This article was written by Jessica Coria, senior lecturer, and Thomas Sterner, professor of environmental economics at the University of Gothenburg.
In 2015 member states of the United Nations adopted the Sustainable Development Goals (SDGs), mapping out ambitious objectives that mobilise efforts to end all forms of poverty, fight inequalities and tackle environmental degradation.
The SDGs are to be accomplished by 2030, and estimates indicate that over the next 15 years US$6-7 trillion in annual investment will be needed globally – roughly 1.5 times the yearly budget of the US government – to meet the demand for a global transition to an environmentally sustainable economy.
Achieving the SDGs will require countries around the world to mobilise capital at a time when global growth is slowing and overseas development assistance is declining.
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As a result, many governments are turning to the private sector as a source of new investment for green development projects. For instance, it is estimated that 85% to 90% of China’s green transition will be funded by private capital.
The speed at which the markets for green investments develop hinges, however, on many variables, including policy and regulatory factors and market conditions.
Indeed, regulations that mandate or incentivise private investments in environmental protection and are enforced by governmental institutions are a major driver of the demand for green investments.
For instance, it is widely acknowledged that introducing a price on carbon – either through a carbon tax or emission trading schemes such as the EU Emissions Trading System (ETS) – represents a precondition for filling the current gap in low-carbon investments.
A price on carbon would correct the market failure related to the exclusion of environmental externalities from the market pricing system, which makes it unattractive for the private sector to invest in green initiatives.
However, to steer the required amount of economic resources to green investments, the carbon price must be stable and credible and not subject to lack of policy commitment or to policy reversal.
This presents a challenge as many existing environmental regulations are subject to a great deal of policy uncertainty regarding their permanence and stringency, which reduces the profitability of green investment projects.
Evidence of this is provided, for instance, by recent empirical studies that have shown that policy uncertainty associated with adjustments of emissions caps can explain the precipitous price jumps on the EU ETS.
“The lack of political commitment to long-term emissions targets is at the heart of the problem”
The lack of political commitment to long-term emissions targets is at the heart of the problem. Since the perception among investors is that this political commitment is low, the sensitivity of prices to regulatory changes remains high. Policy uncertainty makes investment returns more volatile, which leads firms to cut their green investments or demand higher returns.
The fact that firms reduce their investment in response to policy uncertainty is well documented in the financial literature, yet people seem to forget that investments flowing into sustainable development projects and initiatives – so called green investments – are also a financial investment.
Public policy, including environmental regulation, has large economic effects that are largely non-diversifiable since they affect the entire market. Thus, even market-benevolent policymakers can increase risk by generating an environment of uncertainty about their policy decisions by, for example, unexpectedly changing the incentives to invest in renewable energies or the stringency of climate change targets.
Furthermore, the negative impacts of policy uncertainty are exacerbated when future expectations are for lax policy.
Therefore, to steer the world towards sustainable development, policymakers must implement credible and strong long-term environmental regulations.
Institutions for Sustainable Development
Decades of fighting inflation has taught us the benefits of autonomous institutions with a clear long-term mandate that is not directly subject to short-sighted political whims.
For instance, since the 1980s, policymakers envisioned a way to credibly commit to low inflation by taking monetary policy out of their own hands and placing it under the control of an independent agency – an autonomous central bank. Reforming the legislative framework for a central bank to be autonomous – often after an inflationary crisis – helped boost the credibility of monetary policy.
Numerous empirical studies have confirmed the efficiency gains generated by autonomous central banks. Studies have reported, for instance, the existence of an inverse relationship between central bank independence and inflation, as well as autonomy’s ability to reduce pre-electoral manipulation of the economy.
Unfortunately, we too often see sustainable development being jeopardised by political cycles, time-inconsistency and demagogic leadership. The need for autonomous institutions thus seems apparent, even in countries at the forefront of environmental protection.
Let us take, for example, the case of Sweden, whose overall environmental objective is to hand over a society in which the main environmental problems have been solved to the next generation.
To this end, in 1999, Sweden specified 16 environmental objectives – the so-called environmental goals – which are a promise to future generations of clean air, healthy environments in which to live and rich opportunities to enjoy nature.
Despite decades of attempts, so far only two of the goals (safe radiation environment and protective ozone layers) will be achieved by 2020, while the remaining 14 goals will not.
The lack of success in achieving the goals might be explained by many factors, but a clear explanation is the large trade-off between environmental protection and economic activity that might lead governments to compromise with environmental goals in the pursuit of short-run goals like employment.
The situation in several other countries is equally bad or often much worse.
Policy design for the long term
Climate mitigation is particularly prone to time-inconsistency since we humans have cognitive limitations when it comes to long-term issues such as climate change: we are myopic, tending to discount things in the future in favour of short-term reward.
Furthermore, the unequal distribution of power in society serves to further work against action for the long term, as it usually comes at a cost to the present incumbents. Thus, even if politicians are willing to implement stringent climate policies to induce firms to invest in low-carbon technology, once investments have occurred, they often want to reduce policy stringency to achieve other objectives, such as lower energy prices, redistribution and electoral success.
“Could real progress be made through a fundamental reform of our political institutions?”
Could real progress be made through a fundamental reform of our political institutions? In the scenario outlined above, it is tempting to implement a new form of governance, whereby key institutions are given agency to act with a single mandate to ensure that economic development is truly sustainable.
If the agency is a long-lived institution removed from short-term political pressures, concern for its reputation would provide it with an incentive to implement the commitment outcome, despite short-term gains from reneging.
The agency would have a mandate to use its economic instrument (e.g. setting a carbon tax or a number of carbon emission permits) to achieve an emissions target fixed (in advance) by the government. Appointing an “environmentalist policymaker”, much like the appointment of a conservative central banker, might resolve the time-inconsistency problem by allowing governments to credibly commit to their climate policies.
One has to recognise that the creation of new institutions – be they regional or global bodies for governance in general, or for particular issues like monetary or environmental policy – are prone to risk. Such changes to our democratic system are sensitive and must be done carefully and consciously.
Democratic oversight, accountability and transparency must be promoted, while the risks of corruption or policy capture need careful attention. Conflicts with other environmental (and other political) areas of priority need to be avoided or dealt with.
The interested reader is referred to a more general publication that we and other co-authors have written on how to design policies to respect the “Planetary Boundaries” that confront human society in its quest for expansion, in what has come to be known as the “Anthropocene”.
Jessica Coria and Thomas Sterner
Photo by Angela Benito on Unsplash