Near-Term Macroeconomic Impact of Decarbonisation Policies

In the 2022 edition of its world economic outlook, the International Monetary Fund (IMF) warns that climate inaction will result in “innumerable long term costs”.

In the report, the authors say that the near-term macroeconomic costs associated with decarbonisation are dwarfed by the costs of inertia and will remain manageable if policies are implemented gradually. Adding that further procrastination and “stop and go” climate policies will only exacerbate the toll.

The authors say that to achieve the goal of reducing global greenhouse emissions by 25% by 2030,  will require a “combination of a sustained and large increase in greenhouse gas (GHG) emission taxes and regulations on emissions”.

The paper explores the macroeconomic effects of these measures and compares the implications of various approaches for monetary policy. Their analysis finds that GHG taxes should be increased gradually and be combined with transfers to low-income households, subsidies to low-emitting technologies, and labour tax cuts.

The annual cost of this policy package is estimated between 0.15 and 0.25% of GDP growth and an additional 0.1 to 0.4% of inflation with respect to the baseline, depending on the speed at which electricity generation can transition toward low-carbon technologies. The more difficult the transition, the greater the tax increase or equivalent regulations needed to incentivise change, which will result in larger output losses and higher inflation.

Using the global macroeconomic model for the energy transition, a new model developed by the IMF, the authors say the credibility of climate and monetary responses will determine the impact of emissions taxes and regulations on key economic outputs.

Credible policies are, according to authors, rules-based commitments which are transparent and independently enforced, and they are also perceived as irreversible. This gives organisations in the public and private sectors the incentive and time to transition towards a low-emission economy, including through investment in research and development of low emission technologies that curb the need for abrupt GHG tax hikes.

Concerns about the costs of transition and whether climate policy could complicate central banks’ work by stoking wage-price spirals have been the reason for decades-long hesitation on implementing such policies. However, the IMF’s analysis shows that the longer central banks wait, the larger the output-inflation trade-offs and damage to bank credibility. Further delays would require an even more rushed transition in which inflation can be contained only at significant cost to real GDP.

Monetary policy will need to adjust to ensure inflation expectations remain anchored but, for the policies the authors modelled, the costs are small and much easier for central banks to handle than the typical supply shocks and sudden price surges associated with fossil fuel dependency.