Economy · June 23, 2022

The Grumpy Economist: Update on the Emperor of Climate Finance

I wrote a review of Stuart Kirk’s speech on climate finance, which among other things criticized the Dutch Central Bank for putting its fingers on the scales to make the “financial risk to the climate” seem bigger than it is. .

Remember where we are. Here we are not talking about the fantasy that in the next 5 years or so, on the scale of actual bank investments and the regulatory horizon, some physical “climatic” event will destroy the financial system, we are talking about “transition risk”, the possibility that our lawmakers take such extreme action that their carbon policies cause a financial meltdown of systemic proportions. And here if a carbon tax could do it.

Robert Vermeulen of the Dutch Central Bank wrote (in a personal capacity and with extraordinary courtesy under the circumstances) to defend their calculations:

In the Dutch Central Bank scenario that Kirk refers to, we model the impact of a $ 100 increase in the carbon price. We can argue whether this is low, high or outrageous, but if it were fully passed on to consumers it would make a round trip Amsterdam – New York $ 200 more expensive.

The GDP numbers in the table should be interpreted as relative to the baseline. So, let’s assume base GDP growth of 2% per year. Suppose the economy has a size of 100 in year 0, so the size of the economy is 110 in year 5. Hence, this basic economy has a GDP level of 102 in year 1, 104 in year 2 , etc. Since the scenario must be read as relative to the baseline, the level of GDP in the scenario is 100.7 in year 1, 100.8 in year 2, 103.2 in year 3, 106.7 in year 4 and 109.5 in the year 5. So, the carbon price we model doesn’t destroy the economy at all.

With respect to the interest rate shock, this variable is not assumed but follows endogenously from the model. Note that the long-term interest rate increases by 1 percentage point. As the economy grows slower than the baseline, the interest rate converges back to the base interest rate and is roughly equal to it in year 5. To put things in perspective, the bond yield 10-year US government bonds increased from 1.72% from March 1 to 3.12% on May 6 this year. Since a carbon price has a very similar effect on fossil fuel energy prices, the rise in long-term interest rates is not strange and entirely in line with what we have seen this year.

The main point “the interest rate shock … is not presupposed but follows endogenously from the model” Kirk is not right in saying that high interest rates are a separate hypothesis linked to the model for dropping GDP .

I have not read the appendix, nor studied the model. However, this being a blog, this won’t stop me from some speculation.

I’m still a bit puzzled. That a 2% increase in GDP tax should lower GDP makes a lot of sense, as it adds distortions (not counting externalities) to the economy. But real interest rates usually drop during recessions. Maybe this is a nominal interest rate hike?

It is also baffling that a carbon tax is so harmful. In response, I teased Robert a bit: why don’t you fake a drop in Europe’s already prodigious fuel taxes? If an increase in carbon tax reduces GDP that much, a decrease in fuel taxes should raise GDP and lower interest rates by similar amounts!

In response to some of my questions, Robert adds:

Keep in mind that we look at tail risk scenarios and how banks would be affected in the event of a sharp rise in carbon prices. In case the policy maker wishes to achieve the Paris Agreement carbon emissions targets, we would like to argue that ideally a predictable political path is presented to companies up to 2050. This allows for a gradual adjustment of the economy, but requires a timely action. However, when governments wait too long and still want to meet emission targets, the economy will experience a major shock.

This is interesting. I assume this means that the economic model has very high “compliance costs”. Taxes usually have a “tier effect”, so the speed of implementation doesn’t really matter. Kirk may have something to say about a model where the introduction of the carbon tax suddenly has a much bigger effect than spreading it over a few years.

Perhaps interestingly, in the study we also analyze the effects of technology shocks that make solar energy much cheaper and easier to store. Basically this is a deflationary price shock and, due to the adjustments in the economy, still leads to temporary GDP growth below base growth. In this case, in fact, we see a decrease in the interest rate because the shock of the source is deflationary, that is, energy becomes cheaper.

Doesn’t matter what you do, does GDP go down? Cost reduction supply shocks are usually positive for GDP. Does this model appear to have a very strong Phillips curve, so that lower inflation (which we could now all think of as a good thing) reduces GDP? Luckily our ancestors who built power plants, highways and dams didn’t think they provided improvements to a reduction in GDP! The last comment leads to my question of whether we are looking at real versus nominal interest rates.

Save the best for last:

Keep in mind that increases in the price of carbon, at least by the magnitude we have modeled, should not lead to financial crises. For the Dutch economy, a $ 100 carbon price increase equates to just under 2% of Dutch GDP at face value. We modeled it as a quota (e.g. similar to OPEC production limits), so the benefits of higher prices fall on fossil fuel producers. If you model it as a tax levied by governments and assume that the tax is redistributed, for example as a decrease in VAT, you will find (much) less impacts on GDP. Thus, with appropriate policies it is ideally possible to simultaneously achieve a reduction in carbon emissions and minimize short-term negative impacts on the economy.

“The price of carbon goes up, at least by [big] magnitude we have modeled should not lead to financial crises.“Well, the game is right there. As far as the subject of Kirk’s whole speech is concerned, there is a financial system risk climate, or is it all a smokescreen to convince central banks to define fossil fuels where legislators won’t go, that’s it (and, I would add, it is even more contradictory for regulators to say that they must intervene in defining fossil fuels before lawmakers impose the big carbon tax because lawmakers will never impose the big carbon tax.)

The last part is important as we think about the real problem: What you do with your carbon tax revenue matters a lot for its impact on its economic effect. If the revenue from the carbon tax is used to compensate for other distorting taxes, I can easily imagine that GDP will increase, which is good for everyone. There are other taxes with much higher marginal rates and much worse distortions.

We are obviously seeing an experimental version of the calculation, courtesy of Vladimir Putin. Others like Ben Moll are making more microeconomic calculations that the effect of this large and sudden price increase and quantity reduction will be much smaller. We will see. We will also see if there is any stress on the banking system due to the rise in oil prices. For now, the higher prices are causing drama , in legacy oil profits, not the slump predicted by climate financial risk advocates. Econ 101 works. But it is worth pointing out that the carbon tax and “Putin’s price hike” are economically identical, so the experience of one can inform the other and complain about the one is a bit silly if one approves with enthusiasm the other.