Editing IPCC:AR6/WGIII/Chapter-15 (section)

=== Box 15.6 | Macroeconomics and Finance of a Post-COVID-19 Green Stimulus Economic Recovery Path ===

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Financial history suggests that capital markets may be willing to accommodate extended public borrowing for transient spending spikes ( [[#Barro--1987|Barro 1987]] ) when macroeconomic conditions suggest excess savings relative to private investment opportunities ( [[#Summers--2015|Summers 2015]] ) and when public spending is seen as timely, effective and productive, with governments able to repay when conditions improve as economic crisis conditions abate ( ''high confidence'' ). A surge in global climate mitigation spending in the post-pandemic recovery may be an important opportunity, which global capital markets are signalling ( [[#Global%20Investor%20Statement--2019|Global Investor Statement 2019]] ). The standard ‘neo-classical’ macroeconomic model is often used in integrated energy-economy-climate assessments ( [[#Balint--2016|Balint et al. 2016]] ; [[#Nordhaus--2018|Nordhaus 2018]] ). This class of Computable General Equilibrium (CGE) models, however, has a limited treatment of the financial sector and assumes that all resources and factors of production are fully employed, there is no idle capacity and no inter-temporal financial intermediation ( [[#Pollitt--2018b|Pollitt and Mercure 2018b]] ). Investment cannot assume larger values than the sum of previously determined savings, as a fixed proportion of income. Such constraint, as stressed by [[#Mercure--2019|Mercure et al. (2019)]] , implies that investment in low-carbon infrastructure, under the equilibrium assumptions, necessarily creates a (neo-Ricardian) crowding-out effect that contracts the remaining sectors. Box 15.6, Figure 1 shows the implications (in the red-shaded part of Figure 1).

Post-Keynesian demand-side macroeconomic models, with financial sectors and supply-side effects, in contrast, allow for the reality of non-equilibrium situations: persistent short- to medium-term underemployed economy-wide resources and excess savings over investment because of unexpected shocks, such as COVID-19. In these settings, economic stimulus packages allow a faster recovery with demand-led effects: ‘Economic multipliers are near zero when the economy operates near capacity. In contrast, during crises such as the GFC, economic multipliers can be high’ ( [[#Blanchard--2013|Blanchard and Leigh 2013]] ; [[#Hepburn--2020b|Hepburn et al. 2020b]] ). The expected results are opposite to the standard supply-led equilibrium models as a response to investment stimulus (the green-shaded part of Box 15.6, Figure 1), as intended by ‘green-stimulus’ packages such as proposed by the EU ( [[#Balint--2016|Balint et al. 2016]] ; [[#Mercure--2019|Mercure et al. 2019]] ).

Even if demand-led models work better in depressions, the question nevertheless is whether the additional public borrowing for such ‘green stimulus’ can be undertaken by market borrowings given already high public debt levels and recovered in the future from taxes as the economy revives. The results of recent macroeconomic modelling work ( [[#Liu--2021|Liu et al. 2021]] ) represented by 10 major countries/regions suggests answers. It uses a non-standard macroeconomic framework, with Keynesian features such as financial and labour market rigidities and fiscal and monetary rules ( [[#McKibbin--2013|McKibbin and Wilcoxen 2013]] ). First, a global ‘green stimulus’ of about an average of 0.8% of GDP annually in additional fiscal spending between 2020–30 would be required to accelerate the emissions reduction path required for a 1.5°C transition. Second, such a stimulus would also accelerate the global recovery by boosting GDP growth rates by about 0.6% annually during the critical post-COVID period. Third, the optimal tax policy would be to backload the carbon taxes to later in the macroeconomic cycle, both because this would avoid dampening near-term growth while pre-announced carbon tax plans would incentivise long-term private energy transition investment decisions today and provide neutral borrowing. This macroeconomic modelling path thus replicates the ‘green stimulus’ impacts expected in theory (Box 15.6, Figure 1). There are also some other additional features of the modelled proposal: (i) fiscal stimulus – needed in the aftermath of the pandemic – can be an opportunity to boost green and resilient public infrastructure; (ii) green research and development ‘subsidies’ are feasible to boost technological innovations; and (iii) income transfers to lower income groups are necessary to offset negative impacts of rising carbon taxes.

Substantial effects of the COVID-19 pandemic, which is relatively unique in its public health impacts when combined with the consequences of deep economy-wide shocks (economic downturn, public finances, and debt), are expected to last for decades even in the absence of no significant future recurrence. A scenario where the pandemic recurs mildly every year for the foreseeable future further hinders GDP and investment recovery, where growth is unlikely to rebound to previous trajectories, even within OECD economies ( [[#McKibbin--2020|McKibbin and Vines 2020]] ) and with worse effects in developing regions. History is strongly supportive: studies on the longevity of pandemics’ impacts indicate significant macroeconomic effects persisting for decades, with depressed real rates of return, increased precautionary savings ( [[#Jordà--2020|Jordà et al. 2020]] ), unemployment ( [[#Rodríguez-Caballero--2020|Rodríguez-Caballero and Vera-Valdés 2020]] ) and social unrest ( [[#Barrett--2021|Barrett and Chen 2021]] ). The direct effect on emissions is likely to be a small reduction from previous trajectories, but the longer-lasting impacts are more on the macroeconomic-finance side. Pandemic responses have increased sovereign debt across countries in all income bands ( [[#IMF--2021e|IMF 2021e]] ). However, its sharp increase in most developing economies and regions has caused debt distress (Bulow et al. 2021), widening the gap in developing countries’ access to capital ( [[#Hourcade--2021b|Hourcade et al. 2021b]] ). While strong coordinated international recovery strategies with climate-compatible economic stimulus is justified ( [[#Barbier--2020|Barbier 2020]] ; [[#Barbier--2020|Barbier and Burgess 2020]] ; [[#IMF--2020c|IMF 2020c]] ; [[#Le%20Quéré--2021|Le Quéré et al. 2021]] ; [[#Pollitt--2021|Pollitt et al. 2021]] ), national recovery packages announced do not show substantial alignment with climate goals ( [[#D’Orazio--2021|D’Orazio 2021]] ; [[#Hourcade--2021b|Hourcade et al. 2021b]] ; [[#Rochedo--2021|Rochedo et al. 2021]] ; [[#Shan--2021|Shan et al. 2021]] ). Contradictory post-COVID-19 investments in fossil fuel-based infrastructure may create new carbon lock-ins, which would either hinder climate targets or create stranded assets ( [[#Hepburn--2020a|Hepburn et al. 2020a]] ; [[#Le%20Quéré--2021|Le Quéré et al. 2021]] ; [[#Shan--2021|Shan et al. 2021]] ), whilst deepening global inequalities ( [[#Hourcade--2021b|Hourcade et al. 2021b]] ).

'''Considerations on global debt levels and debt sustainability as well as implications for climate finance.''' The Paris Agreement marked the consensus of the international community that a temperature increase of well below 2°C needs to be achieved and the SR1.5 has demonstrated the economic viability of 1.5°C. However, in terms of increase of supply of, in particular, public finance, often the debate is still driven by the question on affordability, considerations around financial debt sustainability and budgetary constraints against the background of macroeconomic headwinds – even more in the (post-)COVID-19 world ( ''high confidence'' ). The level of climate alignment of debt is hardly considered in debt-related regulation and/or debt sustainability agreements like the Maastricht Treaty ceilings (3% of GDP government deficit and 60% of GDP (gross) government debt) not considering economic costs of deferred climate action as well as economic benefits of the transformation.

Robust studies on the economic costs and benefits in the short- to long-term of reaching the LTGG exist for only few countries and/or regions, primarily in the developed world ( ''high confidence'' ) (e.g. [[#BCG--2018|BCG 2018]] ; McKinsey 2020a). With many studies underpinning the strong economic rationale for high investments in the short-term(e.g., McKinsey 2020a), regional differences are significant highlighting the need for extensive cooperation and solidarity initiatives.

For many developing countries, the focus of debt sustainability discussions is on the negative effect of climate change on the future GDP and the uncertainty with regard to short-term effects of climate change and their economic implications ( ''high confidence'' ). With long-term economic impacts of climate change being in the focus of the modelling community, the volatility of GDP in the short term driven by shocks is more difficult to analyse and requires country-specific deep-dives. IPCC scenario data is often not sufficient to perform such analysis with additional assumptions being needed ( [[#Acevedo--2016|Acevedo 2016]] ). For debt sustainability analysis, these more short-term impacts are, however, a crucial driver with transparency being limited to the significance of climate-related revision of estimates. The latter might result in a continued overestimation of future GDP as happened in the past, increasing the vulnerability of highly indebted countries ( [[#Guzman--2016|Guzman 2016]] ; [[#Mallucci--2020|Mallucci 2020]] ). While climate change considerations have already impacted country ratings and debt sustainability assessments (and financing costs), it is unclear whether current GDP forecasts are realistic. The review of the IMF debt sustainability framework leads to a stronger focus on vulnerability rather than only income thresholds when deciding upon eligibility for debt relief and/or concessional resources ( [[#Mitchell--2015|Mitchell 2015]] ), which could become a mitigation factor for the challenge described before.

Debt levels globally but particularly in developing and vulnerable countries have significantly increased over the past years with current and expected climate change impacts further burdening debt sustainability ( ''high confidence'' ). For low- and middle-income countries, 2018 marked a new peak of debt levels amounting to 51% of GDP; between 2010 and 2018, external debt payments as a percentage of government budget grew by 83% in low- and middle-income countries, from an average of 6.71% in 2010 to an average of 12.56% in 2018 ( [[#Fresnillo--2020b|Fresnillo 2020b]] ). COVID-19 has further reduced the fiscal space of many developing governments and/or increased the likelihood of debt stress. With many vulnerable countries already being burdened with higher financing costs, this limited fiscal space further shrinks their ability to actively steer the required transformation ( [[#Buhr--2018|Buhr et al. 2018]] ). Limited progress in increasing debt transparency remains another burden ( [[#15.6.7|Section 15.6.7]] ).

Considering the need for responses to both short-term liquidity issues and long-term fiscal space, current G20/IMF/World Bank debt service suspension initiatives are focused on the liquidity issue rather than underlying problems of more structural nature of many low-income countries ( [[#Fresnillo--2020a|Fresnillo 2020a]] ). In order to ensure fiscal space for climate action in the coming decade, a mix between debt relief, deferrals of liabilities, extended debt levels and sustainable lending practices including new solidarity structures need to be considered in addition to higher levels of bilateral and multilateral lending to reduce dependency on capital markets and to bridge the availability of sustainably structured loans for highly vulnerable and indebted countries. More standardised debt-for-climate swaps, a higher share of GDP-linked bonds or structures ensuring (partial) debt cancellation in case countries are hit by physical climate change impacts/shocks appear possible. The ‘hurricane’ clause introduced by Grenada, or wider natural disaster clauses provide issuers with an option to defer payments of interest and principal in the event of a qualifying natural disaster and can reduce short-term debt stress (UN Addis Ababa Action Agenda Art. 102) ( [[#UN--2015a|]] [[#UN--2015|UN 2015]] a ). A mainstreaming of such clauses has been pushed by various international institutions. The collective action clause might be a good example of a loan/debt term which became market standard. Definition of triggers is likely the most complex challenge in this context.

The use of debt-for-nature and debt-for-climate-swaps is still very limited and not mainstreamed but offers significant potential if used correctly ( ''high'' ''confidence'' ) ''.''

An increasing number of debt-for-climate/nature swaps have been seen in recent years applied primarily in international climate cooperation and in bilateral contexts, however, not (yet) to an extent addressing severe and acute debt crises ( [[#Essers--2021|Essers et al. 2021]] ; [[#Volz--2021|Volz et al. 2021]] ) offering significant potential if used correctly ( [[#Warland--2015|Warland and Michaelowa 2015]] ). Significant lead times, needs-based structuring, transparency with regard to the additionality of financed climate action, uncertainty with regard to own resource constraints and ODA accountability remain as barriers for a massive scale-up needed to make transactions relevant ( [[#Mitchell--2015|Mitchell 2015]] ; [[#Fuller--2018|Fuller et al. 2018]] ; [[#Essers--2021|Essers et al. 2021]] ). At the same time, the limitation of the use of debt-based instruments as a response to climate-related disasters and counter-cyclical loans might be necessary ( [[#Griffith-Jones--2010|Griffith-Jones and Tyson 2010]] ).

Ensuring efficient debt restructuring and debt relief in events of extreme shocks and imminent over-indebtedness and sovereign debt default are further crucial elements with a joint responsibility of debtors and creditors ( [[#UN--2015a|]] [[#UN--2015|UN 2015]] a ). In this context, the Commonwealth Secretariat flagged that the diversification of the lender portfolio made debt restructuring more difficult with more and more heterogeneous stakeholders being involved ( [[#Mitchell--2015|Mitchell 2015]] ) and the UN AAAA raising concerns about non-cooperative creditors and disruption of timely completion of debt restructuring ( [[#UN--2015a|]] [[#UN--2015|UN 2015]] a ). This is a side effect of a stronger use of capital markets, which needs to be carefully considered in the context of sovereign bond issuances ( [[#15.6.7|Section 15.6.7]] ).

'''Stranded assets.''' The debate around stranded assets focuses strongly on the loss of value to financial assets for investors ( [[#15.6.1|Section 15.6.1]] ), however, stranded assets and resources in the context of the transition towards a low-emission economy ‘are expected to become a major economic burden for states and hence the tax payers’ ( ''high confidence'' ) ( [[#EEAC--2016|EEAC 2016]] ). Assets include not only financial assets but also infrastructure, equipment, contracts, know-how, jobs as well as stranded resources ( [[#Bos--2019|Bos and Gupta 2019]] ) '''.''' Besides financial investors and fiscal budgets, consumers remain vulnerable to stranded investments. Against the background of the frequent simultaneousness of losses occurring for financial investors on the one hand and negative employment effects as well as regional development and fiscal effects on the other hand, negotiations about compensations and public support to compensate for negative effects of phasing out of polluting technologies often remain interlinked and compensation mechanisms and related redistribution effects untransparent.

Recent phase-out deals tend to aim for (partial or full) compensation rather than no relief for losses. In contrast to the line of argument in the tobacco industry, the backward-looking approach and a resulting obligation of compensation by investors in polluting assets can be observed rarely with the forward-looking approach of compensations by future winners for current losers dominating – despite the high level of awareness about carbon externalities and resulting climate change impacts among polluters for many years ( [[#van%20der%20Ploeg--2020|van der Ploeg and Rezai 2020]] ). In particular, transactions in the energy sector show a high level of investor protection also against much needed climate action which is also well illustrated by the share of claims settled in favour of foreign investors under the Energy Charter Treaty and investor-state dispute settlement ( [[#Bos--2019|Bos and Gupta 2019]] ) '''.'''

Late government action can delay action and consequently strengthen the magnitude of action needed at a later point in time with implications for employment and economic development in impacted regions requiring higher level of fiscal burden ( ''high confidence'' ). This has also been considered in the context of global climate cooperation with prolonged support for polluting infrastructure resulting in heavy lock-in effects and higher economic costs in the long run ( [[#Bos--2019|Bos and Gupta 2019]] ) '''.''' Despite a significant share of fossil resources which need to become stranded in developing countries to reach the LTGG, REDD+ remains a singular example for international financial cooperation in the context of compensation for stranded resources.

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