Macroeconomic fault lines of climate policy

Economic opinion

The climate transition is one of the major challenges for the coming decades. Hesitant climate policies and the recent economic crises have substantially narrowed the time window for this adaptation and an abrupt transition seems more likely by the day. This (abrupt) transition to a sustainable economy - if it takes place - will, because of its magnitude, also be felt macroeconomically. Even if, according to certain economic models, climate policy and the climate transition have only a moderate economic impact in the longer term, the short-term costs and disruptions of the transition may be substantial. In the new baseline scenario, with a more abrupt (but necessary) transition, a thorough analysis of the macroeconomic impact of climate policies is no longer a luxury, but rather a necessity. Thus, climate policy is increasingly also becoming macroeconomic policy.

The years 2020 and 2021 will undoubtedly go down in history as the years of the covid crisis. With around 5 million deaths and 250 million infections worldwide – as well as one of the biggest economic recessions – the covid-19 crisis is leaving deep scars. But as the pandemic gradually becomes more manageable, policymakers’ attention will continue to shift back from the current covid crisis management to other, structural challenges. 

As COP26 highlights, one of the major (and urgent) challenges that is coming back to political focus is climate change and the transition to a more sustainable economy. The latest IPCC report sends out an unambiguous ‘Code Red’ for the climate targets contained in the Paris Agreement (COP21)1. With the increasing consumption of the global carbon budget - the maximum amount of carbon in the atmosphere that is consistent with a given amount of global warming - a firm tightening of global greenhouse gas emissions becomes necessary, at least if the commitments under the Paris climate agreement are to be met.  In that context, it is also alarming to note that the emission reductions (the National Determined Contributions) to which countries committed themselves prior to the COP26 climate conference are not enough to limit climate warming to 2°C. More is needed and fast.

Hesitant climate policy is raising the bar....

Although innovations and the expansion of carbon sinks can make an important contribution to improving the carbon balance in the longer term, current climate policy focuses on reducing greenhouse gas emissions in the short term. Both socio-economic and technological factors determine total greenhouse gas emissions. The so-called Kaya identity illustrates the impact of some of these factors. This identity states that the amount of emissions (GHG) is determined by the size of the population (P), GDP per capita (GDP/P), the energy intensity of production (E/GDP) and the emission intensity of energy consumption (GHG/E):

GHG=P*GDP/P*E/GDP*GHG/E

Depending on the developments in socio-economic factors (population growth or economic growth), the necessary adjustments in energy and emission intensity that are required to bring total greenhouse gas emissions to certain levels can be determined.

Recent scenarios from the EC (Table 1) simulate the drastic actions needed to achieve the COP21 commitments in line with 2°C warming (the policy simulations assume adjustments in carbon pricing). Although the EU met its (moderate) 2020 target of a 20% reduction compared to 1990, global GHG emissions increased by around 30%. EC projections suggest that major additional efforts (reduction of energy and emission intensity by more than 50% in the EU and 60% globally) are needed to meet the 2°C target. Moreover, hesitant climate policies and the recent economic crises have significantly shortened the time window for the transition, making the impact of these measures also felt macroeconomically, especially since the ‘low hanging fruit’ of measures has already been picked. 

… and macroeconomic consequences

The long-term impact of climate warming (and transition) on the economy remains very uncertain. Economic studies generally find a long-term negative impact on GDP (ranging from a few percentage points to above 25 percentage points relative to the baseline GDP path), increasing with the extent of global warming. These results should be interpreted with caution due to high model uncertainty. Moreover, the question remains whether such impact studies should focus on the expected (average) economic impact or rather on the possible (much more threatening) tail risks. The simplifying economic models provide little guidance at present and are not suitable for accurately evaluating tail risks and non-linearities. 

Moreover, these long-term impact studies do not (or not enough) take into account the important additional costs and disruptions that a very abrupt transition to a more sustainable economy may entail. After all, this requires major structural adjustments to the economy. The energy efficiency of production (but also of transport and buildings) must increase drastically, and the energy system must be made low-carbon (e.g. based on renewable or nuclear energy). 

To realize this economic transformation, governments are looking at an amalgam of measures ranging from subsidies and investments to legal restrictions and taxes. De facto, a transition policy – explicitly or implicitly – puts a (higher) price on carbon emissions. The abrupt and drastic repricing of this ‘forgotten’ negative carbon externality in production processes means an important negative supply shock with a temporary macroeconomic impact. Such shocks can lead – like the oil shocks of the past – to the premature depreciation of existing capital stock, a loss of human capital in the affected sectors and challenges around the reallocation of labour. In addition, the transition is also associated with significant income redistribution effects. Carbon taxes and measures – once passed on in consumer prices – are usually regressive. This means that lower- and middle-income groups, who are more dependent on carbon-intensive technologies, are hit proportionally harder. So, the climate transition is certainly not neutral. Supportive policies (such as the EC’s Just Transition Fund) can cushion part of that impact and thus limit the damage to the economy. Finally, the transition also brings demand impulses which can support innovation and increase productivity.

Climate policy is therefore (also) macro-policy

Climate policy is, therefore, increasingly becoming macroeconomic policy as well. Due to the scale and urgency of the transition, an (abrupt) transition to a sustainable economy - if carried out - will also be felt macroeconomically. The short-term costs of an abrupt (but necessary) transition to a sustainable economy could be substantial. The ‘window of opportunity’ to implement the transition gradually and slowly - with fewer shocks at the macro level - seems to be lost. In the new baseline scenario, with a more abrupt transition, a thorough analysis of the macro-economic impact of climate policy is no longer a luxury, but rather a necessity. And again, there is no time to lose if the macroeconomic impact of a transition to a more sustainable economy are to be limited.   

Carbon budgets in line with 2°C warming - widely seen as a tipping point - are shrinking fast. With 1,350 GTCO2 still available and annual global emissions of roughly 40 GTCO2, a sharp reduction in net emissions is becoming important if the projected climate targets are to be met.

Disclaimer:

Any opinion expressed in this KBC Economic Opinions represents the personal opinion by the author(s). Neither the degree to which the hypotheses, risks and forecasts contained in this report reflect market expectations, nor their effective chances of realisation can be guaranteed. Any forecasts are indicative. The information contained in this publication is general in nature and for information purposes only. It may not be considered as investment advice. Sustainability is part of the overall business strategy of KBC Group NV (see https://www.kbc.com/en/corporate-sustainability.html). We take this strategy into account when choosing topics for our publications, but a thorough analysis of economic and financial developments requires discussing a wider variety of topics. This publication cannot be considered as ‘investment research’ as described in the law and regulations concerning the markets for financial instruments. Any transfer, distribution or reproduction in any form or means of information is prohibited without the express prior written consent of KBC Group NV. KBC cannot be held responsible for the accuracy or completeness of this information.

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