Green Carrots and Sticks: Incentivizing Climate Solutions

Michael S. Falk, CFA, and Joachim Klement, CFA, are the co-authors of Capitalism for Everyone from the CFA Institute Research Foundation.

Climate change remains a key issue to solve in the coming decade. We say decade because any longer may already be too late.

We all will have to pay a price for burning fossil fuels, but unfortunately the bulk of that price will not be paid by those who burn fossil fuels. It is a classic problem of a negative externality: The profits of an activity — in this case, burning fossil fuels to generate energy — are privatized, while the costs, to human health and the environment, are socialized.

In theory, we know how to deal with these issues. We can either regulate the activity, as President Richard Nixon did with the creation of the Environmental Protection Agency (EPA) to reduce air and water pollution in the 1970s. Or we can internalize the costs by putting a price on carbon credits or instituting cap-and-trade programs as is common across Europe and is now being introduced in China.

The problem with these approaches is that they are green sticks. They restrict freedom of enterprise and thus are, let’s say, not very popular with the companies that burn fossil fuels. But that does not mean we care about popularity as much as we care about incentives. Big Oil’s resistance to environmental regulation and carbon pricing in the United States has been enormous, though recent events at Exxon and Shell indicate that it may be losing the fight.

Nevertheless, the current price of carbon emissions is generally too low, and is at best 50% of what it should be, according to estimates. Carbon emitters spend a lot lobbying to keep that cost well below the threshold required to encourage the fast and effective change that’s needed to avoid climate change’s worst outcomes.

But regulations will have to go even further than carbon pricing. Do we also need rules to help prevent and manage the risk of stranded assets? In a word, yes.

That got us thinking. . . . Instead of using green sticks to force change, why don’t we use green carrots to entice change? After all, these approaches are not mutually exclusive.

One way to introduce green carrots is to create a market for royalties from R&D into renewable and sustainable energy. Both the oil and gas and mining industries are already among the top developers of green technology patents, yet monetizing this research is difficult. A company can either use the knowhow and roll out the technology in-house, or be stuck with it.

Meanwhile, a mining company that builds a new mine can sell that mine’s future production to royalty companies in return for a lump sum payment. For the royalty company, it is the equivalent of buying an annuity financed with the production of the mine. By the way, the greening of so-called dirty industries has perhaps the greatest potential to counteract climate change.

In the biotech space, companies have already specialized in financing intellectual property (IP) in return for a share of the revenues generated from the finished product. Why is there no such system in place for green technology development?

Right now, US taxpayers receive a tax break for investments in oil exploration projects. Why don’t we close this tax loophole and use the money raised to pay super royalties to energy and mining companies that develop green technologies?

Alternatively, we could support dedicated royalty companies in the green technology space to open a new market. Investors could then invest in the shares of these green tech royalty companies and earn a profit from changing the world instead of saving taxes on burning it.

We could even go a step further and learn from successful venture capital (VC) models in countries like Israel. Today, Israel is one of the world’s leading tech hubs and much of the credit goes to the government-funded business incubator Yozma. In 1993, the government established Yozma by seeding it with $100 million in capital. Yozma supported early-stage ventures in exchange for a stake in the projects of up to 40% — provided private investors financed the rest. After seven years, the investors could pay back the government support from Yozma at face value plus interest. It worked, and in 1998, the VC market in Israel grew large enough for Yozma to be privatized.

This effectiveness of providing a carrot for investments should not be underestimated. Today, Israel spends more on R&D as a share of GDP than any other nation and is second only to the United States in terms of venture capital investments relative to GDP. Israel used carrots to transform its rusty 1990s economy to a modern high-tech one. Why can’t the United States use the same approach to accelerate its transition from a carbon-based economy to a green one and ask Big Oil to lead the way?

If the carrots are tasty and the incentives are right, oil and mining companies will gladly invest in green technologies. The old adage of doing well while doing good is the way forward for all of us.

And while we may first think of sticks, we should never forget the appeal of carrots.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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