Responding to climate change has become one of the world’s foremost policy challenges. In line with its mandate and expertise, the IMF focuses on the fiscal, financial, and macroeconomic challenges of climate change. The IMF also provides advice on the appropriate design of fiscal reforms to promote greener growth more broadly, particularly with regard to getting the prices right in energy and transportation systems.

Fiscal implications

Broad-based charges on greenhouse gas emissions are the most effective mitigation instrument because they exploit all possible behavioral responses for reducing emissions throughout the economy. Regulatory policies (at least 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. Fiscal challenges created by current economic difficulties present an opportunity to consider innovative environmental charges.

Cap-and-trade systems are another 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 many issues to consider in designing fiscal policies to mitigate climate change:

• the appropriate tax level and base, and the treatment of traded goods;
• the possible role of complementary policies—such as clean technology research, development, and deployment policies;
• the balance between carbon and other taxes in the government’s budget;
• how to use the additional revenues;
• the treatment of forestry and other non-energy emissions; and
• how to take account of distributional implications of the policies.

These and other issues are discussed at length in a recent IMF book, Fiscal Policy to Mitigate Climate Change: A Guide for Policymakers. And work is continuing on a volume focused specifically on the design of a U.S. carbon tax in the context of broader fiscal reform.

Financing responses to climate change

There is broad agreement that substantial financial assistance is needed for climate adaptation and mitigation projects in developing countries. In 2011, the IMF, in collaboration with the World Bank and others, undertook a study for the G-20 on the effectiveness, revenue potential, and administration, of a wide range of fiscal options for climate finance. This included analysis of potential charges for international aviation and maritime emissions and domestic (carbon-related and other) fiscal instruments.

An IMF proposal for a Green Fund would facilitate financial flows to developing countries’ to assist in their efforts on climate change adaptation and mitigation. The Green Fund would be neither created nor managed by the IMF itself, but it would play an important role as a framework to mobilize resources, and could be the first step toward a binding global agreement on reducing greenhouse gas emissions.

Macroeconomic challenges

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

Other environmental work in the IMF

There is also scope for reforming tax systems to deal better with broader environmental and related 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. The key challenges are to restructure existing energy tax systems to more effectively target the source of environmental harm (e.g., by taxing emissions or driving on busy roads rather than electricity consumption or vehicle sales), to better align (usually increase) tax levels with the scale of environmental harm, and to overcome practical challenges of higher energy and transportation costs.

Earlier IMF papers lay out core principles of green tax design and focus on case studies for Chile and Mauritius. And ongoing work is assessing the magnitude of pollution and other major environmental side effects associated with fossil fuel use, to provide actionable guidance for developed and developing countries—alike—on levels of energy and transportation taxes needed to strike the right balance between environmental benefits and economic costs.

A recent IMF paper measures the magnitude of subsidies for fossil fuel energy sources for over 160 countries, including both direct fiscal costs and implicit subsidies from the failure to charge for environmental damages. The paper draws on case studies to provide practical guidance (e.g., on better targeted instruments commonly available to protect the poor) for implementing energy price reform. 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. The IMF is 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.