Responding to climate change has become one of the world’s foremost policy challenges. In line with its mandate and expertise, the IMF is focused on the fiscal, financial, and macroeconomic challenges of climate change. The IMF provides advice on emissions mitigation policies to member countries where climate change can have a significant impact on economic and financial stability. It also aims to promote understanding of the difficult issues of international fiscal policy cooperation confronting the efforts to design a successor to the Kyoto Protocol. The IMF has also been involved in work for the Group of Twenty advanced and emerging economies on how developed countries can finance responses to climate change in developing countries.

Fiscal implications.

Broad-based charges on greenhouse gas emissions are the most natural mitigation instrument because they exploit all possible behavioral responses for reducing emissions throughout the economy. Regulatory policies, in isolation, tend to be much less effective because they focus on a narrower range of these responses.

Carbon taxes can also raise substantial amounts of government revenue while at the same time providing certainty over future emissions prices to encourage the long-term development and deployment of emissions-reducing technologies.

Cap-and-trade systems are another very promising policy, but generally they should be designed to look like fiscal instruments through revenue-raising and price stability provisions.

Designing a response: There are a number of considerations when designing a mitigation policy:

• the appropriate tax level and base, and treatment of traded goods;
• possible role of complementary policies—such as research, development, and deployment policies;
• treatment of forestry and other non-energy emissions;
• the balance between carbon and other taxes in the government’s budget;
• use of new revenues; and
• whether the distributional effects should affect policy design.

More generally, policy makers need to understand the pros and cons of using fiscal instruments over regulatory approaches, cap-and-trade systems, or project-by-project funding.
Questions also arise as countries coordinate over mitigation policies, such as appropriate compensation to encourage developing country participation and monitoring of broader energy tax/subsidy provisions that influence effective mitigation policies.

Financing responses to climate change

There is broad agreement that sustainable growth in developing countries will require large-scale investments for climate adaptation and mitigation, and that substantial additional financial assistance is needed. Without a credible framework for providing this assistance, on the needed scale and on the right terms, there is a risk that developing countries’ responses to climate change will be insufficient, and inconsistent with maintaining fiscal and broader macroeconomic sustainability.

An IMF proposal for a Green Fund would give developed countries the coordinating, commitment, and burden-sharing mechanism needed to provide finance to assist developing countries’ efforts on climate change adaptation and mitigation. The IMF would not play any role in creating or managing a Green Fund.

IMF staff, in collaboration with the World Bank and others, were also involved in a study commissioned by the G-20 on the effectiveness, revenue potential, and administration, of a wide range of fiscal options for climate finance. The IMF provided analysis on charges for international aviation and maritime emissions and a wide range of domestic (carbon-related and other) fiscal instruments.

Macroeconomic challenges

Climate change mitigation policies affect countries’ economic growth, saving and investment levels, capital flows, and exchange rates. Yet IMF analysis suggests these costs can be minimized if policies are well designed. In particular, policies should be long-term and credible, flexible enough to be able to adjust to emerging information and changing economic conditions, and implemented as broadly and equitably as possible.

Implications for financial markets

Climate change has implications for financial markets. Innovative instruments (e.g., catastrophe bonds, weather derivatives) offer a way to manage some climate-related risks.

Other environmental work in the IMF

There is also scope for reforming tax systems to better deal with broader environmental and other problems that can be a significant drag on economic growth, such as the health and productivity impacts of poor air quality, and severe congestion of major urban centers, as in recent studies on Chile and Mauritius.

IMF staff have also analyzed subsidies on fuel products, including their effects on climate change. In the case of petroleum products for example, reducing subsidies could considerably reduce greenhouse gas emissions in many countries, while at the same time reducing fiscal deficits (and with better targeted instruments commonly available to protect the poor). Staff are also involved in regular monitoring of fuel pricing policies in response to volatile international fuel prices. Another recent study defines and measures the concept of “green investment,” and explains recent trends.