countries’ (FFDCs’) preparedness for climate response measures are
discussed in this chapter.
Measuring Preparedness for an LCT
Figure 5.1 maps countries’ preparedness for a global LCT. The most exposed countries
are located high on the vertical axis. The least flexible countries are located to the right
on the horizontal axis. The least prepared countries are denoted by red dots and located
in the upper-right section, whereas countries in the bottom-left section are the best
prepared.
Not surprisingly, the index of preparedness suggests countries relying heavily on
current and future export revenues from fossil fuels are likely to face the largest chal-
lenges in an LCT (figure 5.1). The index of preparedness developed in this study sug-
gests that the least prepared countries, including Iraq and Libya, are exceptionally
vulnerable to external shocks from an LCT, given that long-term conflicts have
destroyed almost all non-oil tradable industries and tarnished already-weak institu-
tions. Equatorial Guinea, Nigeria, and República Bolivariana de Venezuela are among
the countries that are both the most exposed and the least resilient. Cambodia is vul-
nerable mainly because of the large share of young coal power plants in its generation
mix, as is Guyana because of its large, recently discovered oil reserves. Azerbaijan,
Botswana, and Kazakhstan share high exposure and relatively weak resilience. Some
Gulf Cooperation Council (GCC) countries can be considered borderline cases—
although significantly exposed, they also enjoy relatively high resilience. On the other
79
Diversification and Cooperation in a Decarbonizing World
BOX 5.1 Principal Component Analysis (PCA)
PCA allows for an aggregation of indicators into one composite preparedness indicator with minimal
loss of information or double counting. PCA takes a set of correlated variables (or indicators) and
transforms them into a smaller set of linear, uncorrelated variables called principal components,
while keeping a high amount of cumulative variance (or statistical dimensions) of the data (OECD
2008). To derive the weights for each indicator, three steps are followed:
1. Calculation of a correlation matrix to see if the individual indicators are correlated and there-
fore are likely to share common components. In addition, sampling adequacy tests exclude
indicators that do not add much information because they are highly correlated with one of the
other indicators.
2. Identification of the number of the principal components that account for the largest amount
of variance of the indicators. Each principal component is a linear combination of the original
indicators, where the coefficients (loadings) measure the correlation between the individual
indicator and the component.
3. Calculation of the weights for each individual indicator, accounting for overlapping information
between correlated indicators. To calculate the weights of an indicator, the loading of each
component is multiplied by the proportion of the variance that the corresponding principal
component represents.
TABLE B5.1.1 Structure of Index of Preparedness for Climate Response Measure
Exposure Resilience
1. Macroeconomic stability
Committed power
Built capital
Carbon intensity emissions as a 2. Adjusted net savings
of manufacturing proportion of
3. Financial market development
exports current annual
power generation 4. GDP per capita
5. Economic complexity
Current Forward looking 6. Technology adoption
7. Ease of doing business
Natural resources
8. Quality of infrastructure
Fossil fuel export Expected
9. Human capital
as a proportion resource rents as a
of GDP proportion of GDP 10. Institutional quality and governance
11. Position on the global supply curvea
Source: World Bank.
Note: GDP = gross domestic product.
a. Currently applied only to oil extraction costs.
80
Preparedness for a Low-Carbon Transition
FIGURE 5.1 Countries’ Preparedness for a Low-Carbon Transition
Iraq
1.0 Libya
High exposure
Qatar Brunei Darussalam Kazakhstan
Kuwait
Saudi Arabia
Oman Nigeria
Vietnam
Iran, Islamic Rep. Venezuela, RB
Azerbaijan
Guyana
Equatorial Guinea
Algeria
Botswana
Russian Federation Congo, Rep.
South Africa Cambodia
0.5 Ukraine
United Arab Emirates China Ghana
Indonesia India
Norway Malaysia Bolivia Egypt, Arab Rep. Angola
Australia Colombia Côte d’Ivoire Bangladesh Mozambique
Canada Poland Thailand Turkey Namibia Argentina
Korea, Rep. United States Mexico Malawi
Chile
Germany Japan Philippines Brazil Mongolia Pakistan
Sweden France Italy Uganda
United Tanzania
Kenya
Kingdom
Low exposure
0 0.5 1.0
High resilience Low resilience
Source: Based on several databases.
Note: Some likely poorly prepared countries are not in the figure because the full data sets were not available to the authors. Examples
include Turkmenistan and Papua New Guinea.
hand, Norway is more exposed than some less-prepared countries, such as Angola, but
nonetheless is well prepared for an LCT thanks to its resilience, in particular its eco-
nomic flexibility and diversification and the high quality of its human capital and
institutions.
The majority of countries are well prepared for an LCT (green dots in figure 5.1, or
not shown). This level of preparedness is largely driven by low exposure to an LCT, mean-
ing that their economies do not depend heavily on the export or domestic combustion of
fossil fuels and related products. Especially highly developed, post-industrial economies
have become increasingly knowledge-intensive and “intangible.” Even net exporters of
fossil fuels among them—such as Australia and Canada—are not very exposed because
fuel export value is small compared with their exports of other tradable goods and ser-
vices, and their power generation is relatively clean. In addition, their institutions and
governance are strong and their economies are very resilient and relatively flexible,
making them well placed to adapt to various external climate policy shocks.
81
Diversification and Cooperation in a Decarbonizing World
A large number of developing and emerging market economies are moderately pre-
pared, hence potentially vulnerable to LCT risk. These economies are indicated by the
ategory—
orange dots in figure 5.1. Many large emerging market economies fall in this c
including China, India, Indonesia, the Russian Federation, South Africa, and Ukraine.
Although some of them may be net importers of fossil fuels, they have large fuel extrac-
tive sectors and their growth is driven by carbon-intensive power and industry. The
development choices currently made by these countries will determine their degree of
future exposure and resilience to the impacts of an LCT. They are in development
phases that require large investments in infrastructure with lifespans of decades, with
concomitant risks of long-term locking-in of dependence on carbon-intensive assets.
Their progress with improving governance and strengthening institutional capacity
will determine their ability to deal with the external shocks of an LCT. Other moder-
ately prepared countries include lower- and middle-income countries across Africa,
including Angola, the Arab Republic of Egypt, Ghana, Malawi, and Mozambique. It is
worth noting that the index of preparedness is a static snapshot of data and does not
reflect the perception of LCT risk by any individual country or its revealed strategic
behavior with respect to diversification and decarbonization.
Some of the investment options currently being considered by some of these coun-
tries would move them to the right along the horizontal axis, increasing their exposure to
the LCT and entailing opportunity costs in that fewer funds would be available for invest-
ments to broaden the economic asset base. China is decelerating its buildup of new coal
power plants, yet still hosts more than 50 percent of the world’s coal power plants under
construction. Bangladesh, India, Indonesia, Japan, the Republic of Korea, Malaysia,
Pakistan, Poland, South Africa, and Vietnam are still building coal power generation
fleets, while Mozambique (see box 3.1) is considering the expansion of coal extraction
and use. The future preparedness of these countries for LCT risks will depend on the
development paths they choose for the coming decades. They have an opportunity to
gradually reduce their exposure while enhancing their resilience by investing judiciously,
strengthening their economic and social institutions and domestic education, and pro-
viding stronger incentives for innovation and knowledge-led growth.
Figure 5.2 ranks the countries by just one of the indicators of future exposure to the
LCT, that is, dependence on expected resource rents from proven reserves of oil, gas,
and coal that are still in the ground.
Figure 5.2 illustrates that dependence on future fossil fuel rents is mainly driven by
oil because of its high value per energy content and the sheer quantity of reserves.
Natural gas is a source of future economic dependence for fewer nations, such as
Mozambique, Papua New Guinea, Qatar, and Turkmenistan. Coal reserves are clearly
not the source of significant exposure (except for Mozambique and Mongolia, Mongolia
not presented in the figure) because they do not represent significant contributions to
any country’s economy.
82
Preparedness for a Low-Carbon Transition
FIGURE 5.2 Resource Rents as a Share of GNI, 2016
25
20
Resource rents to GNI (%)
15
10
5
0
a N ss .
Ira aza nia
ud ue
na
Ku a
n
pu ru Rep
n
M inea
a
la
q
An a
Se n
un slam tan
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lG r
To n
er it
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ay
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r
ew alam
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ria ta
bi
oz ta
ija
ine
ga
rkm Ira
ri
a
g
do
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go
r
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ya
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ba
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b
a
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ra
to Qa
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s
ba
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ua
d a Ga
rit
u
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iA
i
au
a
Pa Da
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I
Tu
ua
ei
da
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ini
Br
Tr
Oil Gas Coal
Source: Extracted from Rystad (2018) and Wood Mackenzie (2013).
Note: GNI = gross national income. Bars show the ratio of the net present value of oil, gas, and coal rents (at a 6 percent discount rate) to GNI in
2016. Many more low-income and conflict-affected countries depend on future oil and gas rents.
The next two sections review the results for exposure and resilience in more detail.
Exposure
Exposure captures four indicators in two dimensions (figure 5.1):
■ Type of exposed asset class. A country can be exposed because of (1) its reliance
on fossil fuel resources in the ground or (2) its significant reliance on carbon-
intensive built capital, such as power or industrial plants. Some countries could
be exposed because of both conditions.
■■ Timing of the exposure. A country can be exposed because it (1) currently relies
on carbon-intensive exports or (2) is expected to rely on carbon-intensive rents
and revenues in the future as a result of its large reserves of fossil fuels and the
young age of its carbon-intensive infrastructure. Again, some countries may be
subject to both conditions.
Four key indicators result:
■■ Current reliance on fossil fuel–export revenues as a percentage of gross domestic
product (GDP), an indicator of current dependency on commodity exports. If this
number is high, countries face the risk that demand for one of their key exports
will structurally decline.
83
Diversification and Cooperation in a Decarbonizing World
■■ Future reliance on expected resource rents from known fossil fuel reserves as a
percentage of current gross national income (GNI), a forward-looking indica-
tor of dependency on commodity rents. Countries that expect high future rents
are at risk of lower-than-expected revenues. They may not be able to rely on the
conversion of resource rents to other forms of economic wealth on a scale envi-
sioned in their long-term development strategies.
■■ Current carbon intensity of manufactured exports is an indicator of current
dependency on carbon-intensive manufactured goods and services, captur-
ing the exposure to possible declining international demand caused by climate
action or trade measures by importing countries.
■■ Committed (future) emissions from built capital in the power sector divided by
current annual power generation is a forward-looking indicator of dependency
on carbon-intensive goods and services as a function of the age and emissions
intensity of electricity generation. It is calculated as the ratio of the total esti-
mated volume of emissions of all operating plants built in or before 2020 to total
electricity generation in 2013, hence it captures current plans to expand thermal
generation, with an associated increase in committed emissions.
Putting these indicators together suggests that Iraq, Libya, Kazakhstan, Qatar, and
Brunei Darussalam are the five countries most exposed to a possible LCT. Table 5.1 shows
the assessment of these four indicators for the 20 most exposed countries out of a total of
101 for which data were available. The top five countries display high exposure in a num-
ber of areas, particularly current and expected reliance on natural resource exports.
Natural Assets in the Ground
Measuring exposure to fossil fuel reserves, the share of current net fossil fuel export
revenue in GDP is particularly high in Nigeria (greater than 50 percent), closely fol-
lowed by Brunei Darussalam, Kuwait, Qatar, and República Bolivariana de Venezuela.
Oil and gas revenues dominate the current and expected exposure, largely because of
the higher monetary value per energy content and much larger quantity traded inter-
nationally. Natural gas export revenues play an important role in Equatorial Guinea,
Mauritania, Mozambique, Papua New Guinea, Qatar, and Turkmenistan.
In table 5.1 expected resource rents as a percentage of current GNI are by far highest
in Azerbaijan, Guyana, Iraq, Libya, Qatar, and Saudi Arabia. Turkmenistan is also heav-
ily exposed to risks from future fossil fuels (figure 5.2), although it is not shown in
table 5.1 because of missing data in the other indicators.1 These countries have the larg-
est potential to use fossil fuels in the ground as a driver of economic growth for decades
to come. This potential may not be fully realized if an LCT changes demand and price
trends for fossil fuels. It should be noted, however, that leaving natural resources in the
ground does not necessarily imply that these assets are stranded by an LCT. Known oil
and gas reserves have been growing faster than demand for decades, hence the
84
Preparedness for a Low-Carbon Transition
TABLE 5.1 Exposure Indicators for Selected Fossil Fuel–Dependent Countries
Natural resources Built capital
Indicator Current fossil fuel Expected fossil Current carbon Committed power
description export revenue fuel resource rents intensity of sector GHG emis-
as percentage of percentage of
as manufacturing sions over current
current GDP current GNI exports power generation
Indicator source Based on UN Based on Rystad Adapted from Based on Platts 2016
COMTRADE 2017 2018 and Wood Peters et al. and IEA 2015
Mackenzie 2013 2011
Iraq
Libya
Kazakhstan
Qatar
Brunei Darussalam
Kuwait
Saudi Arabia
Oman
Nigeria
Vietnam
Iran, Islamic Rep.
Azerbaijan
Venezuela, RB
Guyana
Equatorial Guinea
Algeria
Botswana
Congo, Rep.
Russian Federation
Cambodia
High exposure Low exposure
Note: GDP = gross domestic product; GHG = greenhouse gas; GNI = gross national income; IEA = International Energy Agency;
UN COMTRADE = United Nations International Trade Statistics Database. Although the exposure index was calculated for 101
countries, the table shows results for only the 20 most exposed countries. The order of countries reflects the countries’ composite
exposure scores (in descending order of exposure). The weights for each score were calculated using principal component analysis.
reserves-to-production ratio has increased since the 1980s (BP 2018; Covert,
Greenstone, and Knittel 2016; Helm 2017) (see also figures 3.4 and 3.5). Improvements
in supply-side efficiency mean that new discoveries that would have been technologi-
cally and economically impossible to extract in the past can now be recovered, if there
was effective demand for them. Regarding coal, the International Energy Agency
observes that global proven coal reserves are so vast that most of them would stay in the
85
Diversification and Cooperation in a Decarbonizing World
ground for the next 200 years even in the business-as-usual scenario (IEA 2015). The
value at risk that can be attributed specifically to an LCT relates only to the difference
in the present value of resource rents (and the value added of produced capital invested
in extraction and delivery to the market) between business-as-usual development and
development with demand or commodity prices (or both) altered by the impacts of
climate, energy, and technology policies.
Produced Assets
For produced asset exposure, eastern European countries and former Soviet republics
(most notably Kazakhstan), South Africa, and industrial countries in Asia have rela-
tively high degrees of exposed-to-built industrial capital when measured by the carbon
intensity of their exports. The volume of greenhouse gas emissions associated with the
production of intermediate goods, which are eventually embedded into final goods
destined for export, show that Kazakhstan, Libya, and the Russian Federation are
among the most carbon-intensive exporters.
A second indicator, the ratio of committed emissions from future power generation
to current power generation, shows that electricity systems in Botswana, Cambodia,
and Vietnam are particularly exposed to the LCT impact.2 Figure 5.3 shows that the
committed emissions from future power generation compared with total generation
are also high in Vietnam, Malawi, India, and Indonesia, mainly because of the large new
and growing fleet of coal-powered plants. Countries with relatively high shares of new
stocks of thermal power plants will be at greater risk of not being able to profitably
exploit those facilities until the end of their useful economic lives than countries with
relatively old assets.
The analysis above focuses on readily available indicators, but a number of other
factors also affect exposure, such as the asset ownership structure and the prevalence of
fossil fuel–dependent infrastructure. Although countries where fossil fuel assets are
largely owned by the government and state-owned enterprises may try to smooth the
transition by transferring budget resources from elsewhere in the economy, such own-
ership structures can encourage vested interests in carbon-intensive incumbents to
hamper the implementation of diversification strategies that could reduce the impact
of a shock. Investments in fossil fuel–dependent transport infrastructure, such as rail-
ways and ports for the transport of coal, may also be at risk if they have little value for
other transport activities, for example, when located in sparsely populated regions with
few alternative export goods and commodities.
Resilience
Resilience captures how well positioned an economy is to manage LCT risks. It reflects
a country’s capacity to adjust to the impacts and challenges associated with a structural
86
Preparedness for a Low-Carbon Transition
FIGURE 5.3 Ratio of Committed Emissions from Power Generation (to 2020) to Current
Generation Capacity
160
140
Committed power emissions/current power generation (tCO2/ MWh)
120
100
80
60
40
20
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na
ut hi
l
M an
lan
an
i
N ha
go
R
w
y
ni
na
em
In In
kis
oz tr
r
K
a
a
m
Ca
Do
Oil Gas Coal
Sources: Based on S&P Global Platts (2016) and IEA (2015).
Note: tCO2/MWh = tonnes of carbon dioxide per megawatt hour. Each indicator (per fuel type) represents the ratio of the total estimated volume of
emissions of all operating plants built in or before 2020 to total electricity generation in 2013. The indicator has been calculated for 92 countries.
transformation and to tap into some of the opportunities that such a transformation
would offer. Countries whose economies can rely on a broader portfolio of assets will
exhibit more resilience to external shocks. Countries with relatively flexible economic
structures and cultures are able to respond to economic change efficiently and quickly.
This flexibility enables them to minimize the costs of adjustment and harness the
opportunities that changes in comparative advantages during a transition may bring.
To capture countries’ current economic resilience, 11 indicators across four dimensions
are considered (table 5.2).
Table 5.3 summarizes the resilience indicators for the 20 most exposed countries for
which data were available. Clear patterns emerge, with some exposed countries such as
República Bolivariana de Venezuela, Iraq, and Libya also being among the least resilient
economies. Other relatively exposed countries, such as Qatar, Brunei Darussalam,
Saudi Arabia, Oman, and Kuwait, score relatively well across many or all of the resil-
ience indicators.
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Diversification and Cooperation in a Decarbonizing World
TABLE 5.2 Economic Resilience Indicators
Dimensions of resilience Indicators
Built, human, and institutional assets 1. Quality of infrastructure
2. Human capital
3. Institutional quality and good governance
Macroeconomic and financial flexibility 4. Macroeconomic stability
5. Adjusted net savings
6. Financial market development and efficiency
Economic performance and complexity 7. Gross domestic product per capita
8. Economic complexity
Business environment 9. Ability to absorb technology
10. Ease of doing business
Position on global supply curve 11. Levelized extraction costs
Source: World Bank.
Each resilience indicator is briefly discussed below.
Produced and Intangible Assets
As established in chapter 4, in addition to physical infrastructure, human and institu-
tional assets are also crucial for long-term sustainable welfare.
■■ High-quality physical infrastructure facilitates the emergence of new indus-
tries by providing greater flexibility and lower costs for firms and workers to
move to new opportunities, should external shocks to fossil fuels arrive. Several
medium- and high-income FFDCs score well on quality of infrastructure such
as air transport, ports, roads, and electricity supply.3 But specialized infrastruc-
ture for distributed variable power generation or electrification of the vehicle
fleet is poorly developed (Cust, Manley, and Cecchinato 2017). Using the World
Economic Forum’s Global Competitiveness Index 2017–2018, infrastructure
resilience is measured as a combination of transport (road, port, and air) and
electricity and telephone infrastructure, measured by both overall quality and
quantity, including access.
■■ Human capital is crucial for a transition to a knowledge-intensive economy, but
is generally at a low level in FFDCs (IMF 2016). The value of human capital
is captured by multiple indicators (see, for example, Lange, Wodon, and Carey
2018), but is captured in this chapter by an educational indicator. In this assess-
ment, the stock of human capital is measured by overall years of schooling
across countries using the United Nations Development Programme’s Human
Development Reports. This index measures the expected average years of educa-
tion across countries if prevailing patterns of age-specific enrollment rates per-
sist throughout the child’s life. These data provide a coarse picture of the stock
of human capital available, and are based on survey observations.
■■ Quality of institutions is essential for breaking the resource curse, collecting
and managing resource rents for public goods, delivering public services, and
88
TABLE 5.3 Indicators of Resilience to External Shocks for Fossil Fuel–Dependent Countries and Other Selected Countries
Built, human, and institutional assets Macroeconomic and financial flexibility Economic performance and Business environment Extraction
complexity cost
Indicator Quality of Human Institutional Macroeconomic Adjusted net Financial market Economic Economic Technology Ease of Oil
infrastructure capital quality stability savings development performance complexity absorption doing extraction
and good business costs
governance
Database source World Economic UNDP Worldwide World Economic World Bank World Economic Forum World Bank Observatory World Economic World Based on
Forum 2013 Governance Forum 2014– World 2014–2015, Global World of Economic Forum 2014– Bank Rystad
2014–2015, Global Indicators 2015, Global Development Competitiveness Index Development Complexity and 2015, Global 2017 2018
Competitiveness 2016 Competitiveness Indicators 2017 Indicators MIT Media Lab Competitiveness
Index Index 2016 2015 Index
Venezuela, RB
Iraq
Libya
Nigeria
Equatorial Guinea
Algeria
Cambodia
Congo, Rep.
Guyana
Iran, Islamic Rep.
Vietnam
Azerbaijan
Kazakhstan
Botswana
Russian Federation
Kuwait
Oman
Saudi Arabia
Brunei Darussalam
Qatar
High exposure Low exposure
Source: Calculation based on multiple sources.
Note: Although the resilience indicator was calculated for 101 countries, the figure only shows the results for the 20 most exposed countries. The order of countries reflects the countries’ composite resilience score (in descending
order of exposure). The weights for each score were calculated using principal component analysis.
89
Diversification and Cooperation in a Decarbonizing World
stimulating and regulating the diversification process. As contended by many
authors (for example, Acemoglu and Robinson 2012; Gill et al. 2014; van der
Ploeg 2011), good institutions are arguably the most important driver of eco-
nomic resilience. The quality of governance is one indicator of institutional qual-
ity. According to data from the World Bank’s Worldwide Governance Indicators
Project, institutions in FFDCs are still more “extractive” than “inclusive,” as in
most net fuel importers (Acemoglu and Robinson 2012). However, significant
differences between the various FFDCs exist. Some GCC states, such as Qatar and
Saudi Arabia, perform better than many exposed developing countries in Africa
(Equatorial Guinea, Libya, Nigeria) and Guyana and República Bolivariana de
Venezuela in South America. EBRD (2014) argues that the quality of institutions
has been one of the most important determinants of why some former commu-
nist countries have been more successful in economic and social transition than
others. GCC states rank relatively high with regard to rule of law, control of cor-
ruption, and political stability and security, but perform less well on voice and
accountability, as well as on the ability to formulate and implement policies that
permit and promote private sector development. Outside of the GCC, several
FFDCs are captured by fuel-dependent vested interests, notorious for corrup-
tion, disregard for the rule of law, low protection against crime and violence, low
accountability, and low efficiency of public institutions (Kaufmann, Kraay, and
Mastruzzi 2010).
Strong evidence indicates that the per capita incomes of some FFDCs remains a
fraction of what it could be with better governance.4 Olson (1996) finds that the quality
of institutions and economic policies explains a significant part of the variation in
growth rates across countries. Some studies, such as Knack and Keefer (1995), also find
that the quality of governance and institutions is important for explaining rates of
investment. Clemens and Williamson (2004) conclude that historically 85 percent of
the wealth bias between rich and poor, whether caused by market failure or not, is
domestic in origin. The authors argue that poor-country lenders are deterred from
investing in poor countries to nearly the same degree as rich-country lenders. In other
words, investors at the National Stock Exchange in Mumbai face much the same incen-
tives to invest in India as do their counterparts on Wall Street. Countries with poor
property rights and underdeveloped financial markets are therefore vulnerable to
excessive foreign debt and have a propensity to default, with a resultant collapse in all
but concessional financial inflows. By contrast, exit from excess indebtedness is accom-
panied by improved governance and institutions.
There are likely to be covariance and co-relationships between governance, produc-
tivity, and wealth, with causality flowing in interrelated directions and being difficult to
determine. For example, it is possible that the quality of governance is the result rather
than the cause of productivity growth. Rich countries with a history of civil liberties
and rule of law tend to respect property, invest in education, and demand responsive
90
Preparedness for a Low-Carbon Transition
government. It is likely that poor governance is both the result of poverty and an under-
lying driving cause. Such amplifying feedback mechanisms mean sustained, carefully
targeted policy and institutional reform can trigger a reinforcing cycle of good gover-
nance and higher productivity.
Breaking into a positive growth and development cycle requires a trigger, and evi-
dence suggests the trigger often comes in the form of a sustained improvement in gover-
nance. The changes in governance and economic policy that occurred when Deng
Xiaoping reformed Maoist mainland China, the reforms in the Republic of Korea shortly
after Park Chung-hee replaced Syngman Rhee, and Chiang Kai-shek’s economic policy in
Taiwan, China, in the early 1960s provide ready examples. Cross-sectional evidence also
shows that cultures and institutions exert different economic influences on culturally
similar societies. Relevant examples are the German Democratic Republic and the Federal
Republic of Germany during the Cold War; the Democratic People’s Republic of Korea
and the Republic of Korea; and pre–Deng Xiaoping mainland China, compared with the
economies of Hong Kong SAR, China, and Taiwan, China. These differences cannot be
attributed to culture or any preceding differences in income or productivity.
Macroeconomic Stability and Financial Flexibility
A second major factor accounting for the economic resilience of FFDCs is their macro-
economic stability and financial flexibility.
■■ Macroeconomic stability provides a country with the ability to smooth any dis-
ruption caused by diversification away from fossil fuels and carbon-intensive
goods and services through countercyclical fiscal and monetary policies, includ-
ing exchange rates. Many of the most exposed FFDCs, in particular the GCC
states, score high in the World Economic Forum’s macroeconomic stability
index, which consists of indicators of a country’s credit rating, saving rates, fiscal
position, and inflation rates (WEF 2015).
■■ Adjusted net savings measures the true rate of saving in an economy after taking
into account investments in human capital, depletion of natural resources, and
damage caused by pollution. A nation’s wealth is determined by its accumu-
lated stock of physical, human, and natural capital. Accordingly, adjusted net
savings is calculated as the sum of net national savings and education expendi-
ture minus the sum of depletion of nonrenewable natural resources (energy and
minerals), net forest depletion, and damage from carbon dioxide and particulate
emissions. Botswana, Brunei Darussalam, and Qatar perform quite well, whereas
the Republic of Congo, Equatorial Guinea, and Iraq score low on adjusted net
savings, meaning that they have not substituted other forms of capital and have
rather spent the wealth on consumption.
■■ The maturity of financial markets is another relevant factor for FFDCs’ eco-
nomic resilience to LCT impacts. Transparent, sophisticated, and robust financial
91
Diversification and Cooperation in a Decarbonizing World
institutions are capable of facilitating a shift of investment from carbon-intensive
sectors to new sectors and business models. Robust capital adequacy ratios,
loan-to-deposit ratios, and liquidity of the financial sector can smooth struc-
tural transformation. This stability is particularly important because lower oil
and gas prices may adversely impact banks’ liquidity in FFDCs, reduce fiscal rev-
enue, and eventually affect access to finance for nonhydrocarbon sectors (IMF
2016). The banking sectors of Oman, Qatar, and Saudi Arabia score relatively
well in the World Economic Forum’s financial market indicator, while Algeria,
Iraq, and Libya perform poorly (WEF 2015). The importance of being able to
access financial markets to build resilience and support structural change can be
seen from a number of historical and contemporary examples. For instance, in
Southeast Asia during the late nineteenth and first half of the twentieth century,
the development of regional suppliers of credit preceded and facilitated struc-
tural transformation and economic growth (Sen 2016). Also, countries with
higher levels of domestic credit appear to have been more robust and better able
to endure shocks with less harmful impacts on domestic production. At the level
of the individual, a large number of analyses confirm that access to credit plays
an important role in short- and medium-run adjustment to adverse shocks in
both developed and subsistence economies (Dercon and Krishnan 2002).
■■ Finally, in developing countries, social safety nets to shield those who temporar-
ily lose from transition and enable new opportunities through health care, nutri-
tion, education (especially among women), and research and development also
expand total factor productivity and raise steady-state growth, allowing them to
catch up with richer societies.
Economic Performance and Complexity
Another major determinant of FFDCs’ resilience to external shocks is their economic
performance and complexity. Countries with high levels of economic complexity and
stable and high income growth are better prepared to create new capabilities in
anticipation of a decline in markets for fossil fuels and carbon-intensive goods and
services. The Economic Complexity Index (ECI) captures the diversity and ubiquity of
countries’ exports (box 5.2; Hausmann et al. 2013). ECI scores in the 20 most exposed
countries are mixed: Azerbaijan, Iraq, Libya, and Nigeria perform particularly poorly
and may struggle to create new capabilities in their economies because of relatively low
levels of GNI compared with other FFDCs. Guyana displays one of the lowest GNI
scores but performs better on ECI.
Business Environment
The fourth major factor determining resilience is whether the business environment is
conducive to generating new economic activities beyond the fossil fuel value chain.
92
Preparedness for a Low-Carbon Transition
BOX 5.2 Indicator of Economic Complexity
The measure of economic complexity developed by Hausmann et al. (2013) is derived from the number
of products a country makes (diversity) and the number of other countries making the same products
(ubiquity). The Economic Complexity Index (ECI) is strongly correlated with GDP per capita, as shown in
figure B5.2.1. The figure shows a scatter plot of income per capita and the ECI for countries where natu-
ral resource exports make up more than 10 percent of GDP (green) and for those where natural resource
exports make up less than 10 percent of GDP (orange). Noticeably, the figure shows that while countries
with relatively high levels of natural resource exports tend to be significantly richer than what would be
expected given the complexity of their economies, the ECI still correlates strongly with income for that
group. The authors also show that there is a strong positive relationship between annualized GDP per
capita growth for the period 1998–2008 and the ECI for 1998 after taking into account the initial level of
income and the increase in natural resource exports during that period.
FIGURE B5.2.1 Economic Complexity and Variance in GDP per Capita
1000 QAT NOR
DNK CHE
ARE NLD
KWT IRL USA FIN SWF
AUS CAN BEL FRA AUT DEU
GRC ESP ITA GBR SGP
HKG JPN
NZL ISR SVN
PRT
OMN KOR CZE
SVK
GDP per captia in thousands of US$ (2009)
TTO SAU
LBY LVA EST HRV
HUN
RUS LTU POL
VEN CHL
100 GAB KAZ URY TUR ROU MEX
BRA
MUS ARG LBN MYS
BWA PAN
AZE CUB ZAF CRI SRB BLR
AGO PER JAM COL BGH
IRN DZA DOM TUN BIH
ECU NAM MKD ALB THA
UKR
COG TKM MAR GEO GTM SLV JOR CHN
PRY SYR IDN
MNG BOL EGY
SDN HND LKA PHL MDA
NGA
PNG YEM GHA
MRT SEN
CMR ZMB CIV NIC VNM IND
10
TJK UZB PAK KGZ
LAO KHM KEN
MLI
BGD TZA MDG
GIN MOZ UGA
ETH ZWE R2 = 0.75
LBR MWI
–3 –2 –1 0 1 2
Economic Complexity Index (2008)
Source: Hausmann et al. 2013.
Note: GDP = gross domestic product; green = resource exports > 10 percent of GDP; orange = resource exports < 10 percent
of GDP.
■■ The World Bank’s ease of doing business index captures the ease of setting up
and operating a business. FFDCs vary widely in the ease of paying taxes, efforts
to start a business, ease of dealing with construction permits, and getting access
to electricity. These differences reflect the fact that some countries are relatively
agreeable to new business initiatives, while others keep very high bureaucratic
93
Diversification and Cooperation in a Decarbonizing World
and sometimes corrupt barriers to entrepreneurs outside of the energy sector.
The same goes for the ease of cross-border trade and the enforcement of con-
tracts. FFDCs often score poorly on the ease of accessing credit, protecting
minority investors, and resolving insolvencies (World Bank 2016).
■■ A related factor is the capacity to absorb and adopt new technologies, which can
help countries and firms respond to shocks, as described in box 5.3. According
to the technology absorption index of the Economic Complexity Index, FFDCs
vary widely in their technological absorption capacity. This affects their ability
to attract foreign direct investment, and reduces domestic firms’ ability to absorb
innovation and cutting-edge technologies. Poorly performing countries have
limited ability to use foreign direct investment to create positive economic spill-
over effects in innovation and modernization across the economy, most n otably
outside of fossil fuel–dependent sectors. Brunei Darussalam, Oman, Qatar,
BOX 5.3 Significance of Technological Openness
The differential recovery from the 1997 Asian financial crisis across the region can, to some
extent, be explained by different capacities to absorb new technology. For example, Indonesia
has disproportionally grappled with recovering from the effects of the crisis, whereas the
Republic of Korea, Malaysia, the Philippines, and Thailand had already recovered to precrisis
gross domestic product (GDP) levels before 2002. Indonesia recovered far more slowly and did
not reach precrisis GDP levels until 2004. Its manufacturing remained weak after 1997, and its
fragile recovery was based mainly on exports of primary products, including coal and palm oil.
Zen (2012) argues that this slow recovery can be linked to Indonesia’s growth trajectory in the
three decades beginning in 1970, which was focused on low-cost, labor-intensive manufactur-
ing, unlike the approach followed by Korea and Malaysia. This meant that the country strug-
gled to make the lucrative move up the value chain toward trade in high-tech products to gain
export traction after 1997; Indonesia has consistently lagged behind its peers in high-technology
exports as a percentage of manufactured exports.
These challenges may be linked to and exacerbated by weaknesses in its human capital:
Indonesia has fewer years of schooling, on average, than Malaysia and the Philippines (6 years
compared with 10 and 8 years, respectively). This lack of educational attainment not only made the
country relatively unattractive as a production base and investment target for m ultinationals—
which in other countries has been conducive to absorptive capacity for new technology—but also
failed to create an environment for domestic innovation and entrepreneurship in the high-tech
sector.
Similar evidence on the importance of technological openness arises from a comparison of the
Swedish and US pulp and paper industries in response to new social and environmental demands.
Whereas the US paper and pulp companies were technologically locked in, Swedish firms took
a more proactive approach to environmental research and development and established collab-
orative relationships with national policy makers associated with developing integrated abate-
ment technology. Today, Swedish firms are technological leaders in the industry (Bergquist and
Söderholm 2015).
94
Preparedness for a Low-Carbon Transition
the Russian Federation, and Saudi Arabia appear to have relatively high capaci-
ties for technology absorption. Algeria, the Islamic Republic of Iran, Iraq, and
Nigeria, on the other hand, appear to have lower access to the latest technologies.
Another important determinant of resilience is a country’s relative position on the
global supply curve for gas and oil. Even relatively exposed countries are more flexible
to the impacts of a transition if their extraction costs are lower than those of competi-
tors and a large portion of development costs is already sunk. Having low extraction
costs relative to other oil-producing countries is an indication of resilience, given that
countries with high costs would likely be the first to halt production.
Notes
1. Column 2 of figure 5.2 and table 5.2 are two ways of presenting similar data on exposure driven by
the production of fossil fuels; however, data on current fossil fuel exports as a proportion of GDP
is missing for Turkmenistan, as are data on the carbon intensity of exports. Turkmenistan is there-
fore omitted from the composite index. Libya, on the other hand, is not currently included in the
Rystad UCube database but was estimated by expert judgment of the authors in the composite
index.
2. Note that this indicator is calculated as the ratio of the total estimated volume of emissions of all
operating plants built in or before 2020 to total electricity generation in 2013. Hence, it captures
current plans to expand thermal generation, with an associated increase in committed emissions.
3. However, some of this infrastructure may be dedicated to hydrocarbon sectors without multipur-
pose functionality and thus may become underutilized or need significant investment for adjust-
ment if climate change response measures reduce demand for fossil fuels.
4. Olson, Sarna, and Swamy (2000) assume a Cobb-Douglas production function in each country to
draw out differences in total factor productivity and use a fixed effects panel to relate cross-
sectional country heterogeneity (assessed through fixed-country dummies) of governance.
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6. Charting the Future
Successful economic strategies in fossil fuel–dependent countries (FFDCs) will need to
strike a balance between (1) managing traditional carbon-intensive assets to generate
predictable revenue and (2) managing the transition to productivity-led and
knowledge-intensive growth models relying on much broader portfolios of assets.
The FFDCs that successfully navigate the uncertainties of a global low-carbon tran-
sition (LCT) will be those that acknowledge the challenge head on and start prepara-
tions for the best and worst-case scenarios of an LCT. Preparation strategies include
creating hedging portfolios of policies and investments to manage the risks and harness
the opportunities that an LCT brings. Deep uncertainty around the timing and chan-
nels of impact emphasizes the need for robustness, flexibility, and resilience of coun-
tries’ strategies. In this context, robustness refers to the ability of an economy and
society to maintain or increase welfare under the largest number of plausible scenarios.
Flexibility and resilience refer to the ability of an economy and society to adjust to sur-
prising and changing external conditions. Some FFDCs and their state-owned enter-
prises (SOEs) have already started planning to manage the risks associated with such
changes and have identified potential upsides from a low-carbon future.
This chapter explores a three-pillar framework for managing the risks and harness-
ing the opportunities of an LCT (figure 6.1). It consists of the following coexisting
strategies:
■■ Managing carbon-intensive assets to maintain revenues that build on current
skills and strengths through traditional carbon-intensive industrialization
■■ Managing a transition to new asset classes and new knowledge-intensive growth
models, while maximizing flexibility and resilience to external impacts
■■ Finding creative ways to cooperate with other parties on climate change to pro-
vide incentives for efforts to enable and enhance the mitigation co-benefits of
diversification
These three pillars need to rest on an understanding of the key channels through
which an LCT can affect a country and an understanding of the strengths and weak-
nesses of a country’s exposure and resilience to these possible impacts.
97
Diversification and Cooperation in a Decarbonizing World
FIGURE 6.1 More than Divestment: Multiple Strategies Will Help Fossil Fuel–Dependent
Countries Navigate the Risks and Harness the Opportunities of a
Low-Carbon Transition
Managing risks
and harnessing
opportunities of a
low-carbon
transition
Traditional GHG-intensive
Creative climate cooperation
diversification to manage
strategies to provide incentives
carbon-intensive assets,
for and enable mitigation
maintain revenues, and build
co-benefits of diversification
on current skills and strengths
Adaptive asset
diversification to maximize
flexibility and aid the transition
to new asset classes and
knowledge-based growth
Identify key channels of impact and analyze exposure and resilience to low-carbon transition impacts
Source: World Bank.
Note: GHG = greenhouse gas.
Assessing Uncertain Impacts and Preparedness for Managing
a Low-Carbon Transition
A critical first step is to identify the risks and opportunities that a country faces and the
extent to which it is prepared for them. The analysis conducted in previous chapters
serves as a framework for this assessment, which consists of three interrelated tasks:
■■ Identify the channels and pathways through which a global LCT could affect an
economy (chapters 2 and 3)
■■ Different channels of impact will have different effects on different countries
depending on their sectoral composition. However, the intertwined impact
of “disruptive” clean technologies and networks, shifts in consumer and
investor preferences, changes in policies and institutions, and the growth of
influential new business lobbies should be assessed in the context of policy
and trade actions that major trading partners may consider taking.
■■ Assess macro-fiscal and sectoral risks and opportunities through scenario analysis
(chapter 4).
■■ Scenario analysis is an effective tool for dealing with risk (TCFD 2016). It can
stress test key performance indicators against several possible combinations of
external events (UCISL 2016), including best-case and worst-case scenarios.
98
Charting the Future
Scenario analyses should explicitly take uncertainty into account by adopting a
forward-looking assessment of alternative (but plausible) futures (for example,
Peszko, van der Mensbrugghe, and Golub 2020). The challenge is to avoid
scenario selection bias, and to also consider potential worst-case scenarios,
even if they look unattractive from a country or sector perspective.
■■ Evaluate and benchmark the preparedness of an economy and society (for instance,
using the index introduced in chapter 5).
■■ Chapter 5 provides a comprehensive methodology for assessing a country’s
preparedness for managing the risks and harnessing the opportunities of an
LCT. It helps provide an understanding of areas in which exposure needs
to be decreased and resilience to external shocks increased. The index also
allows a country to be benchmarked against its main fossil fuel–dependent
peers and the design of the portfolio of strategies to manage the transition to
be customized.
Developing Strategies to Manage an LCT
Once the impacts of, and preparedness for, an LCT have been identified, FFDCs can
adjust their existing long-term strategies to account for the additional impacts and uncer-
tainties associated with a transition. Some fossil fuel–consuming countries have already
developed strategies aimed at thriving in a net-zero carbon world (for example, the
United Kingdom, through the application of the Climate Change Act1). Fossil fuel export-
ers are in even greater need of doing so. These strategies should recognize uncertainty as
to when and how an LCT may unfold. This uncertainty reinforces rather than invalidates
the need for sophisticated strategic planning.
An array of tools and approaches are available to aid decision-making under differ-
ent degrees of risk and uncertainty. These tools can improve the understanding and
management of risks of an LCT and improve the flexibility and robustness of the deci-
sions of governments, firms, investors, and financial institutions exposed to assets that
may be affected by a transition (box 6.1).
BOX 6.1 Tools to Aid Decision-Making under Uncertainty
Risk can be accommodated with decision-aiding tools such as adjusted expected value or real
options analysis. Such tools allow policy makers to keep as many options as possible open and
limit the likelihood of regret down the line if and when new information comes to light.
In the presence of deep uncertainty, when the assignment of probabilities to different future sce-
nario outcomes is impractical or impossible, robust decision-making can provide additional insights.
All these techniques are underpinned by scenario analysis, which identifies a range of possible
future outcomes and helps navigate toward increasing the probability of the most desirable outcomes
(Kalra et al. 2014).
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Diversification and Cooperation in a Decarbonizing World
An LCT management strategy should consider at least three critical issues:
■■ How to manage existing carbon-intensive assets (see section “Managing Existing
Carbon-Intensive Assets”)
■■ When and how to make a transition to new asset classes (see section “Investing
in a Broader Portfolio of Assets”)
■■ How to address the needs of citizens and firms that are most vulnerable to an
LCT (see section “Protecting Vulnerable Citizens”)
These issues are discussed below.
Managing Existing Carbon-Intensive Assets
Countries can choose among multiple strategies to manage their existing carbon-
intensive assets. The ultimate objective of any strategy is to maintain the ability of
fossil fuel reserves to generate resource rents in a world that may become more
carbon constrained. The same objective applies to the ability of downstream heavy
industries to generate profits or at least operational cash flows under various pos-
sible impacts of an LCT. The right combination of strategies will be different for
each country, depending on the country’s exposure, cost competitiveness, and mar-
ket share, as well as external market conditions. The size, efficiency, and age of
existing infrastructure will also play a role.
FFDCs and their SOEs can learn from the experience of firms operating in
industries facing the risk of structural decline. With increasing technology disrup-
tion and policy initiatives to mitigate climate change, FFDCs and their SOEs find
themselves in risky and potentially shrinking markets. In some, but not all ways
(Foreign Affairs 1994), their situation is similar to firms in declining industries
that are trying to increase their value to shareholders under deteriorating external
market conditions. Therefore, the experience of firms operating in declining
industries can provide important lessons for managing carbon-intensive assets
under the risk of an LCT. Literature on exit patterns, for example, looks at game
theory to inform successful strategies (for example, Filson and Songsamphant
2005), while studies on organizational ecology differentiate between specialists
and generalists and the implications in declining environments (Zammuto and
Cameron 1985). In normative management literature, which tries to provide a
better understanding of the behavior of firms and industries in declining environ-
ments, Harrigan and Porter (1983) present one of the most advanced models for
determining strategy.
The Harrigan-Porter model for determining firms’ strategies in declining indus-
tries is particularly relevant for the strategic thinking of FFDCs (Harrigan 1980;
Harrigan and Porter 1983). For some countries and SOEs, the best strategy will be
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Charting the Future
to start divesting early, even when the signs of a permanent structural decline
remain difficult to discern. Others may try to engage in risky leadership or niche
strategies by betting on increasing their shares in the declining sectors or products.
Harvesters will run down their existing carbon-intensive assets hoping to extract
maximum cash when they believe that a tipping point is imminent. Box 6.2 sum-
marizes the guidance that the Harrington-Porter model provides for companies
trying to choose the most successful strategy under various external market condi-
tions. Some initial observations can be made about how the existing behavior
BOX 6.2 Harrigan’s Model of Firms’ Strategies in Declining Industries
The model describes four generic strategies that firms in declining industries can choose from to
manage a market transition:
■■ Leadership strategy. A company exercising this strategy attempts to become one of the
few companies remaining in the industry, thereby giving the firm the market power to
increase profitability and influence prices. Leadership can be achieved through aggressive
competitive actions in pricing and marketing or by reducing competitors’ entry and exit
barriers.
■■ Niche strategy. In this strategy, a firm attempts to find a favorable segment that maintains
level demand or declines more slowly than the rest of the market. Firms following this
strategy act preemptively to gain a strong position in the niche, while divesting other
segments.
■■ Harvest strategy. Firms using the harvest strategy maximize short-term cash flow, keep
up the maintenance of facilities, but curtail new investments, reduce marketing and
research, and focus on only the most profitable products. The long-term objective is an
orderly exit.
■■ Divest strategy. Divesting firms sell exposed assets before they start losing value. The
earlier the business is divested, the better the possibility of finding buyers for the assets
because the future slide in demand is still uncertain. Although it is risky to divest early
because the forecast of decline may prove incorrect, it is also risky to wait too long given
that buyers will gain bargaining power.
Each strategy can be successful under specific conditions. According to Harrigan and Porter,
firms in declining industries should base their selection on an analysis of their market environ-
ment, especially by answering two key questions:
■■ Are the structural and regulatory factors favorable?
■■ Does the firm have competitive strengths in the remaining demand pockets?
Depending on the answers to these two questions, different strategies have better chances
of succeeding (table B6.2.1).
(Box continues on the following page.)
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Diversification and Cooperation in a Decarbonizing World
BOX 6.2 Harrigan’s Model of Firms’ Strategies in Declining Industries
(continued)
TABLE B6.2.1 Matrix of External Determinants of Successful Strategies of Firms in
Declining Industries
Favorable industry structure Unfavorable industry structure
Has competitive strengths Leadership or niche Niche or harvest
Lacks competitive strengths Harvest or divest quickly Divest quickly
Source: Based on Harrigan and Porter 1983.
Structural factors Environmental attractiveness
Favorable Unfavorable
Conditions of demand
Speed of decline Very slow Rapid or erratic
Certainty of decline 100% certain, predictable patterns Great uncertainty, erratic patterns
Pockets of enduring demand Several or major ones No niches
Product differentiation Brand loyalty Commodity-like products
Price stability Stable, premium attainable Very unstable, pricing below costs
Exit barriers
Reinvestment requirements None High, often mandatory and involving capital assets
Excess capacity Little Substantial
Asset age Mostly old assets Sizable new assets and old ones not retired
Resale markets for assets Easy to convert or sell New markets unavailable, substantial costs
to retire
Shared facilities Few, free-standing plants Substantial and interconnected with important
businesses
Vertical integration Little Substantial
“Single product” competitors None Several large companies
Rivalry determinants
Customer industries Fragmented, weak Strong bargaining power
Customer switching costs High Minimal
Diseconomies of scale None Substantial penalty
Dissimilar strategic groups Few Several in same target markets
Source: Harrigan 1980.
Note: Empirical evidence suggests firms had a success rate higher than 92 percent when they applied the strategy suggested
by this model (Harrigan 1980).
dependent SOEs fit the Harrigan-Porter
of different FFDCs and their fossil fuel–
strategy model:
■■ Leadership strategy. Aim to become one of the few countries or companies
remaining in a particular sector so that market power can be exercised to increase
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Charting the Future
resource rents by raising global prices. Both leadership and niche strategies are
likely to be inherently risky in erratic and uncertain policy environments associ-
ated with an LCT.
■■ In coal extraction, where a degree of product differentiation is possible
thermal versus coking, calorific value, sulphur and ash content, and so on),
(
producers with higher chances of success when using a leadership strategy are
those that will have high-quality coal with low extraction costs, and low costs
of transport to nearby growing markets (for example, Southeast Asia). This is
better news for Australian, East African, and Indonesian coal producers than
for those in the Americas or Eurasia, especially when coal prices in the United
States fall below prices in the Australian and South African hubs.
■■ In oil and gas markets, exercising market power is going to be increasingly diffi-
cult (Helm 2017). Leadership can be achieved only with effective cartel actions
and mergers and acquisitions in other countries, where barriers to entry can be
high for oil and gas industries. However, if peak oil demand becomes immi-
nent, the efforts to exercise market power can be more difficult in the struggle
for increasing slices of a shrinking pie and expected decreasing returns.
■■ Outside of extractive industries the most efficient and the least carbon-
intensive firms in energy-intensive sectors have the best chances to play lead-
ership strategies. Rusal, for example—the world’s second-largest aluminum
producer, from Russia—has been actively pursuing a global leadership strat-
egy trying to differentiate its products by their low-carbon footprint.
■■ Niche strategy. Aim to identify a segment within the fuel-dependent industries
(whether a sector, product, or geographical territory) in which a firm or a coun-
try has a comparative advantage, and which will maintain a relatively high level of
demand, or which will decline more slowly than the rest of the market (for example,
extractive, petrochemical industries, and aviation). Acting preemptively allows a
firm to gain a strong position in the niche by investing in the most efficient tech-
nologies and processes while divesting from other segments. Domestic reforms, such
as commercialization of SOEs, can strengthen their efficiency and incentives to select
successful niches and products that can be resilient to LCT impacts.
■■ In the coal industry niche strategies may be more successful when focused
on coking coal, the demand for which comes from the steel industry where
substitution for other products and fuels is more challenging than for thermal
coal used in power plants. Various coal countries are betting on “clean coal”
technologies such as carbon capture and storage or carbon capture, usage, and
storage, where progress has been very limited so far. It is still easier to build a
coal power plant that is locally clean, with significant improvements of genera-
tion efficiency and efficacy of local pollution control equipment, than a plant
that is globally clean, although minimizing local pollution comes at high capi-
tal and operating costs. South African Sasol demonstrated that under extreme
economic conditions (such as trade sanctions during apartheid), a range of
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Diversification and Cooperation in a Decarbonizing World
innovative chemical products can be derived from coal, but doing so becomes
commercially challenging, although not impossible, under competitive mar-
ket conditions. Some countries, such as Indonesia and Poland, are developing
niches for coal demand in domestic markets by supporting vertical integration
of coal mines and generation companies to expand national coal power genera-
tion. This strategy may not be sustainable in the longer term under competitive
market pressures and the high fiscal costs of providing state aid.
■■ In the oil and gas sector, Qatar and the United Arab Emirates, for example, iden-
tified aviation as a niche, with access to cheap fuel and government support.
Saudi SABIC became the third-largest petrochemical company in the world
and is aggressively pursuing research and development and commercialization
of new material technologies derived from recycled plastics, as well as those
that can be produced from carbon dioxide by carbon capture and use. This may
add value to and extend the noncombustible demand for oil, given that several
traditional petrochemical products may become exposed to the risk of border
adjustment measures. Niche strategies are inherently risky and can only suc-
ceed for selected countries and fuel-dependent companies under specific con-
ditions, for instance, where there are clear barriers to entry for late movers (hub
airports, although they can be easily established now, are examples for which
the value to followers is marginal). Again, a cooperative policy environment
can reduce the risk of stranding investments in fossil fuel–derivative products,
for example, by reducing the probability of surprising trade sanctions.
■■ Harvesting strategy. These strategies aim to generate cash flows from existing
mines, downstream industries, and thermal power plants; curtailing new invest-
ments; minimizing maintenance costs; reducing marketing and research; and
gradually limiting production to only the most profitable products in conjunc-
tion with establishing a mid- to long-term exit strategy.
■■ In the coal sector, for example, many European power companies are opting for
derogations from European Union (EU) environmental performance standards
for old coal power plants, which allows them to operate for a limited time with
capped operating hours per year without investing in expensive pollution
control equipment. The Czech private firm EPH has bought a number of
lignite, hard coal, and gas power plants across Europe, betting that they will
be able to generate a cash flow for at least the next decade or so.2 Harvesting
strategy has to yield large short-term returns to be successful in the fast-moving
European power market, where coal faces particularly strong policy headwinds.
Across Europe, countries are pulling out of coal in power generation. In April
2020, Austria and Sweden closed their last coal power plants. Existing plants
are experiencing record-low utilization rates, with the United Kingdom and
Portugal keeping their entire fleets of coal power plants idle for several weeks
during the COVID-19 crisis. The German government and regional leaders
have agreed on a plan to phase out coal-fired power stations by 2038.
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Charting the Future
■■ In oil and gas extraction, a harvesting strategy may include off-loading new
upstream business to foreign investors under production-sharing contract
structures that frontload the government take and share the LCT risks more
equally between the host country and the foreign developer.
■■ Divestment strategy. These strategies aim to dilute government ownership in
exposed assets by selling shares in SOEs or by opening new extractive operations
to international investors while the assets still have high market value.
■■ In the coal sector, most governments around the world have been
continuously downsizing state-controlled coal mining by restructuring
production and leaving only the most efficient mines operating (Mehling et
al. 2017). Indonesia has been decentralizing and privatizing its coal-mining
operations since 1990, well before an LCT became an issue. As part of its
COVID-19 stimulus package, India broke up the Coal India monopoly and
opened commercial coal mining to private companies, including foreign
ones. The Swedish state-controlled energy company Vattenfall is divesting
all its thermal assets abroad. E.ON, one of the world’s largest investor-owned
electric utility providers, completed the split of its fossil fuel and renewable
operations.
■■ In the oil and gas sector, the divestment movement is mainly driven
by institutional investors (pension funds, university trust finds, and so on)
in major international listed companies. Established national oil and gas
companies are slower to be floated, partly amid concerns about national
security and partly because the governments are often uncomfortable
about transparency associated with foreign investments. For example, it is
difficult to determine whether the planned floating of Saudi Aramco, the
largest crude oil exporter in the world, was part of a divestment or a leader-
ship strategy.
The success of each strategy will depend on the competitive advantages and capa-
bilities of individual firms and countries, as well as market and social conditions. For
example, the leadership or niche strategies can be less risky for extractive firms with
strong international comparative advantages in certain fuels or products, relatively low
production costs, strong market power (individually or through a cartel), unique prod-
uct characteristics (such as a relatively low-carbon content), large sunk costs, low mar-
ginal cost of production, flexible capital schedules (for example, shale oil and gas), easy
access to capital and markets, and a predictable policy environment. On the other hand,
companies that operate less efficient assets, face bulky capital needs for field develop-
ment and access to market infrastructure, and those operating in countries with a low
level of preparedness for an LCT may prefer to gradually divest to reduce exposure to
LCT risks or harvest short-term cash from existing assets. Table 6.1 summarizes the
overall guidance on customizing a successful strategy to the internal and external con-
ditions of a firm and a country.
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Diversification and Cooperation in a Decarbonizing World
TABLE 6.1 Matrix of Determinants of Success of the Strategies of Fossil Fuel–Dependent Firms
Cooperative, smooth LCT Noncooperative, disorderly LCT
Has comparative advantage and high Leadership or niche Niche or harvest
level of preparedness
Lacks competitive advantage and Harvest or divest Divest
has low level of preparedness
Source: World Bank based on Harrigan 1980.
Note: LCT = low-carbon transition.
The chance of success for the inherently risky leadership or niche strategies will
increase if the LCT pathways are relatively smooth and predictable in the medium to
long term. Countries that are better prepared for an LCT will create a more enabling
environment for their SOEs and private fossil fuel–dependent companies to exploit
elements of leadership and niche strategies, whereas firms operating in countries with
inconsistent climate strategies and a low level of preparedness may find it difficult to
take risks associated with these strategies.
Improved governance and commercialization of fuel-dependent SOEs will be essen-
tial to their ability to use smart strategies during an LCT. Currently, many SOEs in
developing countries are less efficient and less flexible than their private competitors.
Often burdened with social mandates and subject to political pressures, SOEs are less
able to prepare for and respond to possible market disruptions. A study on China con-
cludes that the reform of state-owned coal power plants is crucial to managing an LCT.
It recommends that the least efficient, old coal assets be put in a coal sector “bad bank,”
amortized, and retired as quickly as possible (Spencer, Berghmans, and Sartor 2017).
Few countries or companies pursue a single strategy in its pure form. Each country
and SOE may consider and pursue elements of different strategies simultaneously
across different market segments and change strategy over time. Doing so can help
reduce the risk of surprising shifts in external market conditions. For example, Statoil
(now Equinor) is arguably playing a combination of leadership, niche, and divestment
strategies in the oil and gas sector. The firm’s strategy also emphasizes efforts to support
cooperative climate policy actions, including through carbon pricing, and the broader
policy environment toward the LCT (box 6.3). As Eldar Saetre, chief executive of Statoil,
said, “Diversification into renewables makes sense. We have a lot of skills which we can
apply directly into offshore wind. It can deliver good returns, [with] a much lower cost
of capital than oil and gas would require” (Financial Times 2017a).
Determining the appropriate strategy for fuel-dependent SOEs will require moni-
toring of global technology, policy, and market trends. Governments and SOEs will
need to periodically conduct a scenario analysis of how an LCT might evolve and how
it may affect their businesses and diversification strategies.
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Charting the Future
BOX 6.3 Statoil (Now Equinor) Strategic Framework
“We aim to set an example for how the oil and gas industry must develop, show leadership, and
point the way to bolder and better solutions. We are an energy company committed to long-term
value creation in a low-carbon future. We believe a low-carbon footprint will make us more com-
petitive in the future. We also believe there are attractive business opportunities in the transition
to a low-carbon economy.
“Our strategy focuses on three main areas. We are building a high-value and low-carbon oil
and gas portfolio, we are building a material industrial position in renewable energy and low-
carbon solutions, and we embed climate risk and performance into our decision-making. Our
Climate Road Map explains how we plan to achieve our goals and how we will develop our busi-
ness, in support of the ambitions set out in the Paris Climate Agreement:
■ Build a high-value and lower-carbon oil and gas portfolio (CO2 emission reductions of 3 million
tons per year by 2030; Portfolio carbon intensity of 8 kg CO2/boe by 2030; Methane emissions
from the Norwegian gas value chain below 0.3%; Eliminate routine flaring by 2030)
■■ Create a material industrial position in new energy solutions (New energy solutions with
potential to represent around 15–20% of capex by 2030; Up to 25% of research funds to
NES and energy efficiency by 2020; Invest $200 million through our new energy v entures
fund; Partner in the $1 billion OGCI)
■■ Accountability and collaboration (Continued support for carbon pricing; Minimum internal
carbon price of $50 per tonne CO2; Climate risk and performance embedded into strategy,
incentives, and decision-making; Amplifying our climate actions through collaboration)”
Source: Extracts from Statoil. 2017. Shaping the Future of Energy (https://www.statoil.com/en/how-and-why.html
#shaping-the-future-of-energy).
Note: boe = barrel of oil equivalent; capex = capital expenditure; CO2 = carbon dioxide; NES = new energy solutions; OGCI = oil and
gas climate investments.
A strategy-development process can involve three cyclical steps (figure 6.2). First,
decision-makers need to understand the current industry trajectory (McGahan 2004)
and develop scenarios for possible future trajectories depending on technology, policy,
and market trends. This step creates a context for assessing the individual competitive
advantages and level of preparedness for LCT impacts within the industry. Based on
the findings, the appropriate strategy can be chosen and adjusted iteratively as external
factors change or internal capacities increase.
One key lesson that emerges from past studies of declining industries is that it is
notoriously difficult to identify in real time when a temporary fluctuation is developing
into a structural transformation. A tipping point typically becomes evident only after
it has happened.
While managing existing carbon-intensive assets during the transition period,
policy makers will also need to see beyond the interests of their carbon-dependent
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Diversification and Cooperation in a Decarbonizing World
FIGURE 6.2 Strategy-Development Process for Countries and Fossil Fuel–
Dependent SOEs
Assess current
industry trajectory; Assess competitive
scenarios for advantages
future trajectories
Choose and adjust
appropriate strategy
Source: World Bank.
SOEs. The robust development challenge will be to protect the long-term interests of
citizens by steering the entire economy toward more diversified, less carbon-dependent
assets through pricing and other consistent policy signals.
Investing in a Broader Portfolio of Assets
As discussed earlier in this chapter, managing existing fossil fuel assets is crucial to
generating continuous revenue flow to enable asset diversification. However, equally
challenging is avoiding locking the economy into a fuel-dependent growth model.
A prerequisite for a robust and viable economic transformation is the creation of
incentives and institutions to facilitate asset diversification. As demonstrated in this
study, asset diversification maximizes productivity, economic flexibility, and the capac-
ity to diffuse and absorb knowledge and innovation. It also marks a transition to an
“intangible” growth model, one that is less dependent on underground and produced
assets, and more so on human and institutional capital. But its benefits to society do
not manifest immediately and carbon-intensive incumbents may resist change.
Successful diversification and climate cooperation strategies will need to be dynamic
and adaptive, recognizing the value of flexibility. Flexibility means leaving governments
and economic agents with as much freedom of choice as possible at different decision
points, while staying focused on taking early advantage of opportunities as they emerge.
FFDCs must build “hedging portfolios” of policies and investments customized to the
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Charting the Future
country context. Flexibility in the face of uncertain external shocks will require better
economic institutions and policies, including openness to the private sector, better
regulations (such as environmental and energy efficiency regulations), consistent pric-
ing signals that make economic agents see the true social cost of the energy they use,
and enabling conditions for diffusing and absorbing knowledge and innovation.
Facing the possibility of a rapid LCT, FFDCs will need to make decisions about invest-
ment in new, unfamiliar assets. This requirement reinforces the importance of collect-
ing resource rents from extractive companies and using them wisely for the benefit of
the entire society, including future generations. Institutions and incentives will be
needed to level the playing field between carbon-intensive incumbent companies and
innovative new entrants, both national entrepreneurs and foreign direct investors.
Investment in new assets could generate an environment conducive to asset diversifica-
tion and investment in the sources of wealth that FFDCs are traditionally weak in,
especially human capital, knowledge, and institutional capacity. Removing the barriers
to diversification—such as policy and fiscal incentives to continue investing in high-
carbon assets and infrastructure—will be a challenge. These detrimental incentives
include fossil fuel subsidies and energy pricing structures that fail to internalize the
environmental damage and social costs of energy production and use. More specifi-
cally, the framework for converting resource rents into accumulation of new asset
classes, less exposed to LCT risk, can consist of the following elements:
■■ Increasing the fiscal take of resource rents and reducing public revenue risks.
Countries differ in how much fossil fuel rent they collect though royalties,
taxes, dividends, fees, or production-sharing contracts. Rents that are left in the
extractive sectors are usually reinvested by extractive companies (mainly SOEs
in FFDCs) in further expansion of fuel-dependent businesses; converted to high
salaries, bonuses, lobbying expenses, and luxury facilities; or siphoned off to off-
shore accounts (Devarajan 2018). Similar patterns can sometimes be seen in the
dividend policies of SOEs in refineries or the thermal power sector. The risk of
an LCT requires increased government efforts to collect resource rents from the
extractive sectors to enhance the fiscal space to maneuver. Over time, prepared-
ness for an LCT requires that governments gradually shift their fiscal revenues
from relying on resource rents toward instruments that are more resilient to LCT
impacts. Devarajan (2018) also argues that “extractive” state institutions may
become more accountable to citizens at large if resource rents are distributed as
dividends directly to citizens and then collected by governments through tradi-
tional taxes.
■■ Incentives and medium- to long-term public expenditure frameworks to reinvest
the fiscal take of fossil fuel rents in a diverse range of assets. At the core of robust
strategies are institutions and incentives that favor saving over consumption.
Such strategies reinforce the importance of genuine saving and investments
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Diversification and Cooperation in a Decarbonizing World
rather than spending fossil fuel–derived revenues on purchasing foreign
consumer goods. A transparent medium- to long-term public expenditure
framework could help redirect fiscal resources toward building economic resil-
ience. The delivery mechanisms of the longer-term expenditure frameworks
will vary depending on country preferences and circumstances. Some will
strengthen the political independence of their wealth funds or establish new
ones. Others will establish longer-term fiscal frameworks and budget rules that
require the evaluation of public expenditure programs through the lens of cli-
mate sustainability, along with increased disclosure on carbon dependency and
climate risk.
Equally important is to invest the savings in the asset classes that are tradition-
ally underfunded in FFDCs—especially human capital, knowledge, institutional
capacity, and ecosystem services. Renewable natural capital delivers sustainable
ecosystem services underpinning the value of human capital and substituting
for services of produced or nonrenewable natural resources. The value of natu-
ral capital is increasingly being recognized and measured in the frameworks of
national accounts (Hamilton and Hepburn 2014; Helm 2015; Lange, Wodon,
and Carey 2018; World Bank 2011). Intangible assets, such as institutions, good
governance, and knowledge, are responsible for increasing the productivity of
all other forms of capital (see chapter 4). They help increase economic flexibility
and the economy’s ability to absorb, generate, and diffuse knowledge and inno-
vation. The institutional and regulatory protection of disruptive private entities
entering the markets dominated by state-controlled incumbents is crucial for
managing successful transitions. Good governance of the transition also pre-
vents unintended negative effects, such as rebound effects (especially if prices are
inappropriate), misallocation of capital, or capture and rent-seeking behaviors
(Hallegatte, Fay, and Vogt-Schilb 2013).
■■ Regulatory incentives to minimize irreversible capital-intensive investments in fos-
sil fuel–dependent sectors and infrastructure. Effective hedging strategies include
the removal of distortive regulations and policies that perpetuate dependency
on fossil fuels and the introduction of policies that minimize excessive and irre-
versible capital-intensive investments in exposed assets, paving the way for the
discovery of new sources of national comparative advantage. During transition,
vertical industrial policies need to be rooted in horizontal pricing incentives
that reflect the value of flexibility and discourage increasing the systemic risk
of an LCT. Such horizontal incentives are the inevitable backbone of national
innovation systems that facilitate innovation and creativity across the economy
and smooth relocation of assets across classes should external impacts become
apparent (Lee 2013; Malerba 2004).
The most distortive regulations involve various forms of subsidies to fossil
fuels and the industries that use them, and energy pricing structures that fail to
internalize the social costs of energy. Systemic risk is also increased by different,
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Charting the Future
often nontransparent forms of protection of fossil fuel–dependent incumbents
from competitive challenge by new players (Whitley and van der Burg 2015).
Although, as discussed earlier, subsidies can be among the tools for managing
the transition through traditional diversification, they carry the risk of masking
the warning signals in the sectors that are most exposed, hence making them
even less prepared for disruptive external impacts. Withdrawal of subsidies is
more difficult than their introduction. Removing subsidies is always politically
sensitive and may require measures to mitigate unwanted social distributional
impacts, and to overcome the rent-seeking habits of incumbents (Kojima and
Koplow 2015). Different methodologies exist to measure fossil fuel subsidies.
In pretax value, these subsidies were estimated at $296 billion in 2017 (0.37
percent of gross domestic product [GDP]). When unpriced externalities were
included—from accidents to air pollution to climate change—the global value
of these subsidies was estimated at $5.2 trillion in 2017, or 6.5 percent of global
GDP (Coady et al. 2019).
Another horizontal incentive structure is fiscal reform that aligns fuel taxa-
tion with the social and environmental (global and local) costs of extracting
and using fossil fuels (Bovenberg and de Mooij 1994; Parry et al. 2014). The
fiscal reform can, for example, link the rates of excise duties to external costs,
or introduce explicit Pigouvian environmental taxes (Pigou 1954). Increasing
the tax burden on economic “bads,” such as pollution, can raise additional rev-
enues from carbon-intensive activities and allow the fiscal burden of sustain-
able economic “goods,” such as knowledge- and labor-intensive activities, to be
lowered (Fullerton 1997). A wide-ranging review of the extensive debate on the
so-called double-dividend hypothesis is provided by Jaeger (2013). Alternatively,
additional revenue can be invested in sources of new, sustainable comparative
advantage. Price signals can help direct private flows of finance and technologies
toward low-emissions investments while giving economic agents flexibility as
to what to invest in. It is often easiest to introduce energy pricing changes at the
same time as undertaking broader energy sector reforms that liberalize energy
markets and make them more flexible. The combination can create a virtuous
circle whereby energy sector reform makes price changes more effective, thereby
encouraging the growth of new energy sector players with an interest in main-
taining and accelerating reform (World Bank 2016). At the same time, shifting
taxes toward carbon-intensive activities exacerbates the risk of rapid erosion of
the tax base if an LCT accelerates. Therefore, fiscal risk management frameworks
are needed to ensure public revenue stability.
■■ Innovation policies and the role of the state. Traditional export diversification
can be combined with broad asset diversification. Investing in human capital,
better regulations, and infrastructure supported by horizontal incentives and
policies may not be able to ignite new sustainable tradable production growth
engines, especially among major oil and gas exporters, because of pervasive
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market failures (Cherif and Hasanov 2014). Sunset industrial policies can be
combined with careful application of sunrise industrial policies building on
existing strengths. This combination could accelerate the discovery of new com-
parative advantages. Facing deep uncertainty, the state sometimes needs to take
a more active “ entrepreneurial” role in discovering new sources of comparative
advantage, shouldering the risks that private firms and venture capitalists are not
willing to take on but avoiding unfair competition with, and crowding out of,
private initiatives (Mazzucato 2013).
Countries at different stages of development vary in their capacity and the
conditions to create, absorb, and access new technologies. Historically, many
innovation policies in developing countries were not successful because they
focused too much on the creation of technology (government-funded upstream
research and development, labs, and technology incubators) and too little on the
absorption and deployment of technology (EBRD 2014).
■■ Managing the politics of transition and established vested interests. Recognizing
political economy realities and challenges when making a transition is cru-
cial. Political risk will apply more to the losses of incumbents than to the
equally valuable opportunities of new entrants because, in most political sys-
tems, “old” vested interests will initially be more effective at lobbying politi-
cians (Baldwin and Robert-Nicoud 2007). Policy makers need to use their
political capital to facilitate the entry of new, innovative firms that can chal-
lenge the dominant position of the powerful incumbents, including those
that are owned or controlled by the state. Institutional arrangements that
actively promote openness to change, creativity, and flexibility can generate
great value.
Indeed, this is not just a problem of distribution between pioneers and los-
ers. Even those who perceive themselves as losers may, in fact, act against their
own interests by blocking or delaying change. For example, Peszko, van der
Mensbrugghe, and Golub (2020) suggest that even though cooperative climate
policies in some circumstances are actually in the interest of oil companies in
FFDCs, many of them are still lobbying against more ambitious domestic cli-
mate actions. Similarly, policies and regulations that firms claim will damage
them can turn out to encourage productive innovation (Combes and Zenghelis
2014). For example, in 2009 the European Union introduced a fleet average
target of 130 grams of carbon dioxide per kilometer by 2015. This target was
opposed by the motor industry but was met two years early. By contrast, in the
United States, car and consumer-industry lobbying kept gasoline taxation low.
The consequence was that the US car industry was much less prepared for higher
oil prices and the global financial crisis than the EU industry, an important con-
tributor to the bankruptcies of Chrysler and General Motors in 2009 (Bassi and
Zenghelis 2014).
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Protecting Vulnerable Citizens
Managing the social impact is an important aspect of structural transformation. Change
requires adjustment, and with adjustment come winners and losers. Caring about those
who stand to lose and enabling them to partake in the opportunities associated with a
more diverse and flexible economy is a key part of successfully managing an economic
transition. Managing the transition involves assisting the people and regions directly
affected by it, and retooling and reskilling workers rather than protecting declining indus-
tries dominated by incumbents who often obstruct change. This aspect is not covered in
depth in this book because it is addressed in the parallel research program initiated by
Climate Strategies (https://coaltransitions.org) and the World Bank (Stanley et al. 2018).
In particular, assistance may be needed for workers and communities directly
affected by the LCT (such as stranded coal labor). For example, a transition away from
using coal for power generation has been found to deprive regions dependent on min-
ing for a long time. Substituting solar or wind energy for coal power may be economi-
cally and commercially efficient, but often reduces local jobs because coal mining and
power generation are more labor intensive. Even in advanced economies that have
undertaken significant policy efforts and fiscal transfers, revitalizing affected commu-
nities can be difficult (box 6.4).
BOX 6.4 The Decline of the UK Coal Industry
The abruptness and social consequences of the demise of coal in the United Kingdom is seen by
some international observers as a model of how not to wind down a declining industry.
The UK’s coal industry has experienced a prolonged decline since the 1920s, but the accom-
panying social malaise was exacerbated by British postwar industrial policy. The industry was
nationalized in 1947. By the early 1960s it was suffering from overcapacity and low productiv-
ity, which resulted in its sharp contraction. The spread of natural gas, fuel switching in the rail-
way network, and new sources of oil all contributed to rapidly falling demand. In addition, in the
1970s coal became an increasingly internationally traded commodity, leading to competition from
imports. Overoptimistic demand projections in the nationalized industry went unchallenged and
overproduction ensued, but coal mines were insulated from heavy losses by tolerant government
support, subsidies, and debt cancellation.
During the 1970s, the United Kingdom suffered from considerable industrial unrest, which
resulted in the election of a government led by Margaret Thatcher with the aim of confronting the
coal industry, which it saw as a politicized monopolist damaging national interests. In the height-
ened political climate and the flashpoint strike that followed in 1984–85, compromise and support
packages for unemployed miners were not high on the political agenda. Nor was shoring up the
long-term feasibility of coal; rather, there was an impetus to find alternative sources of energy. The
production of deep-mined coal fell by half in 10 years, and the number of employees shrank by a
factor of 10. This confluence of factors left coal-dependent communities ill-prepared for the reality
of pit closures, which left them with a legacy of poorly paid, unskilled jobs; petty crime; substance
abuse; and health problems. The last deep mine was closed in 2015.
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Strategies for Cooperation in International Climate Initiatives
FFDCs can hedge LCT risks not only with various diversification strategies, but also vari-
ous strategies for international cooperation. Cooperation on climate action could help
FFDCs avoid abrupt shocks to income, consumption, and asset values. Cooperative
domestic climate policies in FFDCs would help prevent a threat of trade measures being
implemented by trading partners with significant market power. Cooperation enhances
the benefits of asset diversification and can also increase oil rents in FFDCs, compared
with noncooperative scenarios in which other countries take unilateral actions to stabi-
lize climate at safe levels and impose trade sanctions. However, cooperative climate poli-
cies can reduce output and growth in the short term, and therefore are vulnerable to the
tragedy of the horizon (Peszko, van der Mensbrugghe, and Golub 2020).
FFDCs need to consider creative ways in which they could contribute to interna-
tional climate cooperation and implementation of the Paris Agreement in line with
their special national circumstances and capabilities. Proactive cooperation in
international climate action offers access to cooperative instruments under Article 6 of
the Paris Agreement, and an opportunity to design instruments and modalities benefi-
cial to all parties. For example, when a credible threat emerges that a Nordhaus border
adjustment tax will be levied by trading partners with substantial market power, policy
makers in FFDCs may want to have a few alternative designs for potential cooperative
mechanisms ready in their back pockets.
This study suggests that one option for encouraging broader coalitions for climate
change mitigation is to agree on a cooperative regime that involves sharing carbon
tax revenues between exporters and importers. Wellhead taxes are a special form of
carbon price imposed on the carbon content of fossil fuels and collected at the point
where oil, gas, and coal are extracted from the ground. They do not discriminate
between fuels consumed domestically and fuels exported (unlike traditional upstream
carbon taxes, which are imposed in only the country that releases greenhouse gases).
Wellhead taxes deliver incentives to cooperate as well as pricing incentives and reve-
nues to accelerate asset diversification in FFDC economies. The analysis shows that
global cooperation with wellhead taxes turns cooperative domestic climate policies
into new development opportunities, boosting the net present value of consumption
in FFDCs well above business as usual over time. Thus, they overcome the tragedy of
the horizon because carbon revenues are retained domestically instead of being col-
lected by fuel importers.
Cooperative wellhead carbon taxes could help align diverging incentives between
and within countries and climate policy clubs. They could be an effective means for
pricing carbon in a way that prevents the growth of emissions in FFDCs and enables
the broader diversification of assets in those countries. Retained revenues can also
help mitigate the social and political challenges of transition. Wellhead taxes would
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Charting the Future
have the same incentive effect on demand and terms of trade as traditional carbon
prices, but would allow wealth sharing between fuel exporters and importers.
Although the design and implementation of an international wellhead carbon tax
regime deserves more analysis, it would not necessarily be more challenging than any
other international cooperative outcome—for instance, those based on harmoniza-
tion of traditional carbon prices, carbon markets, or financial and technology trans-
fers (Gollier and Tirole 2015; Jakob, Steckel, and Edenhofer 2014; Weitzman 2014,
2016). Wellhead taxes can be combined with national traditional carbon prices and
strategic financial transfers in the framework of bilateral or multilateral deals. As
many others have proposed for emissions-based carbon taxes, a portion of wellhead
carbon tax revenue can also be transferred to the Green Climate Fund to assist the
lowest-income and most vulnerable countries in meeting the challenges of adapta-
tion to climate change.
With or without wellhead carbon taxes, international climate cooperation will
always reinforce the long-term benefits of asset diversification. A diversified, flexible,
knowledge-based economy is the stated aspirational objective of virtually all FFDCs,
and intelligently designed international cooperation can provide incentives and
resources to enhance the climate co-benefits of diversification. It can unlock new green
growth models for FFDCs and serve as their unique contribution to the global effort to
decarbonize the world economy and stabilize global warming.
Notes
1. The UK Climate Change Act 2008 is the basis for the United Kingdom’s approach to tackling and
responding to climate change. It requires that emissions of carbon dioxide and other greenhouse
gases be reduced and that climate change risks be prepared for. The act also establishes the framework
for delivering these requirements. See https://www.theccc.org.uk/tackling-climate-change/the-legal
-landscape/the-climate-change-act/.
2. See Financial Times 2017b.
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7. Conclusions
As the world grapples with ways to mitigate and adapt to climate change, the role of
fossil fuel–dependent countries (FFDCs) is increasingly attracting attention. The
potentially distressing impact of a low-carbon transition (LCT) on their economies is
still sometimes disregarded as collateral damage. More and more people, however, are
trying to understand these concerns and to create a space for these countries to
proactively engage in the global efforts to decarbonize the world economy and stabilize
the climate in a way that enhances their sustainable growth while managing the risks of
transition. This book provides the analytical underpinnings to support this approach.
An LCT can affect FFDCs through several mutually reinforcing channels over which
they have little control. These channels include global mega-trends in “disruptive” clean
technologies and business models, networks that lock them in, shifts in consumer and
investor preferences, changes in policies and institutions in other countries, and the
growth of influential new global business lobbies. While the tipping points after which
fundamental shifts in economies occur are unpredictable, their possibility can no longer
be ruled out in policy makers’ and business leaders’ mid- to long-term planning horizons.
They represent a qualitatively new type of risk that the FFDCs have not faced so far—a
risk of structural and permanent decline of the entire fossil fuel value chain.
No one can predict the future, but one can prepare for it. FFDCs can manage the
risks and tap into emerging opportunities of an LCT with two broad strategic choices:
■ Whether and how to diversify their economies
■ Whether and how to cooperate on global efforts to stabilize the climate
High exposure and low resilience of many FFDCs to an LCT underscores the impor-
tance and urgency of new approaches to diversification. Traditional output diversifica-
tion underpinned by the fossil fuel value chain decreases reliance on fossil fuel export
revenues by developing fossil fuel–dependent industrial, transport, and power systems.
It can help hedge the risks of cyclical commodity price volatility familiar from the past,
but at the cost of increasing exposure to the structural impacts of an LCT.
On the other hand, diversifying assets—the inputs being used by an economy—is
essential to building competitive knowledge economies that are more flexible, innova-
tive, and resilient to external shocks, including those associated with an LCT. A more
diverse set of assets can be achieved by reinvesting resource rents into broadening the
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wealth foundation of an economy, including renewable natural capital and intangible
assets such as human capital, innovation, and institutions. In the long term, asset diver-
sification stimulates sustainable, faster, and more resilient growth driven by productiv-
ity improvements rather than fossil fuel resource rents.
Cooperative domestic climate policies enhance the benefits of asset diversification.
They effectively hedge LCT risks to growth and welfare in FFDCs by preventing
surprising external policy shocks and providing economy-wide price signals to better
prepare for a transition.
However, asset diversification and cooperative climate policies are victims of the trag-
edy of the horizon. The combination of asset diversification and international climate
cooperation maximizes output and welfare in FFDCs, but only in the long run. Asset
diversification and cooperative climate policies give FFDCs the highest upside in best-
case scenarios over the long term, and the lowest losses in worst-case scenarios. However,
in a short time frame—one relevant for most policy makers, business leaders, and inves-
tors—asset diversification is costly and risky for FFDCs. Traditional diversification, on
the other hand, builds on existing strengths, abundant domestic resources, and skills, and
hence generates higher immediate revenues and consumption than asset diversification.
Suddenly abandoning the strengths and capabilities accumulated over decades is an
unsettling proposition for many countries and regions that have depended on them for
decades. Delaying domestic energy reforms and climate policies can harness the short-
and medium-term benefits of attracting energy- and emissions-intensive industrials
(emissions leakage). This challenge is amplified by the prevailing regulatory capture by
powerful, vested interests in fossil fuel–dependent industries and the relative weakness of
new emerging lobbies.
FFDCs have the weakest short-term incentives of all countries to join global climate
action on a voluntary basis. The incentives to increase climate action ambitions are not
built into the letter of the Paris Agreement. But, unlike the Kyoto Protocol, the open,
bottom-up architecture of the Paris Agreement explicitly permits a group of parties
under Article 6 to form a “climate action club” to pursue voluntary cooperation to allow
for higher ambition in mitigation and adaptation actions. This analysis finds that
Organisation for Economic Co-operation and Development (OECD) countries, China,
India, and several other net fuel importers enjoy a primary-mover advantage in a low-
carbon, knowledge-based economy and have fundamental incentives and enough market
power to form such a club and encourage the cooperative behavior of FFDCs.
Economic literature argues that a climate action club can become effective when its
members complement their individual Nationally Determined Contributions with col-
lectively determined (but individually binding) commitments to specific policy pack-
ages, such as minimum rates of carbon pricing. To make a climate club stable, its
members should enjoy exclusive benefits and privileges (financial, technology trans-
fers, trade preferences) that prevent them from defecting and allow effective
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Conclusions
enforcement based on reciprocity (“I will if you will”). Exclusions from privileges and
credible threats of sanctions would attract nonparticipants and further increase the
market power of the club.
Cooperative instruments can be designed to encourage formation of a coalition of
climate action between fuel importers and exporters and can overcome the tragedy of
the horizon. One way to align incentives for the type of cooperation that increases
climate policy ambition and avoids trade sanctions is through cooperative climate pol-
icy agreements between fossil fuel exporters and importers. Cooperative alignment of
traditional carbon taxes imposed on emissions from consumption of fossil fuels is not
likely to attract FFDCs, since such carbon prices extract resource rents from fuel
exporters and transfer them to importing countries. One cooperative carbon pricing
design that can be a win-win for both importers and exporters of fossil fuels is a coop-
erative wellhead carbon tax treaty with a revenue-sharing agreement. Under such an
agreement, both parties apply a carbon price on fossil fuels when they are first extracted
from the ground. Tax revenues are not rebated when the fuel is exported, but under a
cooperative deal the importer agrees to reduce a domestic carbon tax on the carbon
embedded in the fuels imported from the countries that put a carbon tax on fuel pro-
ducers to avoid taxing the same carbon twice. These types of taxes thus extend carbon
prices to domestic emissions in FFDCs in return for the opportunity to retain a portion
of revenues otherwise collected by importers. Such price-based cooperative policy
agreements can be complemented by international technology cooperation to acceler-
ate and enable asset diversification. Credible, strategic financial and technology trans-
fers could help the countries that are least able to diversify and adapt or that face a
significant social cost of a transition, such as low- and lower-middle-income countries
that have not yet been able to extract and monetize their underground fuel reserves.
The incentives for FFDCs to seek cooperative climate policy agreements are reinforced
by the possible implementation of border adjustment taxes (BATs). FFDCs’ competitive
advantage in energy- and emissions-intensive industries is so large that traditional border
adjustment measures based on the carbon content of imported goods may not be strong
enough to encourage cooperative domestic climate policies. But flat trade sanctions on all
imports from noncooperating countries would have a large impact on FFDCs. The mere
possibility that flat trade sanctions could be implemented in the future creates a short-
term incentive for FFDCs to collaborate and diversify their economies.
Successful economic strategies in FFDCs need to include a diverse portfolio of
hedging policies and investments that strike a balance between (1) managing traditional
carbon-intensive assets to capture resource rents, maintain revenues, manage price
volatility risk, and keep social peace and justice during a transition; and (2) reinvesting
these revenues in the broader asset base to strengthen economic flexibility and pre-
paredness for the multiple possible impacts of an LCT. In the global endgame for fossil
fuels, different strategies for managing existing fossil fuel assets can be successful for
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Diversification and Cooperation in a Decarbonizing World
different countries and firms. Some will choose to divest quickly, while others will
choose to increase the market share in declining industries. There will be losers
and winners for each strategy chosen. Therefore, instead of focusing on the risk of
stranded assets in the dialogue on climate action in FFDCs, this book suggests a shift
toward focusing on managing the risks and tapping emerging opportunities. Changes
in the value of underground and produced assets are less relevant indicators of eco-
nomic performance during an LCT than changes in asset structure and in income and
welfare of whole countries.
One of the key messages of this study is that asset diversification represents a funda-
mental shift toward a dematerialized long-term growth model, in which fewer material
inputs generate higher economic output and welfare. This underlying mega-trend can
have strong environmental co-benefits. Concerns about climate change just make it
more urgent, and climate mitigation policies both hedge the risks and pave the way for
asset diversification. In this new growth model the people, their collective know-how,
and renewable natural capital, as well as knowledge and institutions, increasingly
substitute for produced traditional capital assets and exhaustible natural resources in
driving prosperity.
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ECO-AUDIT
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T
his book is the first stocktaking of what the decarbonization of
the world economy means for fossil fuel–dependent countries.
These countries are the most exposed to the impacts of global
climate policies and, at the same time, are often unprepared to
manage them. They depend on the export of oil, gas, or coal; the use
of carbon-intensive infrastructure (for example, refineries, petro-
chemicals, and coal power plants); or both. Fossil fuel–dependent
countries face financial, fiscal, and macro-structural risks from the
transition of the global economy away from carbon-intensive fuels
and the value chains based on them. This book focuses on managing
these transition risks and harnessing related opportunities.
Diversification and Cooperation in a Decarbonizing World identi-
fies multiple strategies that fossil fuel–dependent countries can
pursue to navigate the turbulent waters of a low-carbon transition.
The policy and investment choices to be made in the next decade will
determine these countries’ degree of exposure and overall resilience.
Abandoning their comfort zones and developing completely new
skills and capabilities in a time frame consistent with the Paris
Agreement on climate change is a daunting challenge and requires
long-term revenue visibility and consistent policy leadership. This
book proposes a constructive framework for climate strategies for
fossil fuel–dependent countries based on new approaches to diversi-
fication and international climate cooperation. Climate policy leaders
share responsibility for creating room for all countries to contribute
to the goals of the Paris Agreement, taking into account the specific
vulnerabilities and opportunities each country faces.
ISBN 978-1-4648-1340-5
SKU 211340