Horizon | Jan 2022

Wood Mackenzie’s base-case Energy Transition Outlook sees global temperatures 2.5-2.7 °C above pre-industrial levels by mid-century. To limit this warming to 1.5 °C, in line with the Paris Agreement, the energy transition must accelerate. The world has the means, motive and opportunity to do so. An accelerated energy transition will pay off - both in economic and planetary terms. But it’s going to take time. Our analysis suggests that much of the lasting economic benefits will materialise beyond our forecast horizon of 2050. Preventing more extreme warming is likely to have a positive economic impact over the next three decades, by avoiding damage caused by rising temperatures. But the actions required to deliver it could have an offsetting negative effect. Based on a review of existing economic studies on climate damage and the impact of mitigating global warming, we estimate that keeping warming to 1.5 °C would shave 2.0% off our base-case gross domestic product (GDP) forecast for 2050. As new transition technologies – electric vehicles, utility-scale batteries, hydrogen and carbon capture and storage – come down in price over time, there will come a point when low-carbon investments are more competitive than phased-out high-carbon alternatives. We think the turning point will be around 2035, after which global GDP growth will outpace our base case, meaning lost economic output could be recouped by the end of the century. Some economies will feel the effects more than others. Hydrocarbon-exporting and carbon-intensive economies are likely to see the biggest hits to economic output. Less developed and low-income economies will bear a disproportionally high burden. Climate finance for lower-income countries, including government transfers and private sector investment, can help address inequity. But a truly fair and just transition will require actions to exceed our current expectations. Economies that are already closer to net-zero targets will see a smaller economic impact from now to 2050. For a fortunate few, the transition need not result in economic loss at all. Those that are better positioned – typically wealthier economies with a strong propensity to invest in new technologies – may even benefit economically by 2050. Some countries facing the greatest burden from the costs of a 1.5 °C pathway are also among those expected to see the fastest growth in population over the next 30 years. The effect on population is one of the many uncertainties of climate change. If limiting global warming lifts population growth, in per capita GDP terms, the cost of decarbonisation could be even greater.

HORIZONS

No pain, no gain:

The economic consequences of accelerating the energy transition

January 2022

Peter Martin, Head of Economics Yanting Zhou, Principal Economist

Contents

No pain, no gain Bigger-picture scenarios The transitional trade-offs So, where will it hurt most? The likely winners The potential losers Short-term pain for long-term gain

1. 2. 3. 4. 5. 6. 7.

Bigger-picture scenarios

Under our base-case outlook, the global economy is set to double in size in real terms - from US$85.6 trillion to US$169 trillion* - by 2050. Accelerating the energy transition will inevitably alter this trajectory. The economic impacts of climate change and efforts to prevent it are complex, however. In this relatively new field of economic research, methodologies and expected outcomes vary greatly. Amid myriad unknowns and high uncertainty, the magnitude of impacts is hotly debated. In a new economic analysis developed for this issue of Horizons, we created a framework for assessing the distribution of economic impacts at national and regional level. It is in line with our Accelerated Energy Transition (AET-1.5) scenario, which shows a possible energy system that would be likely to limit global warming to 1.5 °C. The analysis brings together the two main strands of economic research on climate change: the effect of global warming and the ramifications of trying to mitigate that warming by reducing carbon emissions. While this is a framework for quantifying the economic impact from this point forward, over 2022 to 2050, it should be noted that climate damage and mitigation efforts have already been imposing costs and benefits on the global economy for some time and they will continue to do so beyond 2050, too. Our top-down approach is based on a review of existing economic studies. Collating third-party results on climate damage impacts, we estimate that avoiding a higher temperature increase could boost global GDP, on aggregate, by 1.6% in 2050. At the same time, however, the actions required to successfully mitigate global warming to 1.5 °C could knock 3.6% off GDP in 2050.

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The transitional trade-offs

Governments committed to meeting net-zero carbon targets generally promote the positive impact on the economy of the investment and job creation the energy transition will bring. We estimate the required investment in power supply and infrastructure, alone, to be at least US$50 trillion. However, investment in the transition is not all upside. There are trade-offs. Transition investment offsets some investment in hydrocarbon alternatives. Job creation in low-carbon industries will be offset by lost jobs, profits and tax revenues in higher-carbon sectors. Furthermore, at least initially, nascent transition technologies will be less competitive than traditional alternatives. To achieve emissions consistent with limiting global warming to 1.5 °C, action needs to be heavily front-loaded in the years to 2030. Therefore, we expect the value added by new transition investments to underperform foregone traditional investments in the early stages. But as new technologies become cheaper over time, there will come a point when high-carbon and low-carbon investments are competitive. Further losses arise from write-downs on hydrocarbon assets as prices fall. Some assets are stranded entirely. The introduction of carbon pricing and trading also pushes up price levels by internalising the externality of carbon emissions. This brings inflationary pressure, impacting the cost of capital as interest rates rise accordingly to contain inflation. A turning point is reached after 2035. Under our 1.5 °C scenario, global GDP growth outpaces the base case, kick-starting the slow convergence of GDP levels. Lost economic output is eventually recouped before the end of the century.

Conclusion: Short-term pain for long-term gain

Limiting climate warming to a global average of 1.5 °C above pre-industrial levels is imperative if the environmental and humanitarian crises wrought by extreme temperature increases are to be avoided. Should the weak pulse of a 1.5 °C pathway transform into a thumping heartbeat, it will be positive for the environment and for humanity. There will be tangible economic implications, however. While global economic output is likely to take a hit in our forecast horizon to 2050, it could be recoverable by the end of the century. The spread of the impact will be uneven, with low-income economies and hydrocarbon producers suffering bigger losses than developed economies. The real damage will be seen on a per capita basis, exacerbating existing global inequalities. Curbing household income growth makes shifting consumption choices to more expensive lower-carbon products even harder. But an accelerated transition could pay off in the end, in economic terms. It is likely to lead to stronger economic growth rates for some economies beyond 2030, enabling their losses to be recouped before the end of the century. That is the essence of transition economics – short-term pain for long-term gain.

No pain, no gain The economic consequences of accelerating the energy transition

So, where will it hurt most?

Some economies are more exposed to climate risks than others. To assess the distribution of the economic impact, we score all economies on their exposure to climate-related risk. These risks include rising sea levels, enforced migration and extreme dry or wet climates. The economic costs incurred by climate-related events since 2000 give a glimpse of future risk.

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Andrew Brown

Head of Polymer Demand

Andrew heads the polymer demand modelling team, forecasting across multiple value chains. His work includes identifying and analysing trends across sustainability, recycling and consumer preferences to develop and integrate base case and alternative scenario views for the future. Andrew joined our Chemicals team in May 2018, and has played a key role in creating market research products for chemistries throughout the chlor-vinyls chain. Prior to joining Wood Mackenzie, he was an Integrity Management Engineer for National Fuel Gas Company, managing 2,000 miles of transmission pipeline facility risk and supporting business strategy development.

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Yanting Zhou

Principal Economist

Yanting leads our in-house macroeconomic research for Asian economies, working closely with commodity teams across the company to align macro views and commodity demand. She joined Wood Mackenzie in 2015 as a copper demand analyst and draws on her knowledge and experience of commodity end-use markets in China and major economies in Asia, which extends to the property, electrical network, transportation, machinery and appliance sectors. Yanting started her career in the natural resource industry in Rio Tinto‘s Economics and Markets team, where she focused on the economic outlook for China and long-term metals demand analysis.

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Peter Martin

Head of Economics

Peter joined Wood Mackenzie in September 2010, initially covering European energy markets before moving to the macroeconomics research team in 2011. Responsible for producing Wood Mackenzie’s macroeconomic outlook to 2050, Peter is experienced in forecasting key macroeconomic metrics such as GDP, Industrial Production, FX and inflation. Peter regularly develops macroeconomic scenarios and sensitivity analysis. Examples include Brexit, banking crises and trade wars. He has also contributed to consulting projects, assessing the economic impact of oil and gas development. An area of special interest is the fiscal stability of oil-producing economies in the Middle East and Africa. Before joining Wood Mackenzie, Peter was an energy analyst at Iberdrola for three years. In this role he was responsible for providing technical and fundamental analysis of European energy markets to the trading desk.

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Figure 4: Resilience to climate change

Source: Wood Mackenzie

Avoiding more extreme climate change reduces the cost of adapting to it. Countries need fewer processes and structures to protect against rising sea levels, storms, drought or changes in biodiversity. Capital destruction caused by extreme weather events is lower, so insurance costs are less punitive. Other benefits include less soil degradation for better agricultural yields, fewer pandemics and emission-related illnesses. Reduced heat stress on the labour force drives higher labour productivity, along with less chaotic migration due to rising sea levels and uninhabitable climates. Those economies most resilient to climate change could benefit from some global warming. Northern European countries, such as Finland and Sweden, are more likely to fall into this category, benefitting from higher productivity. By reducing the increase in average global temperatures to 1.5 °C, therefore, they could see an economic loss.

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Resilience to climate change

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Figure 1: Global GDP impact compared to base case

Source: Wood Mackenzie

Figure 2: % Share of US$75 trillion economic loss by 2050

Source: Wood Mackenzie

34%

27%

11%

12%

7%

5%

4%

Figure 3: Turning point: growth picks up after 2035

Source: Wood Mackenzie

Most resilient

Least resilient

Successfully mitigating climate change will entail shifting economic activity from high- to low-carbon-intensive sectors. Becoming a net zero-carbon global economy will be disruptive. Carbon emissions will be dramatically reduced as fossil fuels are displaced by renewables in the energy supply, transportation and virtually all sectors of the economy. We score economies on their potential to decarbonise and thrive in the transition, to determine the distribution of impact by country. The current carbon intensity of the economy, reliance on hydrocarbon income, transition potential and wealth are major factors.

The effects of avoiding climate change

The likely winners

Economies with high renewable penetration of power generation and advanced power grids are well set for the clean electrification revolution. Having a national resource of the building blocks of energy transition – such as copper and battery raw materials such as lithium and cobalt – is also an advantage. So, too, is a presence in new technologies and future large-scale energy sources: electric vehicle production, utility-scale batteries, carbon capture and storage (CCS) and hydrogen. Furthermore, wealth and a culture of high research and development (R&D) investment to lead the creation of transition technologies are important; rich economies are more likely to prosper. Averting extreme temperature increases brings significant environmental and humanitarian benefits that are difficult to quantify. Coupled with the difficulties and uncertainties of modelling many decades into the future, it is complicated to assess how to accelerate the transition in the most economically efficient way. This is a headache for policymakers and market participants alike, with implications for the design of climate and transition policies and the allocation of investment. Economies that are more advanced towards net-zero targets will see a smaller negative economic impact between now and 2050. Furthermore, the transition need not be an economic cost for a fortunate few. France and Switzerland will enjoy a modest net boost to economic growth by 2050. Those that are better positioned are, typically, wealthier economies with deep capital markets and a high propensity to invest in new technologies or an existing presence in nascent transition sectors.

Figure 5: Total GDP impact in 2050 versus base case and national carbon intensity (2018)

Source: Wood Mackenzie, World Bank

The potential losers

Hydrocarbon-exporting and carbon-intensive economies will incur the biggest losses of economic output. The Middle East has some of the lowest-cost oil assets in the world and it is likely to hold on to a sizeable share of the remaining oil production in an accelerated transition. However, government finances would be severely strained by what is likely to be a precipitous decline in oil demand and price. Currently, most oil-producing economies in the region need Brent oil prices of more than US$60/bbl to balance their government budgets. Minimising the economic shock of the energy transition relies on diversifying economic activity. To this end, some, such as Saudi Arabia, have large stocks of financial reserves and sovereign wealth to invest in non-hydrocarbon sectors. Others, such as Iraq, do not. Iraq is the country most vulnerable to the energy transition, with hydrocarbon revenues accounting for 95% of all government revenue and the oil sector making up 36% of GDP. An accelerated energy transition would slash Iraq’s GDP by 10% in 2050 versus our base-case outlook. Less developed and low-income economies will bear a disproportional burden when it comes to the cost of transition. Developed economies are committed to climate-finance transfers worth US$100 billion per year to developing economies for climate change adaption and mitigation. But we don’t envisage this equalising the impact of transition around the world. It won’t address the dividend that developed economies have had from powering economic growth by burning fossil fuels for over a century, which developing economies can’t repeat now. The developed economies will have to do more to level up impacts if there is to be a truly fair and just transition.

China is facing the greatest potential GDP loss in absolute terms in a 1.5 °C world, of US$20 trillion to 2050. There are few economies to which the transition poses such mixed prospects. As the world’s largest carbon emitter and an energy-intensive economy, its decarbonisation challenge is colossal. But China has many advantages and, in many respects, is ‘transition ready’, producing more than 50% of the world’s solar and wind technology, electric vehicles and three quarters of all lithium-ion batteries. Exporting these to other countries will have economic benefits. US: Re-joining the Paris Agreement and passing the US$1.2 trillion infrastructure bill in 2021 gives fresh impetus to the energy transition. But partisan politics place a big question mark over the US’s ongoing commitment. The 1.5 °C scenario relies on resolute support from the White House to meet net zero by 2050. We estimate such a scenario could cost the US economy a cumulative loss of US$9 trillion by 2050 which is equal to 1.2% of total economic output over the period. India needs to accelerate its net-zero goal to 2050 from 2070, as pledged at COP26, to align to a 1.5 °C world. While India faces hefty mitigation costs, it is also very vulnerable to climate change. Climate change is already imposing economic costs on the economy, as the protracted monsoon season in 2019 showed. The gains from avoided climate damage temper India’s overall impact from transition. Europe: has already paid for some decarbonisation. The EU Emissions Trading System started in 2005, and by early 2022 was pricing carbon emissions at US$99/tonne. It has helped the EU cut carbon emissions by about a quarter since 2005. In our 1.5 °C scenario, Europe pursues an aggressive transition to 2030 and it pays off as GDP growth outpaces the base case beyond 2035. However, recouping the US$8 trillion loss of economic output could take until 2080.

Everyone will feel the pain somewhere

One of the greatest challenges in decarbonisation is meeting the growing demand for energy services created by rising living standards and a growing world population. In our base case forecast, the global population increases from 7.8 billion in 2021 to 9.7 billion in 2050. Some of the countries and regions that are facing the greatest burden from the costs of a 1.5 °C pathway are also among those expected to see the fastest growth in population over the next 30 years. The effect on population is one of the many uncertainties of climate change. Lowering global warming could have health benefits from fewer pandemics and respiratory diseases, pushing up life expectancy. Fertility rates might benefit from reduced heat stress and greater optimism about the future. If limiting global warming does lift population growth, in per capita GDP terms, the cost of decarbonisation would be even greater.

Population – a complicating factor

Source: Wood Mackenzie

Figure 6: Total GDP and GDP per capita versus base case in 2050

Lower income weakens household purchasing power at a time when consumption needs to shift to lower-carbon products. As these products are likely to be more expensive than the alternatives in the beginning, the impact on household consumption could be compounded.

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than traditional alternatives

nascent transition technologies will be less competitive

initially,

A turning point is reached

after 2035

Avoiding more extreme climate change reduces the cost of adapting to it

it is complicated to assess

how to accelerate the transition

in the most economically efficient way

Iraq is the country most vulnerable to the energy transition

* All GDP values in real terms: constant US$ prices and exchanges rates 2010

HORIZONS

The net result is a 2.0% hit to our base-case forecast of global GDP in 2050. In our 1.5 °C scenario, annual global GDP hits US$165 trillion in 2050. The cumulative loss of US$75 trillion over 2022 to 2050, while material, amounts to just 2.1% of total economic output over the period. Accelerating the energy transition is possible without drastically deviating the trajectory of the global economy. However, many factors will influence global GDP over the next 30 years, including unknown unknowns, and it is important to recognise at the outset that the outcome may vary significantly, for better or worse. What’s not in doubt is that the economic impacts of energy transition won’t be felt evenly; there are marked differences in how countries will fare. To determine the distribution of the GDP impact, we assess countries on their resilience to climate change and the impact of actions to avoid it.

Missed our previous editions of Horizons? Download them here.

Edition 10 | Oct

Edition 9 | Sept

Edition 8 | Aug

Edition 7 | Jul

Edition 6 | Jun

Edition 5 | May

Edition 4 | Apr

Edition 3 | Mar

Edition 2 | Feb

Edition 1 | Jan

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Edition 11 | Nov