Public finances and climate change in the post-pandemic era | VOX, CEPR Policy Portal – voxeu.org

Niels Thygesen, Roel Beetsma, Massimo Bordignon, Xavier Debrun, Mateusz Szczurek, Martin Larch, Matthias Busse, Mateja Gabrijelcic, Laszlo Jankovics, Janis Malzubris 16 March 2022

The fourth EFB annual conference1focused on the linkages between public finances (both in terms of sustainability and quality) and the policies aimed at mitigating climate change. Under the Paris agreement and European Green Deal, EU Member States set ambitious carbon reduction targets to turn the Union into the first climate-neutral major economy by 2050. This tectonic shift will require bold and difficult decisions by EU governments (Weder di Mauro 2021), with significant implications for economic growth and public finances.

Valdis Dombrovskis, Executive-Vice President of the European Commission, opened the debate by asking how governments could achieve a growth-friendly composition of public finances, given the risk posed by climate change for fiscal sustainability. Unlike the impact of climate risks on financial stability, their implications for fiscal sustainability are less well understood and might thus be severely underestimated. To fill this gap, the EFB conference aimed at clarifying the challenges posed by climate change for the conduct of fiscal policy, the sustainability of public finances, and, by implication, the future of the EU fiscal framework.

In the transition to a decarbonised economy, governments can deploy a wide range of tools to facilitate that transition. As Frans Timmermans, Executive-Vice President of the European Commission in charge of the green transition, stated in his keynote speech, a mix of carbon pricing emissions trading systems (ETS) and investment is required to reach carbon neutrality. Such changes will inevitably have important macroeconomic, structural and budgetary implications. Even though mitigation policies carry sizable costs, Isabelle Mateos y Lagos (BlackRock) argued that those fall short of the estimated damage under a business-as-usual scenario (25% of 2019 global GDP). Overall, the net welfare impact of climate policies would be positive (Figure 1).

Figure 1 Transition results in net economic gain (estimated cumulative GDP impact of transition, 2020-40)

Notes: The bars show the overall estimated impact of three factors: avoided damage from climate change due to mitigating policies (positive), green infrastructure spending (positive) and costs associated with the transition (negative). The black line shows the estimated net impact.Source: Isabelle Mateos y Lagos: BlackRock Investment Institute, Banque de France, International Energy Agency, OECD.

Inna Oliinyk (Network of EU Independent Fiscal Institutions) specifically looked into the public finance consequences of an unmitigated global warming scenario, confirming that the budgetary footprint of inaction would be much worse than the costs of decarbonisation. For instance, a case study of the UK suggests that over an 80-year horizon, public sector debt would be twice as high under inaction than under costly mitigation policies (Figure 2). Rick van der Ploeg (University of Oxford) also showed that delaying mitigation policies simply inflated future spending on adaptation measures, ultimately resulting in higher income taxes.

Figure 2 Three scenarios of public debt developments in the long-run

Source: Office for budget responsibility (2021).

As green taxes aim at raising the shadow price of carbon, they can both reduce emissions and create fiscal space to fund mitigation measures and other growth-friendly policies (such as distortionary tax cuts). That notion of double dividend is, however, deceptive. Indeed, well-designed Pigouvian taxes are intended to destroy their own tax base and in the longer run, revenues from green taxation are bound to disappear. The bottom line is that the costs of mitigation measures cannot be offset by higher revenues, resulting in higher public debt (Figure 3). A coordinated approach at the EU level might help design effective and efficient mitigation policies.

Figure 3 Net debt impact of reaching net zero by 2050

Source: Office for budget responsibility (2021).

Mitigating climate change and addressing its effects are costly propositions. Given the post-Covid legacy of historically high public debts, the need to preserve debt sustainability will force governments to make hard choices. According to the European Commission, Europe will need around 520 billion in additional investment per year over ten years to achieve its climate targets. Under the 2021-2027 Multiannual Financial Framework (MFF) and NextGenerationEU (NGEU), the EU has secured around 86 billion per year in public funding. Thus, even if scaling up public investment is a must, most of the required investment will have to be private.

One of the most important contributions to climate objectives stems from technology and innovation, Guntram Wolff (Bruegel) argued. However, based on past experience, he was sceptical that politicians faced with the need to consolidate public finances would be willing to pay for additional investment by cutting current expenditure. This argument echoed the work by Larch et al. (2022) showing that in the wake of crises policy makers generally do not boost public investment.

As if efficient prioritisation were not hard enough, Rick van der Ploeg (University of Oxford) argued that it was fraught with political frictions. Experience points to five key obstacles to the efficient greening of our economies: (i) carbon taxes are much lower than fossil fuel subsidies, (ii) carbon taxes hurt the poor disproportionately, (iii) free riding behaviours are ubiquitous on the international stage, (iv) the burden of paying for mitigation is unevenly distributed over generations, and (v) electoral considerations tend to bias decisions in favour of easy solutions, such as a preference for subsidies compared to taxation. Van der Ploeg argued in favour of greater attention paid to distributive considerations. In particular, he favours channelling tax revenues to poorer citizens, organising transfers from rich to poor countries and from future generations to current ones (through debt). Relatedly, Xavier Debrun (EFB) argued that the green agenda magnified the deficit bias that typically results from political frictions. Specifically, governments prefer a package of mitigation policies tilted towards subsidies (over taxation) and public investment (over targeted regulatory and tax measures encouraging private investment). In an environment where interest rates are expected to stay below growth rates for the long haul, the green agenda offers a convenient pretext for permanently higher deficits: debt is free, returns look high.

Ensuring that all stakeholders in the budget process understand the impact of climate change on public finances is a first step in addressing political biases. Unfortunately, most countries lack a comprehensive assessment of the impact of climate transition on fiscal sustainability. According to Inna Oliinyk, only about one-third of national governments have carried out such a comprehensive analysis. Absent estimates of future liabilities due to climate change, authorities have no incentive to act now, argued Helene Rey (London Business School). She proposed enriching standard debt-sustainability analysis with such estimates.

In principle, comprehensive assessments could benefit from independent input or at least vetting from independent bodies such as national independent fiscal institutions (IFIs). However, the EU Network of IFIs and the OECD noted that not all IFIs have the mandate to monitor green budgeting and most have insufficient expertise and resources to do so. Moreover, IFIs also lack information about governments plans, measures and working assumptions. According to the EFB (2021), while national IFIs are now integral part of the EU fiscal framework, they remain too heterogeneous to consistently influence the conduct of fiscal policy through advice.

Although models assessing the impact of climate change on fiscal sustainability remain in their infancy, they are key to provide plausible estimates of climate-related fiscal risks. Stavros Zenios (University of Cyprus) showed how to link a full-fledged assessment model to standard debt sustainability analysis. By incorporating multiple channels through which climate risks affect public finance, Zenios shows that they can have a significant effect on debt dynamics. Hence, it would be crucial for governments to develop a holistic view of fiscal planning.

What does this all imply for the economic governance review, relaunched on 19 October 2021?1The current framework being blind to climate change considerations, a natural question is whether these should be added to the list of well-known weaknesses that the reform should seek to address (e.g. European Fiscal Board 2019, 2021).

For countries to design optimal green policies, clear guidance on the design and implementation of fiscal rules should be in place. In his opening speech, Commissioner Dombrovskis stated that the Commission does not envisage changes to the 3% and 60% of GDP reference values of the Treaty. Instead, the speed of reducing debt should be gradual and growth friendly creating space for investment scaling up.

To be effective, the EU fiscal framework must not be perceived as curtailing the desirable fiscal response to current challenges. In particular, it should encourage climate change mitigation policies without endangering fiscal sustainability. In his closing speech, Commissioner Gentiloni pointed out two ways of including climate change in the EU fiscal framework: through a green golden rule, or a common EU facility. Xavier Debrun (EFB) warned that incorporating green contingencies into rules would make them even more complicated, less transparent, and easier to circumvent. Besides, the Green Deal being a European project aimed at addressing a global problem, green investment is a natural candidate to become a European public good funded by a temporary EU fiscal facility.

The EFB proposed earlier to augment the EU budget by dedicated national envelopes for providing EU common goods, such as green public investment and transnational infrastructure projects. Such a facility could usefully safeguard against possible cuts in national public investments, and be more effective than a complicated and weak green golden rule (European Fiscal Board 2021).

Network of EU IFIs (2021), Assessing the fiscal policy impact of climate transition", February.

European Fiscal Board (2019), Assessment of EU fiscal rules with a focus on the six and two-pack legislation, Brussels.

European Fiscal Board (2021), Annual Report 2021, Brussels.

Larch, M, P Claeys and W van der Wielen (2022), Scarring effects of major economic downturn: the role of fiscal policy and government investment.

Office for budget responsibility (2021), Fiscal Risk Report, July.

Thygesen, N, R Beetsma, M Bordignon, X Debrun, M Szczurek, M Larch, M Busse, M Gabrijelcic, E Orseau and S Santacroce (2020), Reforming the EU fiscal framework: Now is the time, VoxEU.org, 26 October.

Weder di Mauro, B (2021), Combatting Climate Change: a CEPR Collection, CEPR Press.

1https://ec.europa.eu/info/business-economy-euro/economic-and-fiscal-policy-coordination/european-fiscal-board-efb/public-finances-and-climate-change-post-pandemic-era_en

2https://ec.europa.eu/commission/presscorner/detail/en/ip_21_5321

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Public finances and climate change in the post-pandemic era | VOX, CEPR Policy Portal - voxeu.org