Published on 2 December 2022
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How can climate promises be met while maintaining fiscal sustainability?

While the public finances in many countries are now under great pressure, this is no time to forget commitments to tackling climate change. Indeed, conditional on action being taken early, governments’ support for the transition to net zero could ultimately improve fiscal sustainability, say Pati Klusak and Matthew Agarwala.

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

The result is that the investment gap for meeting climate targets must now be closed against a backdrop of higher borrowing costs, higher inflation, a tight labour market, an unpredictable war, less flexibility in government budgets (fiscal space) and, critically, less time.

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

The perpetual paradox in environmental finance is that this is simultaneously too little (only 1.5-2% of total financial assets under management) and too much (an increase in annual green investment of 20-28% will be hard to find under current economic conditions).

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

Private investment can be encouraged through various incentives, including subsidies and tax cuts for research and development (R&D), and the roll-out of renewable technologies. Each of these has fiscal consequences: they will affect public finances – how much we tax, borrow or spend, and how much each of these ultimately costs.

Unfortunately, the lack of fiscal space – which refers to the flexibility in government budgets or overall strength of public finances – may prevent some countries from financing all viable projects. This is especially likely to be the case for lower-income countries, which need to make investments in education, health and other development goals.

Why is fiscal sustainability important?

The OECD defines fiscal sustainability as ‘the ability of a government to maintain public finances at a credible and serviceable position over the long term’. Climate change will affect the public finances through multiple channels (for more on the pathways of physical and transition risks onto fiscal policy, see Agarwala et al, 2021). Some of these include:

  • The depletion of natural capital and ecosystem services. This leads to reduced output, labour productivity and, by association, tax revenue. Research shows how the effects of climate change on natural capital, including biodiversity, have long-lasting implications for welfare and carbon prices, and for identifying an optimal climate investment strategy (Bastien-Olvera and Moore, 2020).
  • The fiscal impacts of climate-related disasters. These include increased spending on disaster relief or a lower return on physical capital (if, for example, transport infrastructure is side-lined). The associated disruption of economic activity affects taxable income and growth similarly (Acevedo, 2014Botzen et al, 2019Schuler et al, 2019). Other impacts include the effects of inflation and interest rates due to supply or demand shocks (Farhi and Gabaix, 2016), changes to commodity prices and damage to physical property requiring intervention programmes.
  • The fiscal consequences of adaptation and mitigation policies. Financing adaptation and mitigation measures to meet the Paris Agreement will require governments to create incentives for private investment, as well as providing direct fiscal expenditure. The transition to a low-carbon economy will not be without difficulties as tax revenues from oil or gas might comprise a significant portion of government revenue, so any reduction may further strain public finances.

Conditional on action being taken early, the opportunities from managing a transition to net zero could substantially outweigh the costs, ultimately improving fiscal sustainability (Agarwala et al, 2021Stern and Zenghelis, 2021).

But let us take a moment to consider the importance of this caveat ‘conditional on action being taken early’. Consider the following excerpts from our recent study:

‘There are increasing opportunities associated with a public drive to steer a zero-carbon economy which can crowd in investment and expand capacity. The IMF [International Monetary Fund] Fiscal Monitor (October 2020) argued that an additional £1 in public borrowing to invest in “job-rich, highly productive and greener activities” would generate an additional £2.7 of additional output (IMF, 2020Gaspar et al, 2020)… This marks scope for strong crowding-in… The markets agree: they continue to lend to governments at real interest rates which remain at near-record lows. The most promising way to bring down public debt in the medium term is to borrow to invest now (Chudik et al, 2017).’

But with inflation now pushing 10% – alongside a series of record-breaking interest rate hikes – these cheap and easy investment conditions have gone.

Amid unprecedented turmoil from Brexit, the Covid-19 pandemic, the war in Ukraine, China’s lockdowns and the associated cost of living crisis, concerns about potential debt repayment plans, narrowing fiscal space and preparedness for future shocks dominate economic discussions.

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

But with high-interest rates and a tight labour market, increasing employment in the renewables sector entails reducing it elsewhere. If there is competition for employees, employers may need to raise wages – good news in normal times, but under current conditions, this could exacerbate inflationary pressures in the short to medium run.

In times of economic difficulty, politicians and the public may shift focus away 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 procrastination in our efforts to reach net zero (IMF, 2022b).

Nevertheless, there is still hope as addressing issues related to energy security and necessary investments in efficient renewables sources – or even preparedness for future pandemics and access to healthcare – goes in hand with fulfilling the goals set out in the Paris Agreement.

What does research show?

Against 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 that:

  • Both the contributions to and consequences of climate change are unequally distributed between and within countries.
  • Estimates of the economic costs of climate change and corresponding uncertainty tend to grow rather than fall over time.
  • Well-designed carbon pricing mechanisms can effectively reduce emissions and inequality; poorly designed ones do not.
  • It is exceedingly difficult to draw broad conclusions from the wealth of climate microeconomic studies to make inferences about macroeconomic outcomes.

Lessons that have proved harder to convey include the facts that:

  • Climate investments are cheaper than the alternative – namely, climate-driven disasters.
  • The effects of climate change are severe even in wealthy countries (Kahn et al, 2021).
  • The consequences of climate change are landing sooner than early projections predicted.
  • Many of the biggest risks may fall in the realm of social and political instability rather than extreme weather.
  • The financial system is far behind and poorly equipped to measure and manage these risks.

Recent evidence also shows that many low-carbon and 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 the carbon-intensive ‘legacy’ assets, such as drilling rigs or processing facilities, they replace (Office for Budget Responsibility, 2021).

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

It is now increasingly recognised that fiscal consequences of climate change, and the policy responses to it, will derive as much from climate transition as from direct physical damages (Volz et al, 2020).

One of the greatest transition risks relates to the skills required by workers in carbon-intensive industries becoming irrelevant in a net-zero economy. This rising human capital obsolescence may have significant social repercussions, where clean energy technology will be replacing a labour force unable to reskill.

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

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This was first published by the Economics Observatory on 10 November 2022.

Authors

Patrycja Klusak

Dr Patrycja Klusak

Affiliated Researcher

Dr Patrycja Klusak is an Associate Professor at Norwich Business School at University of East Anglia and an Affiliated Researcher at Bennett Institute for Public Policy at the University of...

Matthew Agarwala

Dr Matthew Agarwala

Project Leader: The Wealth Economy

Matthew Agarwala, Economist, Bennett Institute for Public Policy, Cambridge. Matthew Agarwala is an economist interested in wealth-based approaches to measuring and delivering sustainability, wellbeing, and productivity. His research is motivated...

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