Expecting the Unexpected: Macroeconomic Volatility and Climate Policy—Summary

Belfer Center, Kennedy School, Harvard Univ. / by Warwick McKibbin, Adele Morris and Peter Wilcoxen (dated “November 2008”)

…All else equal, a climate regime that exacerbates downward macroeconomic shocks or depresses the benefits of positive macroeconomic shocks would be more costly and less stable than a system that better handles global business cycles and other volatility. This occurs because macroeconomic shocks can cause the cost of regulation to be much higher or lower than anticipated. These economic surprises can subject governments to enormous pressures to relax or repeal taxes or other policies perceived to impede economic growth.

Any policy framework whose costs or benefits depend strongly on forecasts of the future state of the world or national economic conditions is likely to fail, because the forecast is likely to be wrong. Countries committing to targets and timetables for emissions reductions are committing to a policy with highly uncertain costs. A global climate framework needs to endure even in the face of the wide variety of shocks that will undoubtedly occur over the coming decades. Thus, there must be a mechanism built into the framework that directly addresses the issue of cost uncertainty.

It is critical to get the global and national governance structures right. There must be a clear regulatory regime in each country and a transparent way to smooth out excessive short-term volatility in prices. A system that enables or even encourages short-term financial speculation in climate markets may collapse at huge expense to national economies. A hybrid system provides many of the advantages of a permit system while limiting opportunities for speculation through the annual permit mechanism.

Since shocks in one part of the world will certainly occur, the global system needs to have adequate firewalls between national climate systems to prevent destructive contagion from propagating local problems into a system-wide failure. A global cap-andtrade system would be extremely vulnerable to shocks in any single economy. A system based on national hybrid policies, on the other hand, would be explicitly designed to partition national climate markets and limit the effects of a collapse in climate policy in one part of the world on climate markets elsewhere.

In many respects, a global cap-and-trade system is less robust to macroeconomic shocks than a carbon tax or hybrid system. A global cap-and-trade system can cause unexpectedly high growth in one country to reduce growth in other economies. Carbon taxes and hybrid policies are not vulnerable to this effect. Additionally, if a global financial crisis were to occur, a cap-and-trade system would miss the opportunity for significant additional low-cost emissions reductions.

The global financial crisis of 2008 has starkly emphasized a number of important lessons for the design of global and national climate policy. These lessons need to be considered explicitly during international negotiations for future climate agreement. Anticipating shocks may mean rejecting global climate policies that reduce emissions reliably in stable economic conditions but are vulnerable to collapse in volatile conditions.


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