Four Challenges for Fossil Fuel Producing Countries in the Low Carbon Transition

President Biden’s announced target to achieve a 50 percent reduction in greenhouse gas emissions within a decade is a tremendous boon to the Paris Climate Agreement goals. Without diminishing the positives of this reset of US policy, it is still important to remember that, with any seismic shift, there will be winners and losers. Recent research has discussed the emerging challenge of fossil fuel producing countries, which risk losing entire swathes of their economies’ production capacities, and thus their wealth. We believe the following four challenges are of particular importance:  

1. Assessing the macroeconomic implications for fossil fuel reliant countries, taking into account the timeline of the transition
2. Modelling the various price dynamics that could occur as the demand for fossil fuels declines
3. Economic diversification of such countries
4. Identifying whether there are scenarios in which the international community should compensate states for voluntarily stranding their fossil fuel reserves

To assist these countries, addressing these issues will soon be an increasingly important area of work for large multilateral institutions like the IMF and the World Bank (e.g. Chapter 5 of Changing Wealth of Nations). These challenges were identified in a private seminar hosted by the Center for Global Development, which facilitated a discussion on the latest research in this area, sharing ideas on where more work is needed. The aim was to integrate the valuable work being done by climate change think thanks into the IMF surveillance and program work with carbon-exporting economies.

The seminar opened with presentations from NRGI and Carbon Tracker. Carbon Tracker presented on their report Beyond Petrostates, which quantifies a country’s vulnerability to carbon transition risks along two main dimensions, its dependence on fossil fuel revenues and its fossil fuel production costs, since low-cost producers may weather the storm longer. Vulnerabilities also arise from the following:

• debts incurred to finance fossil fuel projects whose Net Present Value may be diminishing because of anticipated demand reductions
• population sizes,
• measuring livelihoods at risk
• financial profile (the borrowing costs and fiscal flexibility of vulnerable countries),
• and countries’ score on the Human Development Index (suggesting that the countries most at risk also have high poverty rates, thus indicating the vulnerability of the poor)

NRGI presented their report on the challenges posed for national oil companies in the energy transition. The post-tax break-even prices for many of their investments exceeds projected fuel prices that would be consistent with the Paris goals. As these companies are publicly financed, failed investments impact the public purse. Furthermore, their financial operations are often opaque and have multiple, conflicting responsibilities and only weakly accountable.

The discussion that followed focused on the four analytic challenges mentioned above to help countries prepare for a low carbon future.

Transition risk and timeline

Though there is a considerable amount of research on the risks of stranded assets to the financial markets and investors, there is still a gap within the literature on the quantification of transitional risks on macroeconomic indicators, particularly for developing countries reliant on fossil fuels. The EBRD and UNFP have previously provided practical guidelines for quantifying these transitional risks.

The transition could impact sectoral composition, exchange rate, employment, fiscal revenue, and gross domestic product (GDP). The IMF could play a significant role in bridging this gap, particularly because these impacts could spillover to other states and the global economy, via political instability, migration, or increased sovereign credit risk. According to NFGS, integrating climate-economy models with scenario analysis could lead to different plausible macro-financial scenarios in order to evaluate various possible outcomes.

Incorporating different time horizons into the analysis of transitional risks, particularly stranded assets, is crucial. For some countries (like Bahrain and Oman) with small resource deposits, their assets might be depleted before these risks materialize. Others with larger deposits are exposed for longer. There is also the prospect of these risks manifesting earlier than the 20-to-30-year window that the Paris goals imply. Financial markets are forward looking and could pre-empt these changes in resources, divesting before the transition manifests fully. Norway is an early leader in anticipating these risks, implementing carbon stress testing on carbon fuel-based projects to assess their exposures to these unknown dynamics.

Price Dynamics

The narrative of the transition risks is that over the longer term, as demand for fossil fuels decline, higher cost producers will be priced out of the market first. But the micro dynamics beneath those broad strokes is important. A contracting market could lead to price wars, with low oil prices followed by longer periods of price surges as suppliers are pushed out and supply reduced. Oil prices, already volatile by nature, would likely be even more variable during such a “shake-out” process. Which producers survive would not just be determined by production cost, but also by other factors such as financial resources (to hold out longer), vulnerability to a drop in demand, and the extent of the dependency of other sectors. Analysis of possible price dynamics would be important in understanding countries’ short to medium term vulnerabilities.

Diversification

The transition heightens the need for diversification, which is already a challenge for many of these economies. This has been a goal of resource dependent countries for some time, and an important strand of literature has emerged on the idea of the resource curse. But diversification is a broad concept. In some cases, there is a potential for “dirty diversification” where for instance, a move away from oil and gas to certain types of mining could be just as destructive to the environment. In other cases, with low oil prices, there could be a potential for the reversal of Dutch disease which will stimulate the growth of the manufacturing sector, particularly for gas and coal producers. There is also some misunderstanding at the policy level, with some viewing diversification as an “add on” project, or work stream, rather than a holistic, transformative project for the whole economy, requiring sacrifices and shifts in the status quo that many governments would be unable or unwilling to spearhead.

Pursuing diversification touches on sensitive policy areas, particularly in fossil fuel rich countries where the political, economic, and social actors enable strong dependency on the sector, for instance, through the political influence of the extractive sector. Lack of structural planning strengthens the expectation of the private sector and political actors that business-as-usual will continue, reducing the possibility of a transition. Hence, a more comprehensive planning approach is needed, which could overlap with industrial policy, an idea long tainted in policy circles by its association with some highly interventionist central government policies of the mid-20^th century, which were thought to gravely undermine the operation of markets. But industrial strategy in a different form has gained greater acceptance in recent years. The “New Industrial Strategy” approach is about policy space, governments and private sector cooperating, and a learning environment with scope to experiment and let failures go. Well-designed industrial policies and sectoral targeting are more accepted today than in the past.

Compensating for stranded assets

A further idea floated was that fossil fuel-producing countries might be compensated by the international community for stranding their fossil fuel assets voluntarily. For instance, the government of Ecuador, through the Yasuní-ITT Initiative, asked the international community to compensate for keeping an estimated 921 billion barrels underground, which could have led to saving 410 million tons of C02 and protecting one of the most diverse nature reserves on the planet. Due to insufficient funds, the project failed and the drilling for oil recommenced. One of the reasons for its failure was because it was seen by some as setting a dangerous precedent, raising the costs of climate action for temporary asset stranding. This does not suggest that establishing such a scheme is completely implausible. Examples of successful policies that compensate for not using natural resources exist, namely the REDD+ initiative for forest conservation. However, it does suggest that it is necessary to learn some lessons from the challenges faced by Yasuní-ITT. Some have suggested the creation of a global fund which would keep reserves unexplored in areas of exceptional conservation value, for instance in terms of biodiversity, which are currently lying on top of fossil fuels. The costs and benefits of paying countries for underexploring their assets poses important and challenging questions which the international community must prepare to answer.

What is the role of the IMF?

A particularly important role for the IMF is to raise awareness of the risks of this transition with central bank governors and finance ministers of fossil fuel rich countries. Ministers in these countries may view this issue as peripheral or not significant but were these countries to truly accept that the overall context in which they are operating is one of declining fossil fuel volumes and prices, they could revise down their expectations and find the necessary solutions. The Fund also has a vital signaling role in advancing the agenda outside the government. Article VI consultations could provide a well-structured discussion on transition for such economies, adopting long-terms targets and timetables on GHG-emissions, energy pathways, economic impacts of policies such as carbon prices, and the necessary fiscal and macroeconomic policy changes. Though diversification is a challenging and broad concept, it is not a panacea. The IMF could play a significant part in in advising countries to ensure fiscal sustainability alongside diversification. Fiscal adjustments such as tax reforms and ending fossil fuel subsidies (global post-tax subsidies were estimated at $5.2 trillion in 2017) would be necessary. The IMF estimates that replacing the shortfall in oil revenue in the long term would require an effective tax rate on non-oil GDP to be 50 percent in the long term for GCC countries.

Given the IMF’s limited resources and the significance of these challenges, our private seminar demonstrated the importance of establishing partnerships with the World Bank and independent think-tanks that could offer their expertise in this area.

Conclusion

Our seminar showed that there is strong policy interest in understanding four particular challenges faced by fossil fuel dependent countries in the transition to a low-carbon economy. In particular, it is crucial to quantify the potential impact of the transition on macroeconomic indicators for countries which are disproportionally affected. Such analysis could assist fossil fuel exporters to adjust their policies now to preserve macroeconomic and fiscal stability. The international community must develop the required capacity to respond to challenging questions faced by such countries, including future fossil fuel price dynamics, diversification pathways, and potential compensation for stranded assets. In order to have a globally inclusive and just transition, it is crucial to have well thought out climate strategies and policies for fossil fuel dependent countries.

We would welcome any responses that point us towards work being done in these areas and in particular, on how the development community and large multilateral organizations can incorporate them into their approaches to this issue.