'Carbon bubble' coming that could wipe trillions from the global economy

This transition will result in clear winners, importers such as China and the EU, and losers, exporters such as Russia, the USA or Canada, which could see their fossil-fuel industries nearly shut down. If these countries keep up their investment and production levels despite declining demand, the global wealth loss could be huge: 1-4 trillion dollars, a loss comparable to that which triggered the financial crisis in 2007. Even the USA could not pull out from the transition, as it would only hurt itself even more. Global climate policy is therefore no longer a 'prisoner's dilemma' game. These findings by researchers from Radboud University, the University of Cambridge (C-EENRG), Cambridge Econometrics, The Open University (UK) and the University of Macau are published in Nature Climate Change.

A dangerous 'carbon bubble'

Several major economies rely heavily on fossil-fuel production and exports. The price of fossil-fuel companies' shares is calculated under the assumption that all fossil-fuel reserves will be consumed. But to do so would be inconsistent with the tight carbon budget set in the 2015 Paris Agreement, which limits the increase in global average temperature to 'well below 2°C above pre-industrial levels'. So far, this prospect has not deterred continuing investment in fossil fuels because many believe that climate policies will not be adopted, or at least not in the near future.

However, and crucially, researchers now show that ongoing technological change, by itself and even without new climate policies, is already reducing global demand growth for fossil fuels, which could peak in the near future. New climate policies would only aggravate the impact. Continuing investment in fossil fuels is therefore creating a dangerous 'carbon bubble' that could burst, with massive economic and geopolitical consequences.

Winners and losers

The scientists modelled the decline of demand for fossil fuels using novel modelling techniques that track the diffusion of low-carbon technologies on the basis of empirical data. Examples are technologies in power generation, cars and households that become more efficient and therefore diminish the use of fossil fuels. They then tracked what this means for national economies, as some economies lose an important industry (mostly due to loss of competitiveness), while other economies get rid of high current fossil-fuel expenditures and imports. "This means that by 2035, Gross Domestic Product (GDP) growth is affected negatively in producer countries (e.g. USA, Russia), while it is affected positively in importing countries (e.g. EU, China)," Dr Jean-Francois Mercure of Radboud University/C-EENRG explains.

'Free-riding' climate change mitigation: good or bad idea?

With the USA's withdrawal from the Paris Agreement, the scientists also modelled what would happen if the USA did indeed continue to invest in fossil-fuel assets instead of diversifying and divesting from them. The analysis shows their GDP would be reduced even further. Dr Mercure clarifies this point: "With a declining global fossil-fuel demand, fossil-fuel production in the USA is becoming uncompetitive, and may shut down. If the USA remains in the Paris Agreement, it will promote new low-carbon technologies and reduce its consumption of fossil fuels, creating jobs and mitigating its loss of income, despite losing its fossil-fuel industry. If it pulls out, it will nevertheless lose its fossil-fuel industry, but by not promoting low-carbon technologies, will miss out on job creation opportunities, while increasing its fossil-fuel imports by not reducing its domestic fossil-fuel consumption. The outcome is therefore worse if the USA pulls out."

A new financial crisis?

The study findings support the existence of a carbon bubble which, if not deflated early, could lead to a discounted global wealth loss of between 1 to 4 trillion dollars, a loss comparable to what triggered the 2007 financial crisis. "If countries keep investing in equipment to search for, extract, process and transport fossil fuels, even though their demand declines, they will end up losing money on these investments on top of their losses due to limited exports," Mercure explains. "Countries should instead carefully deflate the carbon bubble through investment in a variety of industries and steady divestment. The way in which this is done will determine the impact of the ongoing low-carbon transition on the financial sector."

Hector Pollitt, study co-author from Cambridge Econometrics and C-EENRG, adds: "This new research clearly shows the mismatch between the reductions in fossil fuel consumption required to meet carbon targets and the behaviour of investors. Governments have an important role to play in emphasising commitments to meet the Paris Agreement to ensure that the significant detrimental economic and geopolitical consequences we have identified are avoided."

Divestment and creative destruction

The process of transition towards a low-carbon economy is now becoming inevitable, as policies supporting this change have been developed and gradually implemented for some time. "New efficiency standards imply that we do more with the same amounts of energy, as older, less efficient technologies are gradually phased out. The transition is therefore irreversible; however its pace can vary according to whether and how new climate policies are implemented."

The scientists conclude that further economic damage from a potential bubble burst could be avoided by decarbonising early. "Divestment is a prudential thing to do. We should be carefully looking at where we are investing our money. For instance, much like companies, pension funds and other institutions currently invest in fossil-fuel assets. Following recommendations from central banks, commercial banks are increasingly looking at the financial risks of stranded fossil-fuel assets, even though their possible impacts have not yet been fully determined. Until now, observers mostly paid attention to the likely effectiveness of climate policies, but not to the ongoing and effectively irreversible technological transition. This level of 'creative destruction' appears inevitable now and must be carefully managed," Mercure concludes.