SustainaWeekly - How might climate policy impact economic growth?

Economist: Climate policy can have negative impacts on economic growth if there is an unbalance between the speed/stringency of such policy, and the ability of the private sector to adjust. We explore two examples in this piece. We first look at how emissions caps under the ETS may restrain growth if the private sector cannot adjust as policy becomes more stringent. We then also show that stricter climate regulation in the housing market could lead to a negative impact on household finances and/or house price declines for poorer energy labels.

Strategist: The DSTA published its Green Bond Report, whereby it shows that proceeds from its green bond tap in 2022 were directed to expenditures that are fully aligned with the EU Taxonomy. Looking forward, the DSTA will issue this year a new 20-year green bond (EUR 5 bn),in which taps of this bond expected in the coming years.

Sectors: The energy transition is metal-intensive and many metals have an important role to play in a sustainable future. Hence, the demand outlook for most of these metals remains favourable. However, from an aggregate price perspective, we do not expect prices to reach the peak levels of 2022. This trend will remain largely dependent on economic conditions in China and the outlook for the global economy.

ESG in figures: In a regular section of our weekly, we present a chart book on some of the key indicators for ESG financing and the energy transition.

How might climate policy impact economic growth?

• We set out a framework of how climate policies can impact economic growth, and give two concrete examples of such transition shocks, focusing on the regulatory side rather than carbon pricing

• In broad terms, the economic impact is determined by the balance between the speed and stringency of climate policy and the ability of the private sector to adjust

• If the private sector is able to adjust at the same or faster pace than policy, economic effects will be limited or even positive; the negative economic effects come if it is unable to do so

• Allowances under the ETS will be reduced at a faster pace in coming years. If the private sector is unable to match this pace of adjustment, output in the sectors will decline to make up the residual

• Stricter regulation in the housing market could lead to house price declines for poorer energy labels, and/or a negative impact on household finances, both of which could impact consumption

The economic effects of climate change are separated into transition shocks (the impact of policies to reduce emissions) and physical shocks (the impact of global warming and acute weather events). When it comes to transition shocks, economists tend to focus on the impact of higher carbon prices, which are designed to increase incentives to reduce emissions and provide revenues that can be recycled into climate objectives, but which can also squeeze household purchasing power and company profits. Though if the revenue is recycled back to households through transfers or tax reductions it can cushion the blow, while it economic growth can be boosted if the revenue is used for government investment spending. However, carbon prices are not the only game in town – and perhaps not even the most important - in terms of climate policy globally. According to the World Bank (see here), only around 23% of emissions are subject to carbon pricing, while the effective price tends to be quite low.

In addition, most carbon price mechanisms work through emission trading schemes (ETS - accounting for 69% of carbon revenues) rather than carbon taxes. An ETS generally works by limiting the supply of emission permits and therefore capping emissions, while the price is formed on the balance of demand and supply. So even here, regulation plays at least as an important role as the price signal. In this note, we set out a framework of how climate policies can impact economic growth, and give two concrete examples of such transition shocks, focusing on the regulatory side rather than the impact of a higher carbon price (which we have covered extensively in the past).

Climate policy and economic growth

In broad terms, the economic impact is determined by the balance between the speed and stringency of climate policy and the ability of the private sector to adjust. That speed will depend on the evolution of technology, the availability and price of capital equipment and the supply of skilled labour. There is also the issue of carbon leakage, where firms find it more profitable to import emission heavy products from economies where regulation is less stringent. If the policy and adjustment pace are in synch, then the impact on economic growth will be limited. Indeed, the impact on economic growth could be positive due to higher investments and innovation, which could spur productivity. However, if the speed and stringency of climate policy exceed the private sector’s ability to adjust, there will very likely be a negative impact on economic growth in the economy where the regulation is applied. There are various channels that can negatively impact the economy, depending on the exact regulation and the nature of the sector involved. These include:

1. Where the emissions related to a particular activity cannot be reduced (quickly enough) the emission reduction can only come from ending or reducing the activity

2. The value of certain physical assets may decline if regulation makes them unusable – or at least implies large costs to make them compliant. This can be exacerbated it there are shortages of labour or materials to make necessary adjustments.

3. Costs related to regulation imposed on households can reduce their spending in other areas

4. Large capital spending requirements in order to reduce emissions, can reduce profitability and capital spending in other areas

5. Uncertainty related to (future) policy and the potential for the effects (1-4) could lead to precautionary cuts in companies’ capital spending or household expenditure

6. Credit conditions could tighten adding to the drags on demand. Threats to the economy and declining physical asset values would lead to tightening financial and bank lending conditions leading to financial accelerator effects

To make these transmission channels more concrete, it is worth looking at a couple of examples. Below we first look at how emission caps under the ETS may restrain growth if the private sector cannot adjust as policy becomes more stringent. We then go on to look at how regulation could impact the real estate market.

Transition shocks and the ETS

The flagship policy in the EU to reduce emissions is the ETS. Under the system a cap is set on how many emissions allowances are put on the market and the cap has been decreasing each year. Changes are coming, which will increase the policy stringency: (a) the target annual reduction in emissions will be doubled (see chart below on the left), (b) free allowances for certain sectors will be phased out - in parallel with the introduction of the carbon border adjustment mechanism (c) two one-off ‘rebasings’ of the cap, reducing it by 90 million allowances in 2024 and an additional 27 million in 2026 (d) the scheme will be expanded to include maritime transport from next year (see our note here), while a separate ETS will be introduced for buildings, road transport and fuels for additional sectors.

As emission allowances decline at a faster pace, on aggregate the covered companies (currently electricity and heat generation, energy-intensive industry sectors and domestic commercial aviation) will obviously need to reduce their emissions more sharply. This can negatively impact output if the sectors covered on aggregate are unable to reduce the emission intensity of their output at the same pace. In that case, output would be lower than it otherwise would in the covered sectors as a whole as that would be the only remaining way to reduce aggregate emissions. Another channel that could impact future output growth is that high investment needs to achieve the emission reductions required by the ETS could reduce capital spending in other areas.

If the sectors covered by the ETS are able to adjust, the impact on output growth will be limited. Improved efficiency and potential lower energy costs could even be a boost to activity. There is evidence from the recent energy crisis of the industrial sector managing to reduce gas usage sharply, while continuing to expand (at least before cyclical headwinds for the industrial sector took over) – see chart below on the right for the case of the Netherlands. However, some of this adjustment entailed switching to other fossil fuels, and potentially the exhaustion of low hanging fruit.

Transition shocks and the building sector

The real estate sector’s transition to net zero emissions involves costly adjustments to properties to improve energy efficiency and switch to an alternative heating system. A study from the Dutch central bank (see here) shows that these costs can be significant (see chart on the left below). The highest costs are estimated in a scenario when all houses need to rely on heat pumps, while the lowest costs are in a scenario where buildings are heated through green gas, which would also require less improvements in energy efficiency. However, green gas is not available at the very large scale needed. The ‘second best’ involves some mix of the two. If the private sector is easily able to finance these costs and if the labour and materials and installations necessary to make the adjustments are readily available, this will reduce the economic impact. However, if this is not the case, there can be a significant negative effects, especially in a situation of a rapid increase in policy stringency. Examples are minimum energy label standards or a ban in the installation of oil and gas heating systems. Buildings with lower energy labels may then suffer price falls to reflect the cost of adjustment. The inability to easily conduct the adjustment due to shortages or financing restrictions could exacerbate the price decline. According to the DNB study, a large proportion of home owners would not have sufficient own funds to finance the adjustment (see chart below on the right). In addition, it estimates that more than 20% of homeowners would be credit-constrained and may not be able to make the required investment.

Real estate price declines can impact consumer spending via negative wealth effects and by depressing confidence. In addition, even where property owner can bear the costs or borrow, it can weaken their financial position and may lead to more saving and less spending. Finally, financial institutions can be impacted if the collateral value and the financial position of the borrower deteriorate, increasing the credit risk of their loans. Finally, these developments can lead to tighter credit conditions.