After Paris: fiscal, macroeconomic, and financial implications of climate change

After Paris: fiscal, macroeconomic, and financial implications of climate change

The December 2015 Paris Agreement lays the foundation for meaningful progress on addressing climate change—now the focus must turn to the practical policy implementation issues. Against this background, this paper takes stock of the wide-ranging implications for fiscal, financial, and macroeconomic policies of coming to grips with climate change.

Most immediate, and key, is the need to recognize and exploit the potential role of fiscal policies in implementing the mitigation pledges submitted by 186 countries in the context of the Paris Agreement. At the heart of the climate change problem is an externality: firms and households are not charged for the environmenta l consequences of their greenhouse gases from fossil fuels and other sources. This means that esta blishing a proper charge on emissions - €”that is, removing the implicit subsidy from the failure to charge for environmental costs - €”has a central role.

Also critical are establishing a clear pathw ay to meeting complementary commitments on climate finance, effective adaptation, and ensuring financial markets play a full and constructive role. Fiscal policies are key to efficiently mobilizing both public and private sources of finance, while the need to adapt economies to clim ate change raises issues that have implications for the design of national tax and spending systems (for example, strengthening fiscal buffers and upgrading infrastructure in response to natural disaster risks). There is also a growing need to enhance the contribution of the financial sector to addressing climate challenges, by facilitating clean investments and pooling climate-related risks.

For reducing carbon emissions ('€˜mitigation'€™), carbon pricing (through taxes or trading systems designed to behave like taxes) should be front and centre. These are potentially the most effective mitigation instruments, are straight forward to administer (for example, building off fuel excises already commonplace in most countries), raise (especially timely) revenues for lowering debt or other taxes, and establish the price signals that are central for redirecting technological change towards low-emission investments. The challenges lie in gauging appropriate price paths and dealing with the adverse effects on vulnerable households and firms, and the consequent political sensitivities.

Moving ahead unilaterally with carbon pricing is likely to be in many countries' own interests, because of the domestic (non-climate) benefits of doing so, most notably fewer deaths from exposure to local air pollution. As national pricing schemes emerge, a natural way to enhance these efforts and address concerns regarding lost competitiveness would be through international carbon price floor arrangements, analogous to those developed to counter some cases of international competition over mobile tax bases.

For climate finance, carbon pricing in developing countries would establish price signals needed to attract private flows for mitigation. Substantial amounts could also be raised from charges on international aviation and maritime fuels. These fuels are a growing source of emissions, are underpriced, and charges would exploit a tax base not naturally belonging to national governments.

For adaptation, specific measures to strengthen resilience to climate change will depend on a country'€™s specific circumstances and vulnerabilities. Policies should be worthwhile across a range of scenarios for (uncertain) local climate effects and are particularly important for low-income countries and small states prone to climate-related natural disasters.

In financial markets, increased disclosure of firmss' carbon footprints, prudential requirements for the insurance sector, and appropriate stress testing for climate risks will help ensure financial stability during the transition to a low-carbon economy. Analyses of how firms’ asset values could be impacted by de-carbonization are needed to efficiently allocate investments across carbon-intensive and other sectors. Strengthening countries's ™ regulatory oversight is also needed to ensure sound and resilient institutions and well-functioning financial markets for providing instruments to manage climate risks. Besides promoting green financial instruments, catastrophe bonds and similar hedging instruments can transfer climate-damage risks to those who are better able to bear them.

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