Posted by: bmeverett | November 11, 2010

McKinsey & Co Concludes that the Soviets were Right!

The key argument of the “Climate Change Community” is that science shows us with nearly absolute certainty that we are headed for doomsday as global warming accelerates in the next 20 years or so. Unfortunately, the actual evidence for this view is at best ambiguous. No matter, all scientists believe in catastrophic near-term man-made climate change. Well, maybe not all. Hal Lewis, Professor Emeritus and for Chairman of the Physics Department at UCal-Santa Barbara and one of America’s most distinguished physicists, recently resigned from the American Physical Society, calling its climate change position “a scam.”

The Climate Change Community keeps in its back pocket another argument which can be pulled out whenever the argument over science heads south. The argument goes like this: Don’t worry, it doesn’t cost very much to reduce carbon emissions anyway. Climate change treaties and legislation are just inexpensive insurance policies, even if the risks of catastrophic climate change are low. Exhibit A is a study by none other than the world’s premier management consulting firm: McKinsey and Company. In 2009, McKinsey published a study which claims to show that there are large carbon abatement steps which would actually save money and many more that would cost very little.

For those of you interested, you can download the full report at You must register, but there is no charge. The curve is on page 7.

This curve is impressive. Global carbon dioxide emissions are about 30 billion metric tons per year with most observers forecasting growth to about 40 billion tons by 2030. McKinsey claims that we could cut that by almost 10 billion tons (25%) with steps that would actually make money. Most of the rest of the carbon emissions could be eliminated with steps costing less than $70 per ton. That’s roughly $0.70 on a gallon of gasoline.

If that’s true, why are we arguing? Let’s just do it! Alas, the problem is not that simple. McKinsey’s work rests on two highly questionable pillars. First, the study assumes that, although entrepreneurs and venture capitalists work long hours seeking every possible profitable investment opportunity, they have overlooked tens of billions of dollars in highly profitable energy opportunities that a small group of (albeit very smart) consultants were able to find easily. This seems to me most unlikely. When analysts with no money at stake say that the market is wrong, they have usually missed some aspects of the problem that real-world investors understand. Investors are a hard-headed lot, not easily swayed by the accolades they would receive by putting their money into popular but unprofitable ventures.

Second, the study assumes that the correct cost of capital to use in evaluating carbon abatement investments is the 4% annual cost of 30-year Treasury Bills. All the carbon mitigation steps on the curve are assumed to be financed with borrowed government funds. Private investors must put up some of their own money and then convince potential lenders that their investment proposal is sound. If the investment goes bad, both the investors and the banks lose their money. Governments aren’t subject to that discipline. They have a low borrowing rate not because they are efficient investors, but because they have taxing power. They can make highly uneconomic investments and pay back their loans with your money. In fact, a logical extension of the McKinsey argument is that the cost of capital should be zero, since governments can raise investment capital directly from taxpayers without paying them any interest.

In essence, the low cost of borrowing disguises the true cost of government investments. All you need to look at is the Big Dig – the underground road project in downtown Boston, which was estimated in 1985 to cost $2.8 billion (about $6 billion in $2010) and ended up costing $14.6 billion – roughly $2,200 for every man, woman and child in Massachusetts. This would have bankrupted any private company, but government just borrows more money. Governments have a very bad track record in the commercial sphere. The McKinsey report assumes that government funds are distributed by highly trained energy experts looking for the most efficient means of carbon reduction, rather than by elected politicians looking to reward favored constituencies with someone else’s money.

Governments also have limited abilities to borrow money. If you don’t believe this, ask the finance ministers of Greece, Portugal, Spain, Italy and Ireland. We should understand this issue much better in the next couple of years, since President Obama seems bound and determined to find out how much debt the US can accumulate before its borrowing power is curtailed by bond downgrades.

The 4% cost of capital is a severe economic distortion of the cost of capital. I would be fascinated to see what the McKinsey curve would look like at a real market cost of capital. This distortion of capital costs is one of the major issues in our debate on alternative energy. Proper analysis requires the use of a market-based cost of capital in these evaluations – not a zero cost of capital, not a T-Bill cost of capital and not a regulated utility cost of capital.

What McKinsey is in essence doing in this report is making the case for a centrally planned economy, which is based on (a) the belief in massive widespread market failures in free-market economies and (b) the low cost and high efficiency of government-direct capital investment. Central planning is the worst idea ever developed by human society (with the possible exception of appeasing the gods through human sacrifice). It has cost hundreds of millions of people their freedom, their living standards and often their lives. That this argument should come from a pillar of the capitalist establishment is truly ironic.

How can we explain McKinsey’s defense of the economic foundations of the Soviet Union? All we can say is that consultants will be consultants. When clients want an answer and are willing to pay enough for it, consulting firms will be happy to oblige. The McKinsey study lists ten sponsors: three environmentalist groups (The Worldwide Fund for Nature, The Carbon Trust, and ClimateWorks); four energy companies (Shell Oil, Entergy, Vattenfall (a Swedish electric power company), and ENEL (the Italian state electric power company)) and three other companies (Volvo, Honeywell and Holcim (a Swiss cement company)). All have strong political and/or commercial interests in carbon mitigation technologies and would benefit from government programs subsidizing these technologies. The study also engaged an Academic Review Panel, composed of eight reliable members of the Climate Community – most notably Lord Nicholas Stern, author of the deplorable 2006 Stern Review of the Economics of Climate Change.

I really have no complaint here. I favor free markets, and McKinsey produced a product valued by its customers. It’s too bad, however, that McKinsey chose to degrade its reputation in the process.


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