Macroeconomic and Fiscal Consequences of Climate Change—and of Policies to Address it

1. Macroeconomic and Fiscal Consequences of Climate Change—and of Policies to Address it Michael Keen and Natalia Tamirisa April 11, 2008

2. Presentation draws on: • Chapter 4 of current World Economic Outlook • Paper on Fiscal Implications of Climate Change Both available at www. imf.org

3. Outline • The Economics of Climate Change • Adaptation • Mitigation • Conclusions

4. The Economics of Climate Change

5. Climate change is one of the world’s greatest collective action problems • It is an ‘externality’—emitters of GHGs do not face the full social consequences of their actions • Economists have long prescribed corrective taxes to deal with this

6. But climate change is a uniquely difficult externality: • Costs of mitigation come long before benefits (hence discount rate critical) • Uncertainty considerable • Possibility of catastrophic damages • Free-rider problem, requiring international cooperation…. • ….exacerbated by differences in countries’ vulnerability and historical (and prospective) responsibility

7. Central estimate 90% confidence interval Future damages from climate change are uncertain, but could be large Baseline Climate, Market Impacts, Risk of Catastrophe, and Nonmarket Impacts Major Factors Causing Variation in the Social Cost of Carbon Percent decrease in cost increase in cost Climate sensitivity Pure time preference rate for consumption Noneconomic impact Equity weight Climate change half-life Economic impact Sources: Panel 1, Stern (2007); panel 2, Hope (2006).

8. Damages are expected to fall disproportionally on emerging and developing economies India (with catastrophic risk) India (without catastrophic risk) Africa Low income OECD (with catastrophic risk) Middle income High-income OPEC OECD (without catastrophic risk) Lower middle income Japan Transition economies Other high income China United States Source: Nordhaus and Boyer (2000).

9. Growth in emissions is driven by catching up economies Western Europe United States Japan Russia China India Brazil Source: International Energy Agency, World Energy Outlook (2007).

10. Growth in emissions is driven by catching up economies Source: International Energy Agency, World Energy Outlook (2007).

11. Growth in emissions in developing countries 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 stock 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 total emissions Sources: World Resources Institute’s Earth Trends database and Energy Information Administration, International Energy Annual (2005).

14. Adaptation

15. Much adaptation to slow moving climate change can and should be left to private sector…. But potential role for public sector, in • Climate-proofing public investments • Responding to additional spending needs, which (even with an expanded resource envelope) will require trade-offs with other development objectives • Dealing with climate change as a fiscal risk, through both self- and market insurance

16. World Bank puts adaptation costs in tens of billions of dollars per annum—but much more needs to be known at country level • Financial instruments also likely to play an increasingly important role—for example, catastrophe bonds and weather derivatives • Good macroeconomic and structural policies can help facilitate adjustment to climate shocks

17. Mitigation

18. Classic prescription to deal with the externality is a ‘carbon price,’ equal to the marginal social damage from emissions • Views differ greatly on the appropriate starting level: often $15-60 /tC (and Stern closer to $100) • But even more important is the expectation of a modest but sustained increase over time • Other policies (e.g., technology incentives and performance standards) also needed to deal with related market failures

19. Carbon pricing can be achieved through either: 1. Carbon taxation, or 2. Cap and trade: allocate rights to emit, but allow them to be bought and sold, or 3. Hybrids combining elements of the above

20. Which is better? • Equivalent if abatement costs certain and permit rights sold…with additional revenue raised a source of benefit (though likely to be modest in most cases) • If abatement costs uncertain, some preference for taxation (since getting emissions wrong over a short interval is not too costly)

21. What would mitigation measures of this kind mean for macroeconomic performance? WEO investigates this, using a global dynamic macroeconomic model (G-cubed, developed by Warwick McKibbin and Peter Wilcoxen)

22. Global emissions are assumed to follow a hump-shaped profile, focus is on costs up to 2040 Global Emissions Targets and Paths, 1990–2100 (gigatons of carbon dioxide) Baseline path 96% below baseline or 60% reduction from the 2002 level in 2100 2002 level Target emission path for the world

23. United States Japan OPEC China Western Europe Eastern Europe and Russia Other developing and emerging economies Emission and Carbon Price under Mitigation Policies Emissions (percent deviation from baseline) Carbon Price (US Dollar per tonne Carbon)

24. United States Japan OPEC China Western Europe Eastern Europe and Russia Other developing and emerging economies Macroeconomic Effects of Mitigation Policies(percent deviation from baseline unless otherwise indicated) Consumption Investment Output Current Account (percent of GDP; percentage points) Interest Rate (percentage points) Real Effect. Exchange Rate 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.

25. United States Japan OPEC China Western Europe Eastern Europe and Russia Other developing and emerging economies Consumption Loss(percent deviation from baseline) Cap and Trade, Initial Emissions- based Allocation Cap and Trade, Population-based Allocation World Uniform Tax

26. Mitigation costs depend on countries’ efficiency in abatement, allocation of emission rights and policy design Total Costs of Mitigation, 2013–40 (percent deviation of consumption’s net present value from the baseline) United States Japan Western Europe Uniform carbon tax and hybrid policy Eastern Europe and Russia China Other emerging and developing economies Cap-and-trade (by population shares) Cap-and-trade (by initial emission shares) OPEC World, GNP- weighted World, population- weighted

27. 2020 2030 2040 Financial flows under cap-and-trade depend on how emissions rights are allocated across countries and countries’ efficiency in abatement By Initial Emissions Shares (percent of GDP) By Population Shares (percent of GDP) United States Japan Western Europe China Other emerging and developing economies Eastern Europe and Russia OPEC NOTE: A positive value denotes a receipt of transfers—the region is selling its emission rights.

28. Conclusions

29. Quantitative results are model-specific… • Depend, among other things, on model structure, countries’ abatement costs and design of policies • Coverage of emissions (deforestation not included) • But they illustrate importance of a few key economic principles:

30. Carbon pricing needs to be • Long-term and credible • Broad-based • Common price for emissions • Flexible to accommodate changes in cyclical economic conditions and new scientific information • Equitable • Supporting macroeconomic policies are needed: • Capital flows • Technology transfers • Managing transfers

31. Drawing on environmental expertise of others, the Fund can • Advise where effects of climate change are macroeconomically significant • Contribute to the wider debate