WP/19/185 Macroeconomic and Financial Policies for Climate Change Mitigation A Review of the Literature by Signe Krogstrup and William Oman IMF Working Papers describe research in progress by the authors and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the authors and do not necessarily represent the views of the IMF, its cutive Board, or IMF management. 2019 International Monetary Fund WP/19/185 IMF Working Paper Monetary and Capital Markets Department Research Department Macroeconomic and Financial Policies for Climate Change Mitigation A Review of the Literature Prepared by Signe Krogstrup and William Oman 1Authorized for distribution by Ulric Eriksson von Allmen and Oya Celasun September 2019 Abstract Climate change is one of the greatest challenges of this century. Mitigation requires a large- scale transition to a low-carbon economy. This paper provides an overview of the rapidly growing literature on the role of macroeconomic and financial policy tools in enabling this transition. The literature provides a menu of policy tools for mitigation. A key conclusion is that fiscal tools are first in line and central, but can and may need to be complemented by financial and monetary policy instruments. Some tools and policies raise unanswered questions about policy tool assignment and mandates, which we describe. The literature is 1This paper benefited from comments from Ruchir Agarwal, Michel Aglietta, Alexander Barkawi, Nicoletta Batini, Peter Birch Srensen, Per Callesen, Oya Celasun, Martin von Allmen, Etienne Espagne, Mai Farid, Pierpaolo Grippa, Dirk Heine, Martin Holmberg, Florence Jaumotte, Prakash Loungani, Donald Marron, Leonardo Martinez-Diaz, Paolo Mauro, Irene Monasterolo, Pierre Monnin, Rasmus Pank, Ian Parry, Catherine Pattillo, Antonin Pottier, James Roaf, Frdric Samama, Romain Svartzman, and Johannes Wiegand. The views expressed in this paper are those of the authors and should not be attributed to Danmarks Nationalbank, the IMF, its cutive Board, or its management. IMF Working Papers describe research in progress by the authors and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the authors and do not necessarily represent the views of the IMF, its cutive Board, or IMF management. 3 scarce, however, on the most effective policy mix and the role of mitigation tools and goals in the overall policy framework. JEL Classification Numbers Q54, E52, E60, E61, E62, G10, G20 Keywords climate change, fiscal policy, monetary policy, financial policy, policy framework, policy coordination -Mail Address skronationalbanken.dk, womanimf.org 4 CONTENTS Abstract .2 Abbreviations and Acronmys 5 cutive Summary 6 I. Introduction .7 II. Setting the Stage The Case for Policy Action .9 A. Climate Science and the Cost of Climate Change 9 B. What Needs to Be Achieved 11 C. Why Is Mitigation Not Taking Place via the Market 14 D. Government Failures. 16 III. Macroeconomic and Financial Policies for Climate Change Mitigation 17 A. Fiscal Policy Tools . 19 B. Financial Policy Tools. 22 Redressing the mispricing and increasing the transparency of climate risks 23 Reducing short-term bias, improving governance frameworks of financial institutions. 26 Supporting the development of markets for green financial securities 27 Actively promoting climate finance using financial regulatory tools 28 C. Monetary Policy Tools 29 D. Other Policies for Climate Change Mitigation . 33 IV. Policy Mix, Framework, and Coordination 35 V. Political Economy Considerations 37 VI. Conclusions . 39 Appendix Integrated Assessment Models . 41 References . 43 5 ABBREVIATIONS AND ACRONMYS BCBS Basel Committee on Banking Supervision DNB De Nederlandsche Bank ECB European Central Bank ESG Environmental, Social and Governance ESRB European Systemic Risk Board EU European Union GHGs Greeenhouse gases IAMs Integrated Assessment Models IPCC Intergovernmental Panel on Climate Change NDCs Nationally Determined Contributions NGFS Network of Central Banks and Supervisors for Greening the Financial System PBoC PPF Production possibility frontier RD Research and development TCFD Task Force on Climate-related Financial Disclosures SDGs United Nations Sustainable Development Goals SVMA Social Value of Mitigation Action UNEP United Nations Environment Programme UNFCCC United Nations Framework Convention on Climate Change 6 CUTIVE SUMMARY Mitigating climate change requires a large-scale transition to a low-carbon economy. The scientific consensus is that climate change is undermining the ecological systems on which human and all other s of life depend, and that mitigating climate change is crucial to preserving the conditions for economic growth and life within earth systems. There is also a strong scientific consensus that limiting global warming to well below 2C requires a transation in the structure of global economic activity on a massive scale. On their own, markets cannot deliver sufficient mitigation. Market failures, unaddressed and exacerbated by government failures, prevent an appropriate market response to the challenge of mitigating climate change. Some market failures can prevent needed long-term private investment even if public investments were sufficient and relative energy prices appropriate, justifying the use of financial policies as complements to fiscal policies. A wide range of macroeconomic and financial policy tools can affect climate change and can be part of the package of measures for mitigation. While both international policy coordination and domestic policy action are key to addressing climate change, this paper focuses on the latter. There is a broad menu of policy options from which policymakers can choose. Fiscal policy options revolve around carbon pricing explicit and implicit, spending and investment, and public guarantees. The needed transation in the productive structure of the economy requires a change in the underlying financial asset structure, implying a key role for financial policy tools. These policies can be divided into those that aim to correct the lack of accounting for climate risks for financial institutions and those that aim to internalize externalities and co-benefits at the level of society. The er support mitigation by changing the demand for green and carbon-intensive investments, as well as relative prices. The latter work through similar channels but give rise to questions about appropriate policy tool assignment, trade-offs and political economy. Monetary policy tools may have a role to play. Some options are within most central bank mandates reflecting climate risks in large- scale asset purchase programs or collateral frameworks, while others are more controversial green QE, credit allocation policies, adapting monetary policy frameworks. More research is needed on the most effective policy mix for climate change mitigation, and the role of climate mitigation in the overall policy framework. While some macroeconomic and financial tools are clearly desirable and complementary, others may substitute for each other, giving rise to trade-offs. The literature is scarce on the desirable package of measures to address climate mitigation. The impact of macroeconomic and financial policies on climate change implies that macroeconomic policy frameworks can be designed with the explicit additional goal of achieving sufficient mitigation within the time frame imposed by the threat of climate change. This raises questions about the role of mitigation in the overall policy framework and interactions with other goals. Coordination among policy areas could be critical for mitigation, and this issue requires more research. 7 I. INTRODUCTION The challenge posed by climate change is unprecedented. The 2015 Paris Agreement, signed by 195 countries, entails holding the increase in the global average temperature to well below 2C above pre-industrial levels and pursuing efforts to limit the temperature increase to 1.5C. We are not on this path yet. A recent report of the Intergovernmental Panel on Climate Change IPCC 2018 warns that global warming is expected to reach 1.5C between 2030 and 2052, and to continue upwards from there. Given extreme uncertainties, the climate may warm much faster, and the risk of catastrophic outcomes is rising. This review focuses on the roles that macroeconomic and financial policies can play in climate change mitigation. Existing international agreements on climate change mitigation require a transition to low-carbon economy IPCC 2018. The implied transation of the economy is massive and unlikely to happen through the market alone, due to various market failures. There is hence a clear case for policy action, and policy authorities are increasingly probing their own role in the required transition. The focus has tended to be on energy policy and variants of carbon pricing policies IMF 2019a, and less on other types of macroeconomic and financial policies. But emissions are high and rising, fossil fuels continue to dominate the global energy mix, and the price of carbon remains defiantly low. Other complementary policies will likely be needed. To spur discussions of what these policies could or should be, we first spell out the case for policy action, and then review the rapidly growing literature on the role of macroeconomic and financial policies in climate mitigation. The literature is complex and large, and for conciseness, we limit the focus of the review in several dimensions. Problems and causes leading to climate change are complex and interact with many earth systems currently affected by human activity, as discussed in Rockstrm et al. 2009 and Steffen et al. 2018. However, this broader perspective is beyond the scope of this paper. We focus on policies to reduce CO2 or greenhouse gas GHG emissions, leaving the discussion of adaptation policies aside. Moreover, we focus on nationally implementable policies, discussing the roles of international leakages, global coordination of policies, and differences across national income levels only briefly. The review of the literature provides a menu of relevant macroeconomic and financial policy tools and instruments for climate change mitigation. We consider three categories of policy tools fiscal, financial and monetary. Fiscal tools are instruments that directly affect the government budget and are implemented by fiscal authorities. Financial policy tools include financial regulation, financial governance and policies to enhance financial infrastructure and markets, whereas we include policies that make use of the central bank balance sheet in the monetary policy category. There are gray zones between these three categories, as we discuss. The review of the literature suggests fiscal policy tools such as taxes, subsidies and public investment, should be in the front line for internalizing climate change externalities, reaping the co-benefits of climate change mitigation and securing low- carbon public infrastructure. The literature on how to design such fiscal tools is well developed. However, even if fiscal tools could be optimally implemented, our review of the 8 case for policy action suggests they may not be enough in a world where climate distortions interact with other types of market and government failures, and where political economy considerations are important. Other complementary policy tools may be called for, notably to secure appropriate levels of private investment. Private as well as public investment will be needed to support the required transation of the productive structure and relative price changes in the energy mix in the long term. Financial policy tools can help achieve the necessary private investments in green productive capital, infrastructure and RD. Ensuring that central bank balance sheets accurately reflect climate risks can play a supporting role, both by leading by example and through a market price impact when central bank asset portfolios are sizeable. The literature also contains proposals for more active roles for financial and monetary policy tools in spurring a shift from high to low-carbon private investment, although the appropriateness of such tools and their interactions with fiscal policy and political economy considerations require more analysis. 2The literature does not spell out an appropriate policy mix, making this a key area for future research. The question of the most effective policy mix for climate change mitigation remains relatively unexplored and is complex given the substantial uncertainties around climate change. Addressing it requires a clear understanding of whether various policies are complements or substitutes in their incidence on the climate. It requires an understanding of policy trade-offs and interactions, as well as political economy considerations. We briefly discuss these issues and make some tentative observations. Notably, fiscal policies and ensuring proper pricing of climate risk in financial institutions, financial stability frameworks and central bank portfolios and operations are for the most part likely to complement each other and should all feature in the policy package. The active use of financial and monetary policy tools to promote green private investments, in contrast, may in some cases substitute for fiscal instruments but could be justified as a second-best policy option. A better conceptual and practical understanding of how to mix and prioritize fiscal, monetary and financial policies to mitigate climate change requires attention in the literature. The review highlights the complexity of the policy challenge and the need for coordination of different policy areas for achieving mitigation efficiently and effectively. Fiscal, monetary and financial policy tools for climate mitigation can to varying degrees interact with other policies and objectives, such as business cycle stabilization and price stability. The literature review highlights the need for coordination between and among different policy areas to ensure the effectiveness of the policy mix and an appropriate assignment of tools and goals. The literature is scarce on these issues, however, suggesting a fruitful area for research. 2While countries at different income levels face different mitigation challenges, these distinctions are complex and not considered here. The menu of policy options for mitigation operates on multiple levels national/international, developing economy/advanced economy, making it difficult and in some cases incoherent to divide the discussion along income-level lines. 9 Finally, political economy