Carbon taxes and financial frictions: assessing climate policy impacts across borders

Economic effects of carbon pricing on developing countries

In this article Francesca Diluiso and Aydan Dogan discuss the international spillover effects of climate policies, focusing on the impacts of carbon pricing in advanced economies on emerging market and developing economies (EMDEs). They employed a multi-region, multi-sector computable general equilibrium (CGE) model which allowed them to simulate various scenarios and examine the complex interactions between different economic sectors and regions. In particular,  the authors compared a baseline scenario without carbon pricing to scenarios with carbon pricing implemented in advanced economies. Various economic sectors were considered, including energy-intensive industries and fossil fuel production and the analysis covered the period from 2020 to 2030.

Main  findings:

• Negative GDP impacts on EMDEs: The implementation of carbon pricing in advanced economies led to a reduction in GDP for EMDEs, with an estimated average decline of 0.25% by 2030 compared to the baseline scenario.
• Varied regional effects: The impact on EMDEs was not uniform, with fossil fuel exporters experiencing more significant negative effects than other regions.
• Sectoral shifts: Energy-intensive industries in EMDEs faced challenges due to reduced competitiveness, while some sectors benefited from increased demand for low-carbon alternatives.
• Trade impacts: The study found changes in trade patterns, with a decrease in fossil fuel exports from EMDEs to advanced economies implementing carbon pricing.
• Carbon leakage: The research identified a modest degree of carbon leakage, where emissions reductions in advanced economies were partially offset by increases in EMDEs.

Authors: Francesca Diluiso, Aydan Dogan
From: Bank of England

Economic effects of carbon pricing between US and the EU

Carattini et al. in a similar fashion as Diluiso and Dogan above, develop a two-country, two-sector dynamic general equilibrium model to study the international spillovers of climate policies through financial and trade linkages. The key elements of the model include:

– Two countries (Home and Foreign) with brown (polluting) and green (non-polluting) production sectors
– Global financial intermediaries that lend to firms in both countries and sectors
– Financial frictions in the form of occasionally binding constraints on banks
– Climate policies including carbon taxes and carbon border adjustment mechanisms (CBAMs)
– Macroprudential policies that can penalize banks’ carbon-intensive exposures

The model is calibrated to represent the European Union (Home) and United States (Foreign). The authors use it to simulate several climate policy scenarios:

1. Unilateral carbon tax in the Home country
2. Unilateral carbon tax plus CBAM in the Home country
3. Coordinated carbon taxes in both countries (global carbon price)

Key findings:

• An ambitious unilateral carbon tax can cause a global recession due to financial contagion through banks’ balance sheets.
• Without financial frictions, there is more carbon leakage but less negative impact on green sectors.
• CBAMs reduce carbon leakage in the short-term but can exacerbate financial instability: CBAMs lower returns on foreign brown capital, causing further losses for exposed banks. This leads to tighter credit conditions globally, worsening the recession.
• Macroprudential policy can mitigate transition risks:  Penalizing banks’ carbon exposures ex-ante makes the financial system more resilient to climate policy shocks.  However, unilateral macroprudential policy can shift carbon exposures to foreign banks, necessitating global coordination.

Carbon Taxes and Tariffs, Financial Frictions, and International Spillovers
Authors: Stefano Carattini, Giseong Kim, Givi Melkadze, Aude Pommeret
From: Georgia State University, Université Savoie Mont Blanc