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

=== 15.2.2 Macroeconomic Context ===

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Entering 2020, the world already faced large macroeconomic headwinds to meeting the climate finance gap in the near term – barring some globally coordinated action. While an understanding of the disaggregated country-by-country, sector-by-sector, project-by-project, and instrument-by-instrument approach to raising climate finances analysed in the later parts of this chapter remains important, macroeconomic drivers of finance remain crucial in the near term.

Near-term finance financial flows in aggregate often show strong empirically observed cycles over time, especially in terms of macroeconomic and financial cycles. By ''near-term'' , we mean here the likely cycle over the next five to ten years (2020–2025 and 2020–2030), as influenced by global macroeconomic real business cycles (output, investment and consumption), with periodic asymmetric downside impacts and crises (Gertlerand Kiyotaki 2010; [[#Borio--2014|Borio 2014]] ; [[#Jordà--2017|Jordà et al. 2017]] ; [[#Borio--2018|Borio et al. 2018]] ). Financial cycles typically have strong co-movements (asset prices, credit growth, interest rates, leverage, risk factors, market fear, macro-prudential and central bank policies) ( [[#Coeurdacier--2013|Coeurdacier and Rey 2013]] ), they have large consequences for all types of financial flows such as equity, bond and banking credit markets, which in turn are likely to impact climate finance flows to all sub-sectors and geographies (with greater expected volatility in more risky and more leveraged regions). This is in contrast to ''longer-term trend considerations'' (2020–2050) that typically focus the attention on drivers of disaggregated flows of climate finance and policies. The upward trends of the cycles tend to favour speculative bubbles like real estates at the expense of investment in production and infrastructures whereas the asymmetric downsides raise uncertainty and risks for longer-term investments on newer climate technologies, and favour a flight to near-term safety (e.g., lowest risk non-climate short-term treasury investments, highest creditworthy countries, and away from cross-border investments ( [[#15.5|Section 15.5]] ) – making the challenge of longer-term low-carbon transition more difficult. In this respect, the impact of financial regulation is unclear. On the one hand, it could be argued that the tighter bank regulations under Basel III, combined with an economic environment with higher uncertainty and flatter yield curve, can push banks to retrench from climate finance projects ( [[#Blended%20Finance%20Taskforce--2018a|Blended Finance Taskforce, 2018a]] ), since banks tend to limit loan maturity to five or eight years, while infrastructure projects typically require the amortisation of debt over 15 to 20 years ( [[#Arezki--2016|Arezki et al. 2016]] ). On the other hand, other studies report that stricter capital requirements are not a driving factor for moving away from sustainability projects ( [[#CISL%20and%20UNEP%20FI--2014|CISL and UNEP FI 2014]] ).

Four key aspects of the global macroeconomy, each slightly different, pointed in a cascading fashion towards a deteriorating environment for stepped-up climate financing over the next crucial decade (2020–2030), even before COVID-19. The argument is often made that there is enough climate financing available if the right projects and enabling policy actions (‘bankable projects’) present themselves ( [[#Cuntz--2017|Cuntz et al. 2017]] ; [[#Meltzer--2018|Meltzer 2018]] ). The attention to ‘bankability’ does not however address access and equity issues ( [[#Bayliss--2018|Bayliss and Van Waeyenberge 2018]] ). Some significant gains in climate financing at the sectoral and microeconomic levels were nevertheless happening in specific segments, such as solar energy financing and labelled green bonds (although how much of such labelled financing is incremental to unlabelled financing that might have happened anyway remains uncertain) ( [[#Tolliver--2019|Tolliver et al. 2019]] ). Issues of ‘labelling’ ( [[#Cornell--2020|Cornell 2020]] ) apply even more to ESG (environmental, social and governance) investments, which started to grow rapidly after 2016 ( [[#15.6.5|Section 15.6.5]] ). Overall, these increments for climate finance remained, however, small in aggregate relative to the size of the shifts in climate financing required in the coming decade. Annual energy investments in developing regions (other than China) which account for two-thirds of the world population, with least costs of mitigation per tonne of emissions (one-half that in developed regions), and for the bulk of future expected global GHG emissions, saw a 20% decline since 2016, and only a one-fifth share of global clean energy investment, reflecting persistent financing problems and costs of mobilising finance towards clean energy transition, even prior to the pandemic ( [[#IEA--2021a|IEA 2021a]] ). In the words of a macroeconomic institution, ‘tangible policy responses to reduce greenhouse gas emissions have been grossly insufficient to date’ ( [[#IMF--2020a|IMF 2020a]] ). The reason is in part global macroeconomic headwinds, which show a relative stagnation since 2016 and limited cross-border flows in particular ( [[#Yeo--2019|Yeo 2019]] ).

'''Slowing and more unstable GDP growth.''' The first headwind was more unstable and slowing GDP growth at individual country levels and in aggregate because of worsening climate change impact events ( [[#Donadelli--2019|Donadelli et al. 2019]] ; [[#Kahn--2019|Kahn et al. 2019]] ). As each warmer year keeps producing more negative impacts – arising from greater and rising variability and intensity of rainfall, floods, droughts, forest fires and storms – the negative consequences have become more macro-economically significant, and worst for the most climate-vulnerable developing countries ( ''high confidence'' ). Paradoxically, while these effects should have raised the social returns and incentives to invest more in future climate mitigation, a standard public policy argument, these macroeconomic shocks may work in the opposite direction for private decisions by raising the financing costs now ( [[#Cherif--2018|Cherif and Hasanov 2018]] ). With some climate tipping points, potentially in the near-term reach (see AR6 WGI Chapter 4) the uncertainty with regard to the economic viability and growth prospects of selected macroeconomically critical sectors increases significantly (AR6 WGII Chapters 8 and 17). Taking account of other behavioural failures, this was creating a barrier for proactive and accelerated mitigation and adaptation action.

'''Public finances.''' The second headwind was rising public fiscal costs of mitigation and adapting to rising climate shocks affecting many countries, which were negatively impacting public indebtedness and country credit ratings ( [[#Cevik--2020|Cevik and Jalles 2020]] ; [[#Klusak--2021|Klusak et al. 2021]] ) at a time of growing stresses on public finances and debt ( [[#Benali--2018|Benali et al. 2018]] ; [[#Kling--2018|Kling et al. 2018]] ; [[#Kose--2020|Kose et al. 2020]] ) ( ''high confidence'' ). Every climate shock and slowing growth puts greater pressures on public finances to offset these impacts. Crucially, the negative consequences were typically greater at the lower end of income distributions everywhere ( [[#Acevedo--2018|Acevedo et al. 2018]] ; [[#Aggarwal--2019|Aggarwal 2019]] ). As a result, the standard prescription of raising distributionally adverse carbon taxes and reducing fossil fuel subsidies to raise resources faced political pushback in several countries ( [[#Copland--2020|Copland 2020]] ; [[#Green--2021|Green 2021]] ), and low rates elsewhere. Reduced taxes on capital, by contrast, was viewed as a way to improve growth ( [[#Bhattarai--2018|Bhattarai et al. 2018]] ; [[#Font--2018|Font et al. 2018]] ), and working against broader fiscal action. Progress with carbon pricing remained modest across 44 OECD and G20 countries, with 55–70% of all carbon emissions from energy use entirely unpriced as of 2018 ( [[#OECD--2021a|OECD 2021a]] ). Climate-vulnerable countries meanwhile faced sharply rising cost of sovereign debt. [[#Buhr--2018|Buhr et al. (2018)]] calculate the additional financing costs of Climate Vulnerable Forum countries of USD40 billion [[#footnote-012|5]] on government debt over the past 10 years and USD62 billion for the next 10 years. Including private financing cost, the amount increases to USD146–168 billion over the next decade.

'''Credit risks.''' The third headwind is rising financial and insurance sector risks and stresses (distinct from real ‘physical’ climate risks above) arising from the impacts of climate change, and systematically affecting both national and international financial institutions and raising their credit risks ( ''high confidence'' ) ( [[#Dafermos--2018|Dafermos et al. 2018]] ; [[#Rudebusch--2019|Rudebusch 2019]] ; [[#Battiston--2021a|Battiston et al. 2021a]] ). Central banks are beginning to take notice ( [[#Carney--2019|Carney 2019]] ; [[#NGFS--2019|NGFS 2019]] ). It is also the case that, even if at greater risk from stranded assets in the future, the large-scale financing of new fossil fuel projects by large global financial institutions rose significantly since 2016, because of perceived lower private risks and higher private returns in these investments and other factors than in alternative but perceived more risky low-carbon investments.

'''Global growth.''' The fourth headwind entering 2020 was the sharply slowing global macroeconomic growth, and prospects for near-term recession (which occurred in the pandemic). During global real and financial cycle downturns ( [[#Jordà--2019|Jordà et al. 2019]] ), the perception of general financial risk rises, causing financial institutions and savers to reallocate their financing to risk-free global assets ( ''high confidence'' ). This ‘flight to safety’ was evident even before the recent pandemic, marked by an extraordinary tripling of financial assets to about USD16.5 trillion in negative-interest earning ‘safer’ assets in 2019 in world debt markets – enough to have nearly closed the total financing gap in climate finance over a decade.

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