Trading Places: the Net Zero Fiscal Trilemma

Insights - Sustainability

Trading Places: the Net Zero Fiscal Trilemma

November 2023

Governments worldwide find themselves at a crossroads, grappling with a challenging trilemma that involves balancing the imperatives of achieving net-zero emissions, ensuring fiscal sustainability, and navigating the intricate landscape of political feasibility.

The temptation to inject substantial public funds into ambitious green projects holds the promise of hastening the journey towards net zero. Not only does this approach potentially enhance re-election prospects, but it also risks drawing ire from the bond market, concerned about fiscal responsibility.

On the flip side, adopting a more discerning and controlled strategy for subsidies may placate debt markets but requires a robust alternative to attain net-zero goals. The solution, invariably, involves employing carbon pricing mechanisms, whether direct or indirect, to reshape behavior and incentives. However, this path is not without its challenges, as it may lead to elevated prices and trigger a backlash from voters.

The current global stance on the net zero fiscal trilemma is nuanced. Research from the International Monetary Fund (IMF) indicates that existing and planned climate mitigation policies among the G20 nations are poised to achieve a 11% reduction in emissions by 2030 compared to a scenario without climate policies. Unfortunately, this falls short of the 25-50% reduction needed by 2030 to align with the Paris Agreement's temperature goals.

Chart 1: Falling Short: Current climate commitments will only reduce emissions by 11% til 2030

Source: IMF

While carbon taxes and emissions trading schemes now cover a significant portion of global emissions, the global average carbon price remains far from the levels necessary to drive impactful change, with Europe standing out as an exception.

In contrast, the United States has taken a distinctive approach, relying on substantial fiscal expenditure to catalyze decarbonization. The Inflation Reduction Act (IRA), initially projected to cost nearly $400 billion over a decade, now faces revised estimates suggesting a threefold increase, reaching around $1.2 trillion, according to Goldman Sachs.

This divergence in strategies puts other nations at risk of emulating the US approach, potentially resorting to increased subsidies, tax breaks, and fiscal incentives to meet their net zero commitments. Geopolitical considerations further fuel the argument for subsidies, driven by concerns over access to critical raw materials and technology. Governments often impose "domestic content requirements" as a precondition for fiscal support, aiming to revive local manufacturing and reduce dependence on global supply chains.

Leaders of the EU and other developed economies express apprehension that the expansive spending spurred by US fiscal support could elevate the cost of meeting their own commitments. The specter of a climate subsidy arms race looms, tempting governments to circumvent established "fiscal rules" in pursuit of net-zero goals. Navigating this delicate balance demands innovative solutions and international cooperation to address the interconnected challenges of emissions reduction, fiscal responsibility, and political considerations.

According to an analysis conducted by the International Monetary Fund (IMF), the strategy of heavily relying on government spending, coupled with the capping of carbon prices, to achieve net-zero emissions by 2050 may lead to an unsustainable increase in debt relative to Gross Domestic Product (GDP). The IMF's findings suggest that if government spending rises at a pace that facilitates an advanced economy reaching net zero by 2050 (and a large emerging economy achieving this goal by 2060), the debt-to-GDP ratio could surge by approximately 50 percentage points by 2050.

Chart 2:

Source: IMF Working Papers

In contrast, adopting a more moderate approach to climate policy spending, in alignment with estimates from the International Energy Agency (IEA) while still assuming the capping of carbon prices, would result in a more controlled increase in the debt-to-GDP ratio. Under this scenario, the analysis indicates a more modest rise of 10-25 percentage points by 2050.

This analysis underscores the delicate balance governments must strike between ambitious climate policy goals and maintaining fiscal responsibility. While robust climate policies are essential for addressing the pressing challenge of climate change, managing the associated fiscal implications becomes crucial to avoid excessive debt burdens. The findings emphasize the importance of exploring sustainable financing models and optimizing the allocation of resources to achieve both environmental and economic objectives.

This challenge is likely more pronounced for emerging economies heavily dependent on the export of oil, gas, and coal. Losing significant tax revenue from these sources may leave them financially strained, impeding their ability to invest in their decarbonization efforts. IMF research indicates that economies heavily reliant on fossil fuel extraction could witness a decline of 5.5% of GDP on average in tax revenue between 2019 and 2040. Those economies most dependent on fossil fuel exports for GDP tend to rely even more on coal, oil, and gas as a source of government tax revenue.

To address the fiscal trilemma, a more balanced approach is essential, one that considers fiscal and political realities. Carbon prices emerge as a crucial tool in this context. While carbon taxes are straightforward, emissions trading schemes represent a significant source of tax revenue, contributing nearly $70 billion to government coffers in 2022.

Chart: Revenue of Carbon Taxes, 2030, as %tage of GDP

Source: IMF Working Papers, Mitigation Policies for the Paris Agreement: An Assessment for G20 Countries

However, the implementation of carbon pricing, which often leads to higher energy prices, can disproportionately affect the poorest segments of society. To enhance the acceptance of carbon pricing, governments could consider transparently recycling a larger portion of the revenue back to the communities most affected. Currently, only 10% of the global revenue raised through carbon pricing is recycled back to vulnerable segments of society.

Presently, governments globally are inclined toward spending, applying industrial policies to boost green industries and align with net-zero goals. Even Europe has responded to this trend with its own support package. However, the reality remains that there's no such thing as a free lunch, and the reckoning for fiscal sustainability will eventually arrive.

The charts from the IMF's Fiscal Monitor report illustrate the formidable challenge confronting both advanced and emerging economies seeking to utilize public funds to expedite the energy transition. While tapping into debt markets for investments might be viable when interest rates are low and the economy is thriving, it presents a different proposition when interest rates rise, economic growth slows, and the debt burden multiplies in size.

The current trajectory of the global economy suggests a return to a pre-2008 environment characterized by high and volatile inflation and interest rates. In such a scenario, excessive government debt becomes undesirable. The challenges are further compounded by the likelihood that governments will find it challenging to reduce spending, particularly as aging populations place strain on infrastructure and healthcare services. Consequently, the primary recourse may be to raise taxes, with a strategic preference for imposing them on negative externalities, such as carbon emissions. This approach is seen as more prudent than burdening the productive components of the economy, namely labor and capital, which are essential for sustaining economic growth.

As long-term interest rates surge to levels not witnessed in 15 years, the bond market is poised to exert pressure on governments to reassess their approach to the net-zero fiscal trilemma. The confluence of rising interest rates, potential inflationary pressures, and the imperative to address climate change necessitates a careful recalibration of fiscal policies. Governments may increasingly consider the adoption of carbon taxes and other environmentally focused measures as part of a broader strategy to manage fiscal challenges while advancing climate goals. The impending decisions governments make in response to these evolving economic dynamics will likely shape the path towards a sustainable and resilient future.

Information is based on our current understanding of taxation legislation and regulations. Any levels and bases of, and reliefs from, taxation are subject to change. Tax treatment is based on individual circumstances and may be subject to change in the future. Although endeavours have been made to provide accurate and timely information, we cannot guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No individual or company should act upon such information without receiving appropriate professional advice after a thorough review of their particular situation. We cannot accept responsibility for any loss as a result of acts or omissions.


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