Fiscal policy can help countries adapt to climate change

Fiscal policy can help countries adapt to climate change

6 novembre 2018

Michele Catalano, Lorenzo Forni, Emilia Pezzolla

In a recent analysis prepared for the World Bank, we addressed how governments can foster climate change adaptation policies


The 8th October Nobel Prize for economics was awarded to William Nordhaus and Paul Romer, two leading economists who embarked on quantitative evaluation of endogenous economic growth including human capital and climate change. In particular, since the 1970s Nordhaus has developed a standardized methodology integrating social and economic development and geophysical processes. His work has been used by the Intergovernmental Panel on Climate Change (IPCC) in the context of its 2°C limit which is considered the maximum safe temperature increase to contain and manage the effects of global warming, albeit at a high financial and resources cost [1].

The IPCC is working on preparation of its sixth Report (AR6) to be published in 2022, based on a decade of scientific activity to assess the consequences of and policies related to global warming. Attention is shifting slowly from policies to mitigate global warming (aiming at reducing the increase in greenhouse emissions related to economic activity and responsible for the increase in global temperatures, Fig. 1) to adaptation policies. These latter aim at reducing the negative impact of climate related trends and the increasing rate of climate related disasters especially for the more fragile poorer countries. In Fig.2 the ND-GAIN index [2] summarizes country vulnerability to climate change and other global challenges in combination with readiness to improve resilience. The idea that is emerging from some of the most recent literature is that mitigation and adaptation interact, and finding their optimal mix should be the goal of future research

Enhancing resilience to climate change requires a multifaceted strategy which includes both preventive and remedial actions to reduce the social, environmental, and economic impacts of climate change. Preventive and remedial investments in adaptation to climate change can increase countries’ resilience to damage, losses and risks from climate change and natural disasters. Preventive actions require policy makers to implement adaptation measures in anticipation of the effects of climate change, such as investments in physical infrastructure and the creation of policy buffers to increase resilience to shocks and alleviate financial constraints, especially for developing countries. Remedial actions namely disaster relief and reconstruction, imply that policy makers should focus solely on responding to impacts already experienced.

Fiscal policy can help countries adapt to climate change

The available evidence indicates a clear bias in favor of remedial rather than preventive action which will imply high costs often concentrated in particular sectors and categories of consumers/firms, thus favoring opposition to rather than support for such measures [3].  Moreover, moral hazard and overreliance on international assistance further encourages remedial strategies over preventive action. 

In a recent work prepared for the World Bank [4], we addressed how governments can foster adaptation policies. We suggest that early, preventive action through proactive investments is always superior to late, remedial action to address climate change. We use the Prometeia Overlapping Generation (OLG) model to assess the relative effectiveness of both types of actions in leveraging limited fiscal resources to adapt to climate change. The public sector can limit the impact of climate change by increasing investment and climate-resilient technology across the entire capital stock although this will not be cheap. The study’s key finding is that early, preventive action to address climate change is always superior to late, remedial action regardless of whether it is related to internal or foreign funding (from donors). Waiting to act simply means that larger and more costly adjustments will be needed in the future. Increasing spending on adaptation early, before the gradual erosion of capital stocks and before extreme events have wrought further damage, would increase fiscal and economic resilience and reduce the need for future spending. 

Fiscal policy can help countries adapt to climate change

The best results come from early investment in adaptation funded via taxation rather than deficit financing. The main intuition behind this result is that the increase in taxes focuses the attention of economic agents on the (otherwise difficult to perceive) existence of the costs related to climate change. By increasing the depreciation of capital, climate change – all other things being equal – makes the economy poorer. By anticipating future losses, economic agents will save, work and invest more, which will have a positive impact on GDP. 
 However, for countries affected by large negative effects, early action is necessary but not sufficient to fully shield an economy from the damage wrought by extreme events such as hurricanes, floods, and droughts. Increasing fiscal space, accumulating resources in a contingent fund before a natural disaster occurs, and use of pooled insurance mechanisms and market insurance can help make fiscal policy climate-resilient. These mechanisms include private or sovereign insurance systems, multilateral safety nets, and regional catastrophe-insurance schemes [5]. So far, both participation in these mechanisms, and disbursements under them, have been limited. However, membership in multilateral organizations can also be viewed as a type of risk-pooling mechanism. Credit lines offered by international financial institutions, and market-based instruments such as catastrophe bonds could help governments to start quicker recovery and reconstruction. In the case of high-indebted countries, such instruments can secure capital markets against the risk that a natural disaster could lead those countries into debt distress.

No consensus has been reached on the best practices for preventive action, and this uncertainty compounds incentives to delay investment in adaptation. However, as the social and economic impact of global warming continues to grow, further delay will likely necessitate much more extensive and costly interventions in the future, reducing long-run growth and destabilizing fiscal balances.

[1] Estimates show that temperatures have already increased by about 1° compared to pre-industrial revolution levels and that they could reach 1.5° within the next one/two decades.
[2], Notre Dame Global Initiative Index.
[3] Nordhaus has for long argued that price increases through, e.g., a carbon tax, are much more effective than direct government controls over emissions levels to reduce carbon pollution and promote mitigation. Nations must raise the price of fossil fuels to protect the climate, which is a global public good. If not, there is no incentive for individual carbon users to reduce their consumption, and all humanity will suffer the consequences.
[4] Forni L., M. Catalano and E. Pezzolla (2018) “Increasing Resilience: Fiscal Policy for Climate Adaptation “ in Fiscal Policies for Development and Climate Action, World Bank Group (2018), Forthcoming. 
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