To build or not to build? Capital stocks and climate policy
To achieve the goals of the Paris Agreement, the use of fossil fuels must peak and then rapidly decline. Yet the world continues to make big investments into the construction of fossil fuel power plants, particularly coal plants. This research investigates the impact of climate change policy on capital invested in these ‘dirty’ assets.
Once capital is invested in fossil fuel power plants it has no value unless used in production. Using a simplified model of dirty and clean sectors Baldwin et al. find that to avoid capital being stranded, investment into dirty plants must stop in 2020. They find that coal plants can be fully utilised for another 25 years until 2045 and still enable climate change targets to be met. After 2045, these assets will need to be underutilised, meaning that the net return on investment will reach zero. Rational policy should anticipate this, and stop investment of this kind early.
The research finds that the investment into renewable energy and other ‘clean’ capital is warranted, and that subsidies should be in place so that this investment is at a higher level than would be stimulated by only a carbon price. Moreover, an early exit from fossil fuels should go hand in hand with a temporary increase in subsidies to renewables. As expected, a combination of carbon price and subsidies is the most cost-effective approach for meeting ambitious climate change mitigation targets. If only one policy is available, a carbon price performs better when the carbon targets are stringent, but a subsidy to renewables is a more cost-effective way to meet mild climate policy goals.
Key points for decision-makers:
- Climate policies like the Paris Agreement set goals that impact the value and returns of investments in fossil fuel-using power plants.
- Continuing investment in coal-fired power plants risks stranding capital as once capital is installed (through the construction of a power plant) it has no value unless used in production.
- Using a simple model this research finds that all investment into the construction of coal-fired power plants must stop in 2020 in order for the Paris goals to be met.
- Existing coal plants can continue to be used until 2045, after which capital invested in coal will be underutilised.
- The research also finds in a time of more stringent climate policy (e.g. fourth and fifth carbon budget in the UK), strong carbon pricing becomes the preferable instrument to facilitate demand for climate-resilient infrastructure and energy assets.
- Under less ambitious climate policy, using subsidies alone can stimulate the development of clean technologies. Once competitive, they would then crowd out the dirty energy sector. For less ambitious climate targets this is less costly than carbon pricing.
- The research also shows that demand-side effects can accelerate the rate in which we withdraw from the dirty sector and increase deployment in the renewable sector, which also encourages the larger subsidies provided to the renewable sector.
ISSN 2515-5717 (Online) – Grantham Research Institute Working Paper series
ISSN 2515-5709 (Online) – CCCEP Working Paper series