How to deliver on climate promises while maintaining fiscal sustainability?


As the public finances of many countries are now under severe pressure, this is not the time to forget the commitments made to fight against climate change. Indeed, provided action is taken quickly, government support for the transition to net zero could ultimately improve fiscal sustainability.

Recent global efforts to tackle the climate crisis are not a happy story. A decade of low interest rates, low inflation and excess labor supply – ideal conditions for vast climate-smart and productivity-enhancing investments – has been largely wasted.

The result is that the investment gap to meet climate goals must now be closed against a backdrop of higher borrowing costs, higher inflation, tight labor markets, unpredictable war, less flexibility in government budgets (fiscal space) and, above all, less time.

The United Nations Environment Program’s 2022 Emissions Gap Report estimates that the global transformation to a low-carbon economy “would require investments of at least $4-6 trillion per year”.

The perennial paradox of environmental finance is that it is both too little (only 1.5-2% of total financial assets under management) and too much (an increase in annual green investments of 20-28% will be difficult to find under current economic conditions).

Governments can raise funds for investment through current taxes, future taxes (borrowing), reallocating existing budgets (cuts to education or the NHS to fund climate investments) or by ‘crowding in’ investments private.

Private investment can be encouraged through various incentives, including grants and tax reductions for research and development (R&D) and the deployment of renewable technologies. Each of these elements has budgetary consequences: they will affect public finances: how much we tax, borrow or spend, and how much each of these elements ultimately costs.

Unfortunately, lack of fiscal space – which refers to the flexibility of government budgets or the overall strength of public finances – can prevent some countries from funding all viable projects. This is particularly likely to be the case for low-income countries, which need to invest in education, health and other development goals.

Why is fiscal sustainability important?

The OECD defines fiscal sustainability as “a government’s ability to maintain public finances in a credible and sustainable position over the long term”. Climate change will affect public finances through multiple channels (for more on physical risk and transition pathways to fiscal policy, see Agarwala et al, 2021). Some of them include:

  • Depletion of natural capital and ecosystem services. This results in reduced output, labor productivity and, by association, tax revenue. The research shows how the effects of climate change on natural capital, including biodiversity, have long-lasting implications on well-being and carbon prices, and on identifying an optimal climate investment strategy (Bastien -Olvera and Moore, 2020).
  • Fiscal impacts of climate-related disasters. These include an increase in disaster relief expenditure or a decline in the return to physical capital (if, for example, transport infrastructure is set aside). The associated disruption in economic activity affects taxable income and growth alike (Acevedo, 2014; Botzen et al, 2019; Schuler et al, 2019). Other impacts include the effects of inflation and interest rates due to supply or demand shocks (Farhi and Gabaix, 2016), changes in commodity prices, and damage to physical assets requiring programs intervention.
  • The budgetary consequences of adaptation and mitigation policies. Financing adaptation and mitigation measures to comply with the Paris Agreement will require governments to create incentives for private investment, as well as direct tax expenditures. The transition to a low-carbon economy will not be without challenges, as tax revenue from oil or gas could represent a significant portion of government revenue, so any cuts could further strain public finances.

Provided action is taken earlythe opportunities of managing a transition to net zero could far outweigh the costs, thereby improving fiscal sustainability (Agarwala et al, 2021; Stern and Zenghelis, 2021).

But let’s take a moment to consider the importance of this caveat’provided that measures are taken quickly”. Consider the following excerpts from our recent study:

“There are growing opportunities associated with a public will to lead a zero-carbon economy that can attract investment and increase capacity. The IMF [International Monetary Fund] Fiscal Monitor (October 2020) argued that an additional public borrowing of £1 to invest in “job-rich, highly productive and greener activities” would generate an additional £2.7 of additional output (IMF, 2020; Gaspar and al, 2020)… This suggests strong crowding-in… The markets agree: they continue to lend to governments at real interest rates that remain at near-record levels. The most promising way to reduce public debt over the medium term is to borrow to invest now (Chudik et al, 2017).’

But with inflation now hitting 10% – alongside a series of record interest rate hikes – those cheap and easy investment conditions are gone.

Amid the unprecedented upheavals of Brexit, the Covid-19 pandemic, war in Ukraine, lockdowns in China and the associated cost of living crisis, concerns over possible debt repayment plans, shrinking fiscal space and preparing for future shocks dominate economic discussions.

The effect of changes in taxes or government spending on GDP – the fiscal multiplier – which has been high, may have been sustained in an economy characterized by cheap borrowing and excess labor supply.

But with high interest rates and a tight labor market, increasing employment in the renewable energy sector means reducing it elsewhere. If there is competition for employees, employers may have to raise wages – good news in normal times, but under current conditions this could exacerbate inflationary pressures in the short to medium term.

In times of economic hardship, politicians and the public can divert attention from the environment. Indeed, until a recent U-turn, the Prime Minister had not planned to attend COP27, despite the UK hosting COP26 in Glasgow in 2021.

Similarly, the IMF’s latest Fiscal Monitor indicates that the energy and food price crises may have undermined the green transition (IMF, 2022a) and added to decades of dithering in our efforts to reach zero. net (IMF, 2022b).

Nevertheless, there is still hope because addressing issues related to energy security and the necessary investments in efficient renewable energy sources – or even preparing for future pandemics and access to health care – will hand in hand with achieving the goals set out in the Paris Agreement.

What does the research show?

In the face of the real-time consequences of extreme weather events, recent advances in climate science and economic analysis have revealed important lessons about the macroeconomic consequences of climate change.

Those that are best understood include:

  • The contributions and consequences of climate change are unequally distributed between and within countries.
  • Estimates of the economic costs of climate change and the corresponding uncertainty tend to increase rather than decrease over time.
  • Well-designed carbon pricing mechanisms can effectively reduce emissions and inequalities; poorly designed ones do not.
  • It is extremely difficult to draw general conclusions from the wealth of microeconomic climate studies to make inferences about macroeconomic results.

Lessons that have proven more difficult to convey include the following facts:

  • Climate investments are cheaper than the alternative, namely climate-related disasters.
  • The effects of climate change are severe even in rich countries (Kahn et al, 2021).
  • The consequences of climate change are being felt sooner than expected.
  • Many of the greatest risks may lie in the realm of social and political instability rather than extreme weather.
  • The financial system is lagging far behind and ill-equipped to measure and manage these risks.

Recent data also shows that many low-carbon, climate-resilient investments – from energy and transport infrastructure to buildings and agriculture – are cheaper than their fossil fuel-based counterparts. As a result, their introduction would lead to the potential stranding of carbon-intensive “legacy” assets, such as drilling rigs or processing facilities, that they replace (Office for Budget Responsibility, 2021).

Although climate-economic analysis offers predictions of the physical impacts of climate change (extreme weather, sea level rise and ecosystem collapse) on the macroeconomy, they often overlook the importance of transition impacts that may affect fiscal sustainability.

It is now increasingly recognized that the budgetary consequences of climate change, and policy responses to it, will come as much from climate transition as from direct physical damage (Volz et al, 2020).

One of the biggest transition risks is that the skills required by workers in carbon-intensive industries become unnecessary in a net-zero economy. This growing obsolescence of human capital can have significant social implications, where clean energy technology will replace a labor force unable to retrain.

But as the global macroeconomic picture unfolds in the months and years to come, a stronger fiscal position – that is, balanced budgets, falling debt-to-GDP ratios, compelling stories about how whose current investments will drive long-term growth – will help ease market expectations and borrowing costs. This should make it easier to finance the investments needed to reach net zero.

Where can I find out more?

Who are the experts on this issue?

Authors: Patrycja Klusak and Matthew Agarwala
Photo by Khongtham on iStock

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