1. CLIMATE RELATED FISCAL POLICY ISSUES: POST COPENHAGEN & POST CRISIS EUROPEAN PEOPLES’ PARTY HEARING BRUSSELS, 14 APRIL, 2010 Victoria Perry Fiscal Affairs Department, IMF

2. Introduction  Core fiscal and macro issues relating to climate change, and their policy implications in the current context — focus on economic recovery and addressing fiscal challenges ahead  How should the challenges of recovery affect climate policy? And how should climate concerns be reflected in macro fiscal policies over the short and longer terms?  Draws on series of recent IMF papers including:  IMF Staff Position Note “Climate Policy and Recovery”, written by Benjamin Jones and Michael Keen  IMF Executive Board Paper “The Fiscal Implications of Climate Change”  “Climate Change and the Global Economy”, World Economic Outlook, Spring 2008

3. A word on climate externalities…  Climate change is an external social cost arising from increased stocks of GHGs in the atmosphere  Classic policy prescription is to set a price equal to the marginal social damage—but highly complex in practice!  Huge uncertainty (including small risk of catastrophe)  Asymmetric costs and benefits across/ within generations  Views differ greatly on the appropriate starting level (often ranging from $15-60/tC, Stern closer to $100/tC)  But even more important is the credible expectation of a gradual but sustained increase in emissions price over time  Technology market failures may also warrant policies on the spending side, for example targeted support for energy R&D

4. Fiscal policies for mitigation  Fiscal policy incentives essential for economic transition— but may not be “sufficient” (requiring wider measures, e.g. strengthened property rights, subsidy regulation)  Pollution pricing can be implemented in many ways (carbon tax, cap-and-trade, hybrids)—the common objective being to face emitters with a price reflecting the global damage caused  Policies are equivalent if abatement costs are known and permit rights sold — but taxes may be preferred (since getting emissions wrong over a short interval is not too costly)  Broad based emissions pricing—with transfers both across and within countries—more efficient (and potentially more equitable) than piecemeal, often subsidy-based actions

5. Emission & carbon price under mitigation policies 5 Emissions (percent deviation from baseline) Carbon Price (US Dollar per tonne Carbon) United States Eastern Europe and Russia JapanOPECWestern EuropeChina Other developing and emerging economies

6. Macroeconomic effects of mitigation policies (percent deviation from baseline unless otherwise indicated) 6 NOTE: Output refers to gross national product, interest rate refers to 10-year real interest rate. For real effective exchange rate, a positive value is an appreciate relative to the baseline. United States Eastern Europe and Russia JapanOPECWestern EuropeChina Other developing and emerging economies ConsumptionInvestment Current Account (percent of GDP; percentage points) Real Effect. Exchange Rate Interest Rate (percentage points) Output

7. Projected financial flows under emissions trading in 2020: upper tile—allocation based on equal per capita emissions rights; lower tile—allocation based on rights per unit of emission

8. Carbon pricing reform & recovery  More moderate mitigation and energy costs justify doing more rather than less — although economic fragility argues against rapid or unanticipated price shocks  Emissions pricing can substantially contribute to medium term fiscal consolidation, necessary in many member states — limiting need for more distorting taxes, productive expenditure cuts, or larger debts…  …but this requires that more emission rights be sold rather than freely awarded! The latter creates windfall profits for firms, and fails to protect consumers or address competitive concerns  Greater market stability in emissions trading markets desirable — improved depth, liquidity, and transparency (e.g. through expanded sectoral and geographical coverage)

9. ‘Green’ fiscal Stimulus  Environmental measures have been a valuable part of fiscal stimulus packages, and will continue to be so as enhanced public spending continues  Some spending also reduces exposure to future energy or emissions price shocks (e.g., subsidies to correct under- investment in energy efficient buildings due to market failures)  $430 billion (roughly 15 %) of stimulus expenditure of 20 countries allocated to climate-related investment themes — although UN suggests little has so far been spent  But much stimulus spending is on “dirty” investments (e.g. $270 billion allocated to road building projects in the G-20) — risks entrenching inefficiencies from the under-pricing of emissions

10. Supporting longer-term, greener growth  Implementation, and withdrawal, of environmental (and other) stimulus measures should reflect contribution to sustained growth and employment — careful monitoring and evaluation key  Best practice is to undertake environmental assessments of both policies and major projects — e.g. EU guidance on structural funding incorporates such assessments into cost-benefit analysis  Important to guard against spending measures substituting for more efficient emissions pricing—especially given the intense fiscal challenges in many countries  Spending support to ‘renewables’ less important than credible carbon pricing — e.g. poor returns to biofuels subsidies in EU/ US

11. Future climate related spending priorities are likely to include:  Reducing market barriers. e.g. limited subsidies to investments in energy-savings in buildings  Supporting new markets for reducing deforestation. e.g. financing new monitoring and verification arrangements.  Financing low carbon energy infrastructure. e.g. expenditure on cleaner electricity grids  Energy research and development essential to reducing future mitigation costs  Investment in adaptation. Sustained improvements in health, education, water, and sanitation services key

12. Fiscal policies for adaptation  Much adaptation will be by private households and firms— so getting price signals rights is key… …however, adaptation requires increased spending, for example, on transport, water, sea defenses, public agricultural R&D, health etc  Public adaptation costs likely high even in some EU countries—e.g. coastal protection in Netherlands  Substantial scope/need for supporting developing countries, where adaptation costs are estimated at $50-60 billion per year through 2020. More quantification work needed!  Uncertainties and irreversibilities require difficult judgments on timing and extent of public interventions  Climate risks are part of broader contingent liabilities management

13. Some concluding thoughts…  The basic climate challenge, or proper response to it, is little affected by the crisis. Emissions pricing key — efficient implementation need not impede the recovery…  Emissions pricing is an important potential source of revenue — and limits future growth risks from more distorting taxes, cutting productive expenditures, or higher levels of debt  “Green” stimulus measures can help sustain short term aggregate demand and employment — while increased climate-related public spending is also likely to be needed into the longer term  But spending policies should not substitute for more efficient pricing of pollution — especially given the intense fiscal challenges many countries now face