Economic Impacts of Climate Change

This joint report from the United Nations Environment Programme Finance Initiative and the UK’s National Institute of Economic and Social Research examines the use of macroeconomic models to identify and examine short-term climate-related shocks for financial sector actors. Based on input from 48 global banks and investors, it introduces three new climate-driven macroeconomic shock scenarios and explores their economic implications using a commonly used short-term global econometric model.

The report begins by reviewing the limitations of integrated assessment models, widely used to examine the effects of economic growth and variables on greenhouse gas emissions and climate change. As slow-moving climate change in turn affects the economy in a self-referencing feedback loop, these models are by nature long term and are therefore of limited or no value in assessing short term climate-related impacts. As a result, the financial industry and its supervisors may not be getting a full view of the climate risks threatening them and the financial system.

As an alternative, the study employed the National Institute’s global econometric model , a leading macroeconomic model used by both policymakers and the private sector for economic forecasting, scenario building and stress testing. The model was used to explore three new short-term scenarios involving a sudden rise in the price of carbon, a spike in oil prices and a trade war.

The exercise found that a carbon price rise of between US $130–$700 per tonne of CO2 by 2025 would result in a decline in GDP growth by 1-4%, with inflation rising by 1–3%. It also found that increases in carbon tax revenue would allow income tax rates to fall, partially offsetting the negative consequences of the higher carbon price.

The oil price scenario assumed that the global price of oil rises by $100 per barrel for three years before returning to baseline. This resulted in a 1-2% decline in GDP growth, along with a significant increase in inflation, rising to over 6% in the oil-dependent United States.

The trade war scenario envisaged a “green club” of China, the euro area, the UK and the US which introduces common border carbon adjustments, essentially imposing an import tax on countries with less-stringent emissions standards. These countries outside the green club in turn retaliate with trade tariffs and barriers. The results of this scenario depend on how the carbon and import tax revenue is used, with an increase in long-term growth if it is channelled into productive government investment.

The report concludes with three recommendations for financial institutions and supervisory authorities, calling for the use of short-term scenarios and incorporating them into regulatory climate stress testing. It also recommends that outputs from long-term and short-term climate scenarios be considered together.