The Grumpy Economist: Climate Finance Emperor Update

I wrote review of Stuart Kirk’s speech on climate financewho, among other things, criticized the Dutch Central Bank for putting its fingers on the scales to make “climate financial risk” look bigger than it really is.

Remember where we are. Here we are not talking about the fantasy that in the next 5 years or so, on the scale of real bank investment and the regulatory horizon, some physical “climate” event will destroy the financial system. We’re talking about “transition risk,” the possibility that our legislators will take such extreme action that their carbon policies will trigger a systemic financial crisis. And here is whether a carbon tax can do it.

Robert Vermeulen of the Dutch Central Bank wrote (on his own behalf and with unusual courtesy given the circumstances) in defense of his calculations:

In the Dutch Central Bank scenario, Kirk refers to the fact that we are modeling the impact of a $100 increase in the price of carbon. Whether this is low, high, or outrageous we can argue, but if passed on entirely to consumers, it would make the Amsterdam-New York round trip $200 more expensive.

The GDP figures in the table need to be interpreted relative to the baseline. So, let’s assume that the underlying GDP growth is 2% per year. Suppose the economy has a size of 100 in year 0, then the size of the economy is 110 in year 5. So this base economy has a GDP level of 102 in year 1, 104 in year 2, and so on. Since the scenario should be considered relative to the base case, the scenario GDP level is 100.7 in year 1, 100.8 in year 2, 103.2 in year 3, 106.7 in year 4 and 109.5 in year 5. So the price of carbon in our model does not destroy the economy in any way.

As for the interest rate shock, this variable is not implied but comes endogenously from the model. Note that the long-term interest rate increases by 1 percentage point. As the economy grows at a slower rate compared to the baseline, the interest rate approaches the baseline interest rate again and roughly equals it in the fifth year. For comparison: the yield on 10-year US government bonds increased from 1.72%. from March 1 to 3.12% from May 6 this year. Since the price of carbon has a very similar effect to fossil fuel prices, the increase in long-term interest rates is not out of the ordinary and is in line with what we have seen this year.

Key point: “An interest rate shock … is not implied, but flows endogenously from the model.” Kirk is wrong in stating that high interest rates are a separate assumption included in the model to cause GDP to fall.

I didn’t read the app or study the model. However, since this is a blog, that won’t stop me from making a few guesses.

I’m still a little puzzled. That a tax increase of 2% of GDP should lead to a decrease in GDP makes a lot of sense, as it adds distortion (apart from externalities) to the economy. But real interest rates usually fall during recessions. Maybe it’s an increase in the nominal interest rate?

Also puzzling is the fact that a carbon tax causes such damage. In response, I teased Robert a little: why don’t you simulate lowering already huge fuel taxes in Europe? If raising the carbon tax reduces GDP so much, then cutting fuel taxes should increase GDP and lower interest rates by the same amount!

In response to a few of my questions, Robert adds:

Please note that we are investigating tail risk scenarios and how banks will be affected in the event of a sharp rise in carbon prices. In the event that a politician wants to meet the goals of the Paris Agreement on carbon emissions, we argue that ideally you present companies with a predictable policy path until 2050. This allows for a gradual adjustment of the economy, but requires quick action. However, when governments wait too long and still want to hit emissions targets, the economy will experience a bigger shock.

It is interesting. I assume this means that the economic model has very high “adjustment costs”. Usually taxes have a “level effect”, so the speed of introduction is not of great importance. Kirk has something to say about a model in which a sudden introduction of a carbon tax has a far greater effect than spreading it out over several years.

Perhaps interestingly, in the study, we also analyze the effects of technological upheavals that make solar power much cheaper and easier to store. This is essentially a deflationary price shock, and due to adjustments in the economy, it still results in some temporary reduction in GDP growth from baseline growth. In this case, you do see a decline in the interest rate because the source shock is deflationary, i.e. energy is getting cheaper.

Whatever you do, GDP falls? Typically, supply shocks associated with cost cuts are good for GDP. This model seems to have a very strong Phillips curve, so lower inflation (which we can all now consider a good thing) lowers GDP? It’s good that our ancestors, who built power plants, highways and dams, did not think that improved supplies reduce GDP! The last comment leads to my question whether we are looking at real ones or real ones. nominal interest rates.

Let’s save the best for last:

Note that rising carbon prices, at least on the scale we modeled, should not lead to financial crises. For the Dutch economy, a $100 increase in the price of carbon represents just under 2% of Dutch GDP at face value. We have modeled this as a quota (similar to OPEC production caps, for example), so the benefits of higher prices are borne by fossil fuel producers. If you were to model it as a tax levied by governments and assume that the tax is redistributed, such as a VAT cut, you would find a (much) smaller impact on GDP. Therefore, with appropriate policies, you can ideally achieve both a reduction in carbon emissions and a minimization of the negative short-term impact on the economy.

“Carbon prices are rising, at least [big] the scale we have modeled should not lead to financial crises.“Well, the game is over here. As for the theme of Kirk’s entire speech, that is financial system risk from the climate, or is it all a smokescreen to get central banks to stop funding fossil fuels, where lawmakers don’t go, game over. (And, I would add, even more controversial is that regulators are saying they have to step in to fund fossil fuels before lawmakers do a big carbon tax, because lawmakers will never do a big carbon tax. )

The last part is important as we are thinking about the actual problem: What you do with carbon tax revenues makes a big difference in how it affects the economic impact.. If carbon tax revenues are used to offset other distorting taxes, I can easily imagine that GDP would rise and that would be a win-win. There are other taxes with much higher marginal rates and much more distortion.

Of course, we are observing an experimental version of the calculation, kindly provided by Vladimir Putin. Others, like Ben Moll, are making more microeconomic calculations that the effect of this large and sudden price spike and quantity cut will be much smaller. We’ll see. We’ll also see if there’s any stress at all in the banking system as a result of higher oil prices. For now, higher prices are causing dramatic increases profited from conventional oil, not the crash predicted by climate financial risk advocates. Economy 101 works. But it’s worth noting that the carbon tax and “Putin’s price hikes” are economically identical, so the experience of one can inform the other, and complaining about one is a bit silly if one enthusiastically supports the other.