How Climate Change Affects Potential Output

Climate change and the actions taken to tackle it will cause structural changes to the economy with “profound effects” on potential output, says this bulletin by the European Central Bank (ECB). The article stresses the need for structural policies that support effective movements of capital and labour as well as innovation in green technologies. 

In the paper, Miles Parker, senior lead economist for the ECB, details the complex impacts of long-run changes to climate patterns, extreme weather shocks and the green transition on potential output. 

Potential output represents the highest level of output economies can sustain over the medium-term and is a key concept in monetary policy. It is determined by three factors: capital stock, labour supply and total factor productivity. TFP captures how effectively capital and labour are used in production, reflecting both technological and managerial capabilities.

Long-run climate change can adversely affect output of certain sectors and regions through various channels. Chronic changes in average temperatures and precipitation, for example, can negatively affect agriculture, particularly in southern Europe. Higher temperatures can also impact labour supply, by reducing labour productivity and increasing climate-induced mortality, morbidity and migration.

Extreme weather events, such as floods and wildfires, reduce economic activity in the near-term through the destruction of capital stock. Shocks that damage infrastructure can amplify the impact on output by spreading the effects to initially unaffected businesses. The report states that higher rates of income, literacy, insurance coverage and access to finance can cushion the impact on output and support recovery.

Weather shocks can also reduce long-run TFP growth, particularly in the affected regions as young, skilled workers often leave and are slow to return. However, if economies “build back better” and seize opportunities to invest in new technologies, long-term impacts can be lessened.

Swift climate action is required to reduce the impact of climate change on output, but can itself have adverse consequences. The transition will shift capital and workers both between and within sectors and companies. Moving workers from carbon-intensive jobs to green ones may impair labour supply if there are substantial skill mismatches, says the report.

The overall impacts of the net-zero transition on TFP will depend on the relative productivity of growing green businesses versus shrinking emitting ones, as well as the rate of green innovation. While firm-level TFP may initially decline following a tightening of environmental policy, short-run costs can be offset if policies encourage productivity enhancing innovation.

Even with a swift and smooth transition, climate change and extreme events are likely to increase, requiring adaptation measures. Adaptation can mitigate long-run impacts on output, but can also divert resources away from innovation with some adverse effects for TFP.  

Finally, potential output may be affected by other climate-related factors, including disruptions to the supply chain for critical materials needed for renewable technologies and the deterioration of natural capital and ecosystem services. The bulletin stresses the need to improve nature-related risk modelling frameworks.