Fiscal tools to reduce the transition costs of climate change mitigation

November 11, 2020

Michele Catalano, Lorenzo Forni, Emilia Pezzolla

The objective of our study is to assess the impact on the costs of energy sources and, ultimately, on the economy of an increase of carbon pricing able to deliver emission levels consistent with the Paris Agreement

 

How the transition out of greenhouse gas emissions will impact the economy? Currently available estimates of the impact on economic activity of carbon mitigation policies differ considerably, depending on the different methodologies and assumptions adopted by different studies, and the inherent uncertainty related to forecasting future greenhouse gas emissions and ensuing temperature increases. 

The objective of our study is to assess the impact on the costs of energy sources and, ultimately, on the economy of an increase of carbon pricing able to deliver emission levels consistent with the Paris Agreement. Our approach is to build an Integrated Assessment Model that combines an economic module and a climate one that interact with each other. We assume as given widely-used mitigation scenarios for future carbon emissions (consistent with a temperature increase below 2°C by the end of the century, embedded in the Paris Agreements) and then back out the combinations of fiscal tools (especially carbon price measures and tax incentives for green investments) that can minimize the transition costs. 

We find that reaching the targeted temperature increases would require an aggressive increase in carbon pricing implying a sharp rise in energy prices. Our point is that the overall economic impact of the transition depends on which fiscal tools are used. For example, how the revenues from carbon taxes – or revenues from any carbon pricing type of policy – are used and whether or not an expansionary fiscal policy to mitigate the negative effects on the economy of an increase in the cost of carbon and in energy prices is implemented. 

A budget-balance scenario, where the revenues from carbon pricing are used to create incentives for green energy investments seems sufficient to ensure the global phase-out of fossil fuels and net zero emissions by 2070 (carbon neutrality). However, this scenario involves significant economic costs in the short term. Indeed, our main conclusion is that if this transition has to follow the temperature path envisaged by the Paris Agreements, it would need more than just a balanced budget policy to avoid to be recessionary. 

The global economy could reduce the potential costs of transition if supported by deficit-financed green policies (public investments, subsidies to private investments, and research and development spending aimed at favouring the adoption of alternative energy sources). In particular, we consider an increase in public green spending of 1% of GDP for 5 years to support the transition, in the spirit of the green spending targets envisaged in the Next Generation EU. Our results suggest that meeting the objectives of the Paris Agreements would imply a sharp increase in the price of carbon, much more so in China and United States, which are among the largest emitters of CO2, than in Europe. However, if there were deficit-financed green public investments to support the transition, the carbon price increase would be more contained. As a result, the increase in energy costs would be lower. Therefore, the benefits of a mitigation policy limiting the damage of climate change to GDP would be greater if there was support from the public budget to ease the transition.

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