Macroeconomic and Fiscal Macroeconomic and Fiscal Consequences of Climate Consequences of Climate

Change—and of Policies to Change—and of Policies to Address it Address it

Michael Keen and Natalia TamirisaMichael Keen and Natalia Tamirisa

April 11, 2008April 11, 2008

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Presentation draws on:Presentation draws on:

• Chapter 4 of current Chapter 4 of current World Economic OutlookWorld Economic Outlook

• Paper on Paper on Fiscal Implications of Climate ChangeFiscal Implications of Climate Change

Both available at Both available at www. imf.orgwww. imf.org

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OutlineOutline

• The Economics of Climate ChangeThe Economics of Climate Change

• AdaptationAdaptation

• MitigationMitigation

• ConclusionsConclusions

The Economics of Climate The Economics of Climate ChangeChange

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• Climate change is one of the world’s greatest Climate change is one of the world’s greatest collective action problemscollective action problems

• It is an ‘externality’—emitters of GHGs do not It is an ‘externality’—emitters of GHGs do not face the full social consequences of their actionsface the full social consequences of their actions

• Economists have long prescribed corrective Economists have long prescribed corrective taxes to deal with thistaxes to deal with this

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But climate change is a uniquely difficult But climate change is a uniquely difficult externality:externality:

– Costs of mitigation come long before benefits Costs of mitigation come long before benefits (hence discount rate critical) (hence discount rate critical)

– Uncertainty considerableUncertainty considerable– Possibility of catastrophic damagesPossibility of catastrophic damages– Free-rider problem, requiring international Free-rider problem, requiring international

cooperation….cooperation….– …….exacerbated by differences in countries’ .exacerbated by differences in countries’

vulnerability and historical (and prospective) vulnerability and historical (and prospective) responsibilityresponsibility

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-100 -50 0 50 100 150 200

increasein cost

Climatesensitivity

Future damages from climate change are Future damages from climate change are uncertain, but could be largeuncertain, but could be large

-40

-30

-20

-10

0

2000 50 2100 50 2200

Per

cent

loss

in G

DP

per

cap

ita

Major Factors Causing Variation in the Major Factors Causing Variation in the Social Cost of CarbonSocial Cost of Carbon

Baseline Climate, Market Impacts, Risk of Baseline Climate, Market Impacts, Risk of Catastrophe, and Nonmarket ImpactsCatastrophe, and Nonmarket Impacts

decreasein cost

Percent

Pure time preferencerate for consumptionNoneconomicimpact

Equity weight

Climate changehalf-life

Economic impact

Central estimate90% confidence interval

Sources: Panel 1, Stern (2007); panel 2, Hope (2006).

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Damages are expected to fall disproportionally Damages are expected to fall disproportionally on emerging and developing economieson emerging and developing economies

-1

0

1

2

3

4

5

6

0 5 10 15 20 25 30

GDP per capita in 1995 (thousands of 1990 U.S. dollars)

Perc

ent l

oss

in G

DP

India (with catastrophic risk)

AfricaLow

income

India(without catastrophic risk)

Middle incomeHigh-income OPEC

OECD(without catastrophic risk)

OECD(with catastrophic risk)

Japan

United StatesOther high income

Lowermiddle income

China

Transition economies

Source: Nordhaus and Boyer (2000).

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-8-6-4-2024681012

1980

–90

1990

–20

2005

–30

1980

–90

1990

–20

2005

–30

1980

–90

1990

–20

2005

–30

1980

–90

1990

–20

2005

–30

1980

–90

1990

–20

2005

–30

1980

–90

1990

–20

2005

–30

1980

–90

1990

–20

2005

–30

Ave

rage

ann

ual g

row

th, p

erce

nt

Energy intensity (energy use per GDP)Fuel mix (emissions per unit of energy use)PopulationGDP per capitaTotal Emissions

Growth in emissions is driven by Growth in emissions is driven by catching up economiescatching up economies

UnitedStates Japan

WesternEurope Russia China India Brazil

Source: International Energy Agency, World Energy Outlook (2007).

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Growth in emissions is driven by Growth in emissions is driven by catching up economiescatching up economies

Source: International Energy Agency, World Energy Outlook (2007).

11

Growth in emissions in developing Growth in emissions in developing countries reflects economic developmentcountries reflects economic development

Sources: International Road Federation, World Road Statistics; World Bank, World Development Indicators; projections from Chamon, Mauro, and Okawa (2008).

12

The share of non-OECD countries in the The share of non-OECD countries in the stock of emissions is projected to risestock of emissions is projected to rise

Sources: World Resources Institute’s Earth Trends database and Energy Information Administration, International Energy Annual (2005).

13

This is true of both energy-related and This is true of both energy-related and total emissionstotal emissions

Sources: World Resources Institute’s Earth Trends database and Energy Information Administration, International Energy Annual (2005).

AdaptationAdaptation

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Much adaptation to slow moving climate change Much adaptation to slow moving climate change can and should be left to private sector….can and should be left to private sector….

But potential role for public sector, in But potential role for public sector, in – Climate-proofing public investmentsClimate-proofing public investments– Responding to additional spending needs, Responding to additional spending needs,

which (even with an expanded resource which (even with an expanded resource envelope) will require trade-offs with other envelope) will require trade-offs with other development objectivesdevelopment objectives

– Dealing with climate change as a fiscal risk, Dealing with climate change as a fiscal risk, through both self- and market insurancethrough both self- and market insurance

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• World Bank puts adaptation costs in tens of World Bank puts adaptation costs in tens of billions of dollars per annum—but much more billions of dollars per annum—but much more needs to be known at country levelneeds to be known at country level

• Financial instruments also likely to play an Financial instruments also likely to play an increasingly important role—for example, increasingly important role—for example, catastrophe bonds and weather derivativescatastrophe bonds and weather derivatives

• Good macroeconomic and structural policies can Good macroeconomic and structural policies can help facilitate adjustment to climate shockshelp facilitate adjustment to climate shocks

MitigationMitigation

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• Classic prescription to deal with the externality is Classic prescription to deal with the externality is a ‘carbon price,’ equal to the marginal social a ‘carbon price,’ equal to the marginal social damage from emissionsdamage from emissions

• Views differ greatly on the appropriate starting Views differ greatly on the appropriate starting level: often $15-60 /tC (and Stern closer to $100)level: often $15-60 /tC (and Stern closer to $100)

• But even more important is the expectation of a But even more important is the expectation of a modest but sustained increase over timemodest but sustained increase over time

• Other policies (e.g., technology incentives and Other policies (e.g., technology incentives and performance standards) also needed to deal performance standards) also needed to deal with related market failureswith related market failures

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Carbon pricing can be achieved through either: Carbon pricing can be achieved through either:

1. 1. Carbon taxation, or Carbon taxation, or

2. 2. Cap and trade: allocate rights to emit, but allow Cap and trade: allocate rights to emit, but allow them to be bought and sold, orthem to be bought and sold, or

3.3. Hybrids combining elements of the above Hybrids combining elements of the above

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Which is better?Which is better?

• Equivalent if abatement costs certain and permit Equivalent if abatement costs certain and permit rights sold…with additional revenue raised a rights sold…with additional revenue raised a source of benefit (though likely to be modest in source of benefit (though likely to be modest in most cases) most cases)

• If abatement costs uncertain, some preference If abatement costs uncertain, some preference for taxation (since getting emissions wrong over for taxation (since getting emissions wrong over a short interval is not too costly)a short interval is not too costly)

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What would mitigation measures of this kind What would mitigation measures of this kind mean for macroeconomic performance?mean for macroeconomic performance?

WEO investigates this, using a global dynamic WEO investigates this, using a global dynamic macroeconomic model (G-cubed, developed by macroeconomic model (G-cubed, developed by Warwick McKibbin and Peter Wilcoxen)Warwick McKibbin and Peter Wilcoxen)

22

Global emissions are assumed to follow a hump-Global emissions are assumed to follow a hump-shaped profile, focus is on costs up to 2040shaped profile, focus is on costs up to 2040

Global Emissions Targets and Paths, 1990–2100Global Emissions Targets and Paths, 1990–2100(gigatons of carbon dioxide)(gigatons of carbon dioxide)

0

10

20

30

40

50

60

70

80

90

100

1990 2002 2013 20 40 60 80 2100

Baselinepath

Target emissionpath for the world

2002 level

96% belowbaseline or

60% reductionfrom the 2002 level

in 2100

23

-140

-120

-100

-80

-60

-40

-20

0

20

2013 20 30 400

10

20

30

40

50

60

70

80

90

100

2013 20 30 40

Emission and Carbon Price under Mitigation Emission and Carbon Price under Mitigation PoliciesPolicies

EmissionsEmissions(percent deviation from baseline)(percent deviation from baseline)

Carbon PriceCarbon Price(US Dollar per tonne Carbon)(US Dollar per tonne Carbon)

United StatesEastern Europe and Russia

Japan OPECWestern Europe ChinaOther developing and emerging economies

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NOTE: Output refers to gross national product, interest rate refers to 10-year real interest rate. For real effective exchange rate, a positive value is an appreciate relative to the baseline.

Macroeconomic Effects of Mitigation PoliciesMacroeconomic Effects of Mitigation Policies (percent deviation from baseline unless otherwise indicated)(percent deviation from baseline unless otherwise indicated)

United StatesEastern Europe and Russia

Japan OPECWestern Europe ChinaOther developing and emerging economies

-3.5-3.0-2.5-2.0-1.5-1.0-0.50.00.51.0

2013 20 30 40

ConsumptionConsumption

-30

-25

-20

-15

-10

-5

0

5

2013 20 30 40

InvestmentInvestment

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

2013 20 30 40

Current AccountCurrent Account(percent of GDP; percentage points)(percent of GDP; percentage points)

-20

-15

-10

-5

0

5

10

2013 20 30 40

Real Effect. Exchange RateReal Effect. Exchange Rate

-1.0-0.9-0.8-0.7-0.6-0.5-0.4-0.3-0.2-0.10.0

2013 20 30 40

Interest RateInterest Rate(percentage points)(percentage points)

-25

-20

-15

-10

-5

0

2013 20 30 40

OutputOutput

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Consumption LossConsumption Loss(percent deviation from baseline)(percent deviation from baseline)

United StatesEastern Europe and Russia

Japan OPECWestern Europe ChinaOther developing and emerging economies

-3.5

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

2013 20 30 40

World Uniform TaxWorld Uniform Tax

-3

-2

-1

0

1

2

3

2013 20 30 40

Cap and Trade,Cap and Trade,Initial Emissions- Initial Emissions- based Allocationbased Allocation

-3

-2

-1

0

1

2

3

2013 20 30 40

Cap and Trade,Cap and Trade,Population-based Population-based

AllocationAllocation

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Mitigation costs depend on countries’ efficiency in Mitigation costs depend on countries’ efficiency in abatement, allocation of emission rights and policy designabatement, allocation of emission rights and policy design

Total Costs of Mitigation, 2013–40Total Costs of Mitigation, 2013–40(percent deviation of consumption’s net present value from the baseline)(percent deviation of consumption’s net present value from the baseline)

-3 -2 -1 0 1 2 3

United States

Japan

Western Europe

Eastern Europeand Russia

ChinaOther emergingand developingeconomiesOPEC

World, GNP-weightedWorld, population-weighted

Uniform carbon taxand hybrid

policy

Cap-and-trade(by initial

emission shares)

Cap-and-trade(by population

shares)

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-3 0 3 6 9 12 -3 0 3 6 9 12

Financial flows under cap-and-trade depend on how Financial flows under cap-and-trade depend on how emissions rights are allocated across countries and emissions rights are allocated across countries and

countries’ efficiency in abatementcountries’ efficiency in abatement

United States

Japan

Western Europe

Eastern Europeand Russia

China

Other emergingand developing

economies

OPEC

By Initial Emissions SharesBy Initial Emissions Shares(percent of GDP)(percent of GDP)

By Population SharesBy Population Shares(percent of GDP)(percent of GDP)

202020302040

NOTE: A positive value denotes a receipt of transfers—the region is selling its emission rights.

ConclusionsConclusions

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• Quantitative results are model-specific…Quantitative results are model-specific…– Depend, among other things, on model structure, Depend, among other things, on model structure,

countries’ abatement costs and design of policiescountries’ abatement costs and design of policies– Coverage of emissions (deforestation not included)Coverage of emissions (deforestation not included)

• But they illustrate importance of a few key But they illustrate importance of a few key economic principles:economic principles:

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• Carbon pricing needs to be Carbon pricing needs to be – Long-term and credibleLong-term and credible– Broad-basedBroad-based– Common price for emissionsCommon price for emissions– Flexible to accommodate changes in cyclical Flexible to accommodate changes in cyclical

economic conditions and new scientific informationeconomic conditions and new scientific information– EquitableEquitable

• Supporting macroeconomic policies are needed:Supporting macroeconomic policies are needed:– Capital flowsCapital flows– Technology transfersTechnology transfers– Managing transfersManaging transfers

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• Drawing on environmental expertise of others, Drawing on environmental expertise of others, the Fund canthe Fund can

– Advise where effects of climate change are Advise where effects of climate change are macroeconomically significantmacroeconomically significant

– Contribute to the wider debateContribute to the wider debate