Using Short-Term Scenarios to Assess the Macroeconomic Impacts of Climate Transition

January 25, 2024Published by Banque de France

An earlier and more gradual shift towards a low-carbon transition will result in lower macroeconomic risks, according to results from short-term scenarios developed by senior economists at Banque de France (BdF).

If not properly anticipated, however, the green transition could lead to a rapid succession of shocks which will increase macroeconomic volatility and undermine the transmission of monetary policy, says the report.

The findings also show that substantial effects emerge within the first four quarters, indicating that the near-term consequences of transition are significant within standard monetary policy horizons.

According to the authors, existing scenarios underestimate the impacts of transition as they tend to be backward looking and therefore calibrated on periods with only modest transition efforts. As such, scenarios usually focus on carbon taxes and ignore transmission channels that may emerge in the future. They also often employ longer-term horizons which assume more smooth and gradual dynamics.

 

In contrast, the BdF’s forward-looking short-term scenarios cover a wide range of transition scenarios, including both positive and negative supply and demand shocks, as well as extremely adverse but plausible narratives. This allows the scenarios to account for uncertain policy trajectories, abrupt changes and tail risks, making them useful for climate stress testing exercises, say the authors.

Using a suite-of-model approach with dynamic, multi-country and sectoral modelling components, the authors start with detailed narratives and then assess their implications on economic activity and inflation.

Overall, the results show that the magnitude and duration of macroeconomic effects vary depending on the transition strategy. And while the effects tend to be inflationary or even stagflationary, private and public investment along with greater support for households could curb inflation and boost economic growth, according to the report.

With negative supply shocks, triggered by higher costs stemming from a disorderly carbon taxation or a sudden tightening of environmental regulations, stagflationary episodes could appear. The more gradually such policies can be introduced, the less inflationary the impact will be.

Line graph showing the effect of BdF transition scenarios on France's GDP
Image: Green Central Banking. Data: Banque de France

Instances of negative demand shocks such as uncertainty around transition policies or financial market turmoil caused by a mispricing of transition risks and stranded assets, are likely to be disinflationary and recessionary.

In the case of positive supply shocks caused by a boom in green public investment or a green bubble, the impacts are mixed.

Significant public investment has the strongest positive impact on GDP of any of the scenarios as well as a substantial upward effect on inflation, before stabilising after nine quarters. However the green bubble scenario has a positive impact on economic activity in the demand acceleration phase, but a recessionary one once the bubble bursts.

Line graph showing the effect of BdF transition scenarios on France's inflation
Image: Green Central Banking. Data: Banque de France

Finally, positive demand shocks, like a boom in green private capital expenditures or a scenario of green innovation that spills over to aggregate productivity, could stimulate economic growth and reduce inflation if they foster technological progress and productivity.

Finally, the authors indicate avenues for further research, including work to attribute probabilities to different scenarios, and to combine transition scenarios concurrently and together with physical risk scenarios.

This page was last updated February 1, 2024

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