Accelerating structural change in the early 21 st century

Manuel Pinho 1

This keynote lecture addresses accelerating structural change in the early 21st century. What are the driving forces? To what extent this time is it different? What are the main challenges? Who may be the winners and the losers?

1. Welcome to BEW 2017

BEW is an independent, non-partisan and non-for profit platform that produces an annual event in Beijing involving students and young professionals from all over the world. Its goal is to connect young professionals and graduates from top schools and engage a serious discussion on energy, sustainability and technology.

It is held at several prestigious venues in Beijing: Tsinghua and Beijing universities and the Beijing Yale and Columbia centers.

I created BEW in 2015 together with 2 of my most brilliant former students in the US. Sheng Yen now runs a Beijing based education group that is the main sponsor of BEW and Harsh Poddar is developing in India an ambitious group focusing on finance and energy.

I welcome the institutions that have accepted to host the event, the sponsors and the participants. In BEW 2017, we have participants from schools in China, the US and Australia and we will have a session at the EU delegation in Beijing. I am strongly committed to creating bridges between the young leaders of the future from different regions and countries and give them opportunity to express their views.

This event takes place in Beijing for 3 main reasons:a. China is the engine of growth of energy demand and the largest investor

in renewable energies and electric mobilityb. China, together with Europe, is leading the global effort to reduce CO2

emissions and avoid dangerous climate changec. More broadly, the center of gravity of the world economy moved to Asia,

it is not anymore in the West

The world is changing very fast in many aspects, all along from technology, dislocation of the center of gravity of the world economy, urbanization, climate awareness and energy sources. Although this is a unique opportunity to lift

1 Columbia University, Adjunct ProfessorBeijing Foreign Studies University, Top Overseas Teacher

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hundreds of millions of people from poverty it creates many challenges and involves risks.

I will talk about the main drivers of change using as much as possible practical examples and identify the main challenges ahead, with a special focus on China and in the US.

2. My first summer in Beijing

For many of the overseas participants, this will be your first opportunity to discover China. For me, it will be the 6th consecutive year that I spend the summer in China to learn about the country.

When I moved to the US in 2010, I was surprised with how little, poor and biased was the information about China, although a few years later the country became the largest economy in the world, as measured by GDP expressed in PPP. This is why I decided to visit the country on a regular basis to learn as much as possible and I do not regret it.

By then, China had also become the largest energy consumer, was heavily dependent on coal and the main engine behind the commodities super cycle and was the largest CO2 emitter. Fast forward to 2017, the growth of energy consumption is crawling, coal consumption has reached a peak, the price of fossil fuels in global markets collapsed and China became the largest investor in renewable energies and a champion of Paris COP21.

I will use energy and carbon emissions as an example to illustrate the scale and scope of the transformation that is taking place in China. The figure below shows that after a decade of breakneck growth of energy demand, coal consumption and CO2 emissions, they fell abruptly during the great recession, subsequently recovered, however they are almost flat for 3 consecutive years. Eventually, coal consumption has already peaked. 2

The reason is structural change; without understanding the scale and scope of structural it is impossible to understand the developments in China´s economy and the prospects ahead.

2 Zhang Guobao, Remarks at the launch of the US-China Energy and Climate Program, http://energypolicy.columbia.edu/remarks-zhang-guobao-former-administrator-chinese-national-energy-administration

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My first summer visit coincided with the new normal becoming the mantra and, as could be expected, there were doubts about how the economy would switch to a model of lower but higher quality growth based on the development of services and high value added manufacturing, instead of on construction and energy intensive industries.

I remember that there were areas where the country lagged clearly behind, for example the payments system was extremely inefficient.

Now, the new normal appears to be reasonably well established and the digital economy is developing tremendously fast. I am truly impressed with how the use of digital technologies and platforms has allowed China to leapfrog and create a modern payment system with features that are not available in richer countries. China became a world leader in renewables energy, and energy consumptions is almost flat. The country committed to peak its CO 2 emissions by 2030, however it is likely that this will happen before. It became the champion of globalization and climate change and launched the One Belt Road, admittedly the most ambitious initiative of its kind since the Marshall Plan. This is no ordinary change.

3. Lessons from the G 20 meeting

The G20 meeting held last week in Germany is a good starting point given that it showed differences among countries on trade and climate change and that soft power, once a pillar of America´s dominance, is shifting.

The US does not embrace globalization anymore and defends protectionism as a way to create jobs and make America great again. It withdrew from TPP and announced its intention to renegotiate NAFTA.

However, on trade what matters is the balance of payments, it is not bilateral trade and the figure below highlights the following:

a. In the last 20 years, the US recorded a structural deficit in the current account of the balance of payments i.e. this is not a new problem. Any other country would be forced to devalue its currency and tighten fiscal policy.

b. China recorded an abnormally high surplus in the current account until the Great recession, which declined to close to balance

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subsequently as a result of several factors, including a real exchange rate appreciation.

c. The EU recorded large surpluses that remain unabated since the Great Recession, Germany being the great beneficiary.

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The recent focus on protectionism to bringing jobs to America is not easy to understand given that the rate of unemployment in the US is at below 5 p.c., emigrants are not welcome anymore and the new manufacturing industries would rely heavily on robots to be competitive.

The US also announced its decision to pull out from Paris COP 21. The figure below shows that CO2 emissions peaked a decade ago in the US and in the EU and that they are almost flat in China for 3 consecutive years. It is virtually impossible to go back to an era of fast growing CO 2 emissions in an environment of super low cost variable renewable energies, energy efficiency gains and cheap natural gas. What is at stake, as we will see later is, above all, the rate of decline of CO 2 emissions not in the US, the EU or China, but in in developing countries.

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The decision to pull from Paris COP 21 is not either easy to understand and will do nothing neither to revive the coal industry in the US, nor to help implementing the recently announced policy of so- called energy dominance.

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4. The second machine age…and more

We are living a period that in a sense is unique given that structural change is taking place fast and is driven not by one but by 6 major operating at the same time:

a. Rapid technological change b. Beyond globalizationc. Shift of the economic center of gravity to the East d. Urban worlde. Climate awareness, and f. Energy transition.

Although each of these forces has its own momentum, for example the digital revolution is developing faster than urbanization, they are combining to produce a perfect storm. They are producing a transformation that cannot be stopped because it is mostly driven by technology and markets. it creates uncertainty and raises important challenges.

5. Accelerating technological change

The first force is accelerating technological change.

Until the early 19th century, growth in world income per capita was virtually flat. The first machine age was prompted by James Watt´s version of the steam engine that permitted to use unprecedented amounts of energy and, later, by electricity and the internal combustion engine. 3The result was a sustained, i.e. year after year, acceleration of world income per capita that benefitted the most the West until recently.

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We are now living a technological revolution based on digital hardware, software and networks the nature of which is different: it is exponential ❨the number of transistors in an integrated circuit doubles every 2 years❩, digital ❨the marginal cost of scaling up production is zero) and combinatorial ❨for example drones are the result of the combination of data processing, sensors and digital imaging

3 Brynjolfsson, E., A. McAfee, The second machine age, Norton, 2016

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technologies). Although it has already produced many changes, its end is not near.

In the US, 4 or the 5 and 6 of the 10 largest companies by market cap are digital based.

Company Market cap billion of US dollars1 Apple 6882 Alphabet 5283 Microsoft 4554 Amazon 4665 Berkshire Hathaway 4186 Exxon Mobil 3577 Johnson and Johnson 3678 Facebook 3449 JPMorgan Chase 34110

Wells Fargo 323

How many of you have a smart phone? Everybody does. Our smart phones have more capacity than the supercomputers of the past. Most do not remember anymore that the iPhone was launched in the US only in 2007. Ten years later, Apple is still a major player, however the largest manufacturer of smartphones, Samsung, is from Korea and the third, Huawei, is from China.

What’s App was launched in 2010 in the US and the number of subscribers grew to 1.2 billion. One year later, We Chat was launched in China, where it has 1 billion subscribers that spend on average 60 minutes per day using this app that is much more than a social network. Siri was launched in 2010 and the i Cloud one year later. The rate of adoption of new technologies is tremendously fast and innovations can be easily replicated.

When I first came to China on a regular basis five years ago, I was surprised with how difficult it was to open a bank account, get a credit card and make payments and I wondered how this problem could be solved. A few days ago I went to the supermarket and realized that I was the only one using a credit card, everybody was making payments with their smart phones using we chat- pay and ali- pay. I was surprised with the relatively small number of clients in the supermarket and was told that most people shop online. Amazon has 250 million clients, while Ali Baba has 500 million; it ships more than 50 million packages per day.

I recently visited my son in Mexico where he works for a top international consultant. A few years ago he would have bought a fancy sports car. Mexico city is a very large city with heavy traffic and instead of having a car opted for an unlimited Uber account. Car- pooling is progressing tremendously fast and a world with driverless Ubers is not science fiction anymore.

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The digital revolution combines with other technologies such as sensors, artificial intelligence, 3 D imaging and robotics to turn everything upside down at an amazing pace. China is well positioned in several key areas, for example next week I will travel to Shenzen to visit DJI, by far the largest producer of drones in the world. For less than 500 dollars I can buy a nice drone.

6. Beyond globalization

The second force is cross border flows.

World trade on goods, services and finance rose fast until the 2008 financial crisis, but never fully recovered. This was offset, by the exponential growth of cross border flow of data that have connected the world as ever before.. According to McKinsey, “cross-border data flows are increasing at rates approaching 50 times those of last decade. Almost a billion social-networking users have at least one foreign connection, while 2.5 billion people have email accounts, and 200 billion emails are exchanged every day. About 250 million people are currently living outside of their home country, and more than 350 million people are cross-border e-commerce shoppers— expanding opportunities for small and medium-sized enterprises to become “micro- multinationals.” 4

The figure below shows the exponential growth of cross border data transmission that connects countries and regions of the world as never before. Whenever there is an attempt by a country to limit data transmission, VPN comes to the rescue.

4 The global forces inspiring a global narrative of progress, McKinsey, 2017 http://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/the-global-forces-inspiring-a-new-narrative-of-progress

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7. Shift eastwards of the center of gravity

The third force is the shift eastwards of the center of gravity. 5

The world´s economic center of gravity shifted to the East, back to where it was 1000 years ago and is not anymore in the West.

For the sake of the argument, let us ignore Japan. In 2000, China, India and Korea accounted for 13 p.c. of world GDP. Since then, their share of world GDP doubled, and according to IMF projections it will reach 30 p.c. in 2022 due to the stellar performance of China and to a lesser extent to India, both countries accounting for one third of the world population.

The idea of Western weakness is evident and creates risks, the emergence of populism in the US and the UK being a strong sign.6 This shift explains, to a large extent, why the US has adopted an America first approach.

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8. Urban world

The fourth force is urbanization.

It is not only a shift from the West to the East, but also that from rural areas to cities. For the first time ever, more than half of the world population lives in cities.

5 Rachman, Gideon, Easternization, war and peace in the Asian century. Penguin, 2016

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Urban habitants get richer given that they have higher skills on average, have the opportunity to perform more specialized tasks and enjoy economies of scale. The largest 600 cities account for 20 p.c. of the world population but more than 50 p.c. of world GDP.

Their projected contribution to world GD growth in 2010- 2025 is 65 p.c. Among them, stand out the so- called Emerging 440, a group of medium and large cities in developing counties of which 242 are in China.

The growth of the urban population in developing and middle- income countries creates a tremendous opportunity to develop consumer spending and investment in areas such as ports, airports and buildings.

In a period when accelerating technological change may destroy jobs, developing and middle income countries enjoy the cushion provided by the increase in consumption and investment from rapid urbanization.

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600 cities expected to account for 60 p.c. of world GDP growth

9. Climate awareness

The fifth force is climate awareness.There is undisputed evidence that the climate is changing due to man- made causes, mostly by the release of carbon from the combustion of fossil fuels and that this may produce effects that are irreversible and difficult, if not impossible to quantify.

Climate change is a global externality, the solution of which needs the contribution of all countries and it does not require halting the growth of carbon emissions; they must instead be strongly reduced from current levels. This was known in 1997 when the Kyoto protocol was agreed; however progress in international climate negotiations stalled given the high cost in adopting new technologies, mitigation in climate jargon, not least by the lack of commitment of large emitters.

Recent data show that, surprisingly, carbon emissions are flat since 2014 as a result of slower growth of energy consumption, stronger energy efficiency improvements, development of clean energy sources and the switch from coal to natural gas. This is positive; markets drive it more than by policies, however it is not enough.

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After many years of slow progress, Paris COP 21 was an important step in the right direction. Paris COP 21 is essentially an energy deal and its success depends above all on developing countries.

In my classes I run a very interesting game where students are divided in groups representing a country- region and negotiate their future commitments for energy related CO2 emissions and forestation. 7 This game allows grasping the 3 key elements of Paris COP 21: the ratchet mechanism and the importance of developing countries and climate finance.The US pulling out from Paris COP 21 is not a welcome development, however it will not derail the global commitment to address climate change. It will do more harm than good to the US.

10.The energy transition is well under way

The 6th force is the energy transition. The energy system is being turned upside down as a result of 4 forces:

a. Slower growth of energy consumption in middle- income and developing counties;

b. Abundant oil and natural gas;c. Ultra low cost renewable energies;d. Decentralized generation.

Overall, the growth rate of world energy demand has fallen by half. Energy consumption is flat, or even declining, in advanced economies. In middle income, including China, and developing countries it is growing slower as a result of the combined effect of more rapid gains in energy efficiency and lower GDP growth.

7 Climate interactive C ROADS https://www.climateinteractive.org/tools/c-roads/

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On the supply side, reserves of oil and natural gas are more abundant than ever as a result of the combined effect of large investments during the commodities super cycle and the shale revolution in the US. Coal is the big loser.

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At the same time, renewable energies became the largest source of investment in power generation as a result of a precipitous decline in costs. Wind costs have fallen 50 p.c. since 2009 and solar module costs by 80 p.c. since 2009. Unsubsidized solar power was bid at below 28 dollars per kilowatt-hour in countries with high solar exposure, onshore wind at 30 and offshore wind a 50, which compares with 120 dollars in the Hinckley Point nuclear power plant in the UK and is much lower than coal generation.

Super low cost renewables and thermal generation are turning upside down the traditional utilities model.

The transition will not be easy, as highlighted by the stranded assets in Germany´s power sector and by the decline of the load factor of thermal generation and curtailment of renewables in China. The future is difficult to predict given that it

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depends to a large extent on 2 factors: the capacity to produce batteries at a lower cost and the future of mobility. 8

However, change is accelerating, as witnessed by the decline in the cost of batteries, a top brand carmaker like Volvo announcing that it will stop using internal combustion engines in 2019 and the announcement by the French government that ICE´s will not be allowed after 2040. 9This will radically change the energy system, as we know it.

11.Adapting to change

The accelerated structural change witnessed in the beginning of the 21st century has few parallels.

It is idiosyncratic because it is the result of several forces operating at the same time and the rate of technology adoption is faster than in other episodes of accelerating technological change. Technology and markets are mostly driving it, Therefore, change can hardly be stopped.

The transformation is combinatorial, it is far from running out of steam and no single country in the world will avoid important challenges.

Different countries face different situations.

Adaptation is easier in an economy growing at 6 p.c. and is forging ahead than in one that grows only by 2 p.c.; in a country with high quality urban infrastructures and transportation networks than one with poor infrastructures and a subpar transportation system; in a country with a world class secondary education system than in one where public schools underperform and only the rich can afford to send their children to the best private schools; in a country with a high savings rate than in a consumer oriented society.

The West´s dominance is coming to a close. History, teaches that the transition to a new world order is most often non linear.

In an ideal world, all countries would cooperate to make the transition as smooth as possible, however this is unlikely to happen. Accelerated structural change is producing losers, for example the low skilled workers in advanced economies that are subjected to the combined effect produced by imports and robots. However, this should not distract for the real cause of their problems, for

8 Back to the future, electric vehicles and oil demand, BP energy economics http://www.bp.com/content/dam/bp/pdf/speeches/2016/back-to-the-future-electric-vehicles-and-oil-demand.pdf

9 Levelized cost of storage analysis 2.0, Lazard https://www.lazard.com/perspective/levelized-cost-of-storage-analysis-20/

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example mediocre and expensive secondary education systems and a tax system that favors the rich.

In many regards, China looks to be well positioned to take advantage of the structural transformations of the world economy. For America and the EU, it is not time to try to stop the tide with policies such as protectionism or promoting fossil fuels but, instead, to reconsider their societal choices and work ethics.

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