Michael Pollitt is Professor of Business Economics at the Judge Business School, University of Cambridge. He is an Assistant Director of the university’s Energy Policy Research Group (EPRG), a Fellow and Director of Studies in Economics and Management at Sidney Sussex College, Cambridge, and the Academic Co-Director of the Centre on Regulation in Europe (CERRE).
He is a former external economic advisor to Ofgem. He is a member of the editorial board of the Review of Industrial Organization, Competition and Regulation in Network Industries, Utilities Policy and The Energy Journal. He was a founding co-editor of Economics of Energy and Environmental Policy.
His research interests include productivity analysis, measurement of economic reform impacts and future electricity and carbon market design and regulation. Michael has a D.Phil. from the University of Oxford.
Professor Pollitt, thank you very much for this opportunity. It’s that time of the year again when everyone is looking at the outcomes of the COP event. How do you evaluate the result of this year’s edition? What was different, if anything? Has the pandemic changed anything regarding climate diplomacy and climate action/urgency/mobilization? What would you say is the most meaningful outcome?
The overall outcome has been quite positive in terms of making some substantive progress. I would take away the agreement to work towards phasing out coal, that has the potential to be very significant. It does, in a way, sign the death for coal, which is a significant part of the greenhouse gas problem. I would take away the positive commitment to stop deforestation. And, if that actually happens, that would be significant, relative to what might have happened. Then I think I would also pick out the Indian announcement of actually committing to a net-zero target, by 2070, and that’s because there was no net-zero target before. This is clearly very significant, for such a large share of the global population to be covered by net-zero. And then the final thing I would pick out is the joint declaration by US and China to work together on climate change, which I think in the light of generally poor international relations between these two major superpowers, is potentially very positive. Going forward and making sure that China is still part of the global process towards net-zero is really important.
Additionally, a positive outcome was the commitment to come back in a year’s time, because clearly five years is too long. We know it needs to be a much more active process of policy development and implementation. It’s just not realistic to be working on these five-year intervals, if you want to stay on track for any sort of net-zero, any time close to 2050.
What about the biggest failure of this year’s COP?
Not everybody came and that was disappointing. It was disappointing that China was not officially represented at the highest level. It’s disappointing that other countries like Russia didn’t come. But maybe that was to be expected in the current circumstances. And I think that as an economist, one is always disappointed that economic solutions to climate change weren’t more prominent. While there was some progress on standardizing the rules around carbon trading I didn’t really hear anybody discussing the extension of carbon markets and pricing in the context of net-zero consistent agreed overall GHG targets, which still is the only policy that could actually guarantee net-zero being achieved.
How do you get rid of coal from your energy mix? Well, we know how to do that, you just price carbon sufficiently high that coal gets priced out of the energy mix, that’s how we are going to leave coal in the ground. It would therefore have been nice to have seen more clarity around some of the policies that deliver on some of the promises.
Net-zero is a sum of domestic efforts and ambitions and 2050/2060 are the targets for reaching this goal. What are the main policy priorities to reach it and are they politically feasible? What are the odds for global net-zero in 2050?
The odds of the world reaching net zero by 2050 are still very low. They were low before COP and they are still low after COP. Net-zero by 2050 or even by 2070 remains an incredibly ambitious policy.
I’ve been involved in the modeling for the European net-zero plans by 2050. Even in Europe, you’re still talking about continuing massive scale-up of renewables. You’re talking about the development of hydrogen. You’re talking about a mass electrification of transport. You’re talking about a carbon capture and storage. After all that, you are still talking about direct air capture of CO2 to meet net-zero. So, you’re talking about scaling-up multiple industries at the same time. And we are not altogether clear that some of the technical problems have been solved in all of these new industries. We’re seeing prolonged wind lull in Europe as we speak, and that is illustrating that we might need a lot more wind [capacity] in less windy years or less windy decades, than in a typical year.
How would you manage that, within the existing design of the electricity market? Or even imagine the design of the electricity market? We’re still not really sure that we could do this consistently. We’re not really sure that we can scale up hydrogen or biomethane or synthetic fuels to anything like the level required, in the 29 years we’ve got left before 2050.
So, do I think it’s possible? Yes, the modeling tells us it’s possible. But do I think it’s at all likely? I would still say: not by 2050.
Speaking about markets, the challenges that we are already seeing, although we are at the beginning of this net-zero path. Gas and electricity prices spikes are seen as a crisis right now, with some actually calling for a rethink of climate policies. Do you expect this to have lasting effects, thus to be a recurrent phenomenon, a series of events that will basically slow down the transition to net-zero? What could be done to avoid future shocks?
Some energy shocks have unpredictable effects, don’t they? The oil shock of the 1970s and early 1980s led to a massive reduction in the oil intensity of advanced economies and economies around the world. So there is no doubt that very high prices for fossil fuels have major impacts on countries which use fossil fuels and increase the desire to move away from fossil fuels. And we know that one of the major motivations in Europe for rolling out renewables has been a desire to reduce imported fossil fuel dependence. So I don’t think high prices of fossil fuels are necessarily bad for climate change policy.
But we do need to distinguish between income and substitution effects, so the substitution effect of higher fossil fuel prices is to encourage low carbon fuel alternatives. The problem is that there’s also an income effect, which is the one that impoverishes people. It’s not totally clear how those two effects counteract each other. And people get more worried about the actual upfront costs of climate policy, as they’re actually feeling the pinch, just paying their current energy bill. But, I suppose the COVID crisis has been interesting, in one economic aspect, which is it has shown the ability of governments to mobilize huge amounts of money at very short notice, to deal with a problem. We shouldn’t forget that advanced economies still have the capacity to do that. They may not like it, in the sense that they have to pay for it for decades, potentially, but it’s still possible that with enough will, you can mobilize huge amounts of capital to achieve a big societal objective.
So, can it be done? With appropriate protection for poorer citizens, yes. Will it involve big political costs? Absolutely, and it will require widespread citizen support for a net-zero policy to continue. What is not clear is, when push comes to shove, if there will be a majority in every country in Europe in favor of climate policy, which is very costly. We’ve seen the political tensions created by climate policy in Australia and in the US, where support for climate action is more like 50/50.
When it comes to political support, we’ve been lucky so far in Europe that it hasn’t been 50/50, but as the costs rise, the support for going more slowly on climate policy is likely to rise. However, this may be counterbalanced by the fact that concern about climate policy may exogenously increase, because people actually see climate change happening and they still believe that governments can do something about it.
Obviously, the pace of this transition is the key to everything that we are discussing. As countries are phasing out their dependency on fossil fuels, others, like Russia, will probably develop an oligopoly, for instance with gas supplies to Europe or other regions. Will that transform even more this in a geopolitical leverage, in a geopolitical tool used from time to time, just to remind Europe or other regions to slow down with the transformation, with this high pace of the energy transition, as they are still using this important fuel for the winter periods?
I’m not sure. I think if you were talking to decision-makers in Russia and Saudi Arabia and trying to give them some advice you would say “Be very careful!”. They are dependent on fossil fuel income as well. We should never paint this as a one-way street. There’s mutual interdependence. They are dependent on their export markets being willing and able to pay a premium for their products. So, Russia is more dependent on European purchases of natural gas than Europe is dependent on Russian natural gas. And Russia would do well to remember that. Exploiting short-term opportunities for price hikes could mean you lose more money in the long run as a result of increased European commitment to more rapid decarbonization and getting off fossil fuels.
Once Europe has committed to more renewables or more green hydrogen it’s not likely it will ever go back. So I would think Russia or Saudi Arabia have a very careful calculation to make, to get your money while you can and avoid leaving too much oil and gas in the ground or risk bringing forward the end of European markets for fossil fuels in the interests of shorter run profits.
And we know that there’s a lot of supply-side elasticity out there. In terms of shale gas and oil, which can come to the market if prices are sufficiently high. And it can actually come quite quickly. So, I’m not sure that Europe should be worried in the longer run.
And Russia is perhaps much more rational than we give it credit for. What they want is for Europe to buy more natural gas, right? They don’t want us to buy less. They want us to buy more, because they can see that in the long-run they’re going to be left with a lot of natural gas in the ground. It’s not clear that some of the short-run policy that Russia seems to be engaged with isn’t entirely rational, if they are trying to maximize their long-run and gas revenue. I don’t worry about that. I’m more worried about any irrationality. Deliberately withholding gas when it actually impoverishes Russia: I’d be worried about that. Because, you know, that’s more difficult to deal with than a rational Russia.
About the evolution of gas/electricity prices. The merit order and everything we’re starting to hear from some Member States. Some challenges to the model of the electricity market that closes at the marginal price. What’s your view on that?
We’ve got to distinguish between the wholesale market and the retail market. They’re already substantially decoupled at the retail level. Thus, the price that final consumers pay depends on the portfolio of contracts that the retailer is holding, so increasingly we’re going to look more carefully at the retailer contract portfolio. What we’re seeing in the UK is companies that were engaging in quite an irresponsible business model, where they were purchasing on the monthly market and then selling a one-year contract. That was always a very risky strategy, if prices went up sharply in the short run market, and regulators need to look much more closely at those policies and those business models and actually say you can’t retail those sort of unhedged products.
Retailing has always been backed by a portfolio of contracts and we might need to look much more closely at that in the future. One of the interesting things is that if we purchase renewables through “contract for differences” (CFD) auctions, renewable auction prices will be reflected in the final retail price. The CFD payments are negative at the moment, so there’s money coming back to consumers as a result of these CfD contracts, because they have essentially bought the renewables’ output at a fixed low price. That goes through into the retail pricing model and results in lower retail prices than the marginal fossil fuel prices in the wholesale market would suggest, so there is going to be more and more decoupling of retail prices from wholesale prices.
Your question is still a good one. Should the wholesale price be driven by marginal pricing? Well, I think in most markets there’s more of a decoupling. People selling in the wholesale market are selling a portfolio of contracts. I think increasingly, we may see that.
I’ve been writing about the fact that we might see more “rationing” of electricity in the future by quantity rather than by price. The current model where we ration quantities by letting prices rise is probably an unsustainable model. I think we might want to change the market design, such that we have some sort of allocation mechanism for available renewable generation and that the allocation mechanism is not fully price-based. As you know, we’re talking about mitigating some of the price spikes and I think they’ll be a lot of social acceptability for that. This already happens in many electricity systems where there isn’t a proper wholesale market, and it’s not driven by short-run scarcity, and I think we might well move away from the wholesale market design that we’ve got at the moment towards something that’s more interventionist and is more politically acceptable than what we’re seeing at the moment.
Is this a step back from what is now described as a free market?
Well, I think it’s a different way of pricing. It’s a sort of “Internet-based” mechanism, like in many other markets, you fix the price and you let the quantity vary. It’s ok to either ratio by price or by quantity, within reason. I think if it’s socially acceptable to allocate quantities, according to some sort of priority order, just as we allocate available Internet capacity, and according to protocols, not real-time prices, then you can do that. And of course, the control algorithms are getting better and the ability to ration output to particular devices is going to increase over time and the ability for individual consumers to sign a contract where the deal is to keep my lights on all the time but check whether I’m actually drawing power on other devices which have got their own thermal inertia (e.g. a fridge or a freezer) or their own onboard storage (e.g. an EV) or are shiftable (e.g. a washing machine) and turn these down in reverse priority order. Consumers might sign a contract which looks like that and the impact of that is to begin to dampen wholesale price volatility.
So that actually differs from one market to the other from one country to the other, and I guess also the social acceptance will actually vary a lot – from France to Romania, from Sweden to the UK.
Yeah, well I think what may vary is the default contract. Because you can put everybody on a “rationing” contract as the default and then they have to pay more if they want to be on a “non-rationing” contract. Or you can offer “non-rationing” contracts as a default, but have “rationing” as the option.
The word alone rationing may ignite some very interesting discussions, for instance, in the Eastern part of the continent.
But it’s like in public healthcare. No government minister in the UK will come to a conference, which has rationing healthcare in the title, even though health care must be rationed in any national health system. So yes, we can change the name into “fair allocation” or ‘priority ordering’. That may be better branding.
What is your view on the circular economy model? Conceptually, do you think it is valuable in bringing together climate aspects with other environmental constraints? Do you see gradual changes towards the circular model as compatible with economic growth and development?
If by circularity you mean less material consumption, then yes. I think raising the price of energy and of carbon would seem to encourage that. Certainly, this will encourage certain types of circularity, non-energy intensive circularity because, of course, some types of circularity are very energy-intensive.
I think, in general, I agree that what we want is to use less material and to recycle materials more around the system. That’s certainly consistent with a net-zero climate policy. The first policy in net-zero is energy efficiency, so it’s the energy you don’t use, which is the most efficient energy. Similarly, the goods which you don’t make or don’t use up resources are going to be the ones that are the best.
One suspects that if you start systematically raising the price of goods which are heavy in material consumption and energy consumption, people will of course switch to goods which are less intensive in those things i.e. more information-based goods or personal services. One would expect to see that in a post-material economy, which as you know is what we hope that we are all moving towards. As we all get our one TV, smartphone and computer, we don’t really need any more of these devices. So, I very much hope that’s the sort of world that we’re moving to.
Picture credits: Judge Business School, University of Cambridge (LINK)