Climate change mitigation has become one of the world’s foremost policy problems. The IMF is focused on the macroeconomic, fiscal, and financial challenges of climate change and related policies, but not mitigation policies per se. This is in line with its mandate and expertise. The Fund’s activities in the area of climate change are largely demand-driven, focused on providing advice 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 fiscal policy cooperation and design, likely to arise in negotiating a successor to the Kyoto Protocol, at the United Nations Climate Change Conference planned for December 2009.

The macroeconomic and fiscal challenges of climate change

Climate change is in many respects a unique and particularly difficult global economic problem. It involves a global spillover since emitters of greenhouse gases do not bear all the costs from the damage they cause. There is a strong mismatch between the (early) costs of action to limit its extent and the (later) benefits from doing so. There are large differences in how countries have contributed to the atmospheric concentrations that cause global warming and how they will be affected. And there are pervasive uncertainties, including the risk of a catastrophic impact of climate change on living conditions on our planet.

Two recent publications illustrate the contribution that the IMF can make in understanding and coming to terms with the macroeconomic policy challenges that climate change poses.

Macroeconomic challenges - A chapter in the Spring 2008 World Economic Outlook on climate change and the global economy sets out the macroeconomic challenges posed by climate change and policies to address the problem. It emphasizes that policies to mitigate climate change can have potentially rapid and wide ranging macroeconomic consequences.

The required establishment of a price on emissions of greenhouse gases would affect countries’ economic growth, saving and investment levels, capital flows, and exchange rates. Yet the chapter also reports simulation results that show how these costs can be minimized if policies are well designed. In particular, policies should be long-term and credible, yet flexible enough to be able to adjust to emerging information and changing economic conditions; and implemented as broadly as possible, while being managed so as to ensure an equitable distribution of costs.

Fiscal implications - A policy paper prepared for the Executive Board of the IMF deals in more detail with the fiscal implications of climate change. These take many forms. Climate change will directly affect tax bases and public spending needs, but beyond this there is also a more purposeful role for government tax and spending policies. To mitigate climate change—that is, reducing its extent by cutting emissions—fiscal instruments (emissions taxes, or cap-and-trade schemes to limit emission) are needed to ensure that the full environmental cost is borne by emitters of greenhouse gases.

Underlying fiscal policy for mitigation is the basic principle that any emitter of greenhouse gases should face the marginal cost to the entire world society of doing so. While this is a simple principle, it raises formidable conceptual and implementation problems, requiring worldwide efforts and solutions.

Public expenditure on adaptation—learning to live with changing climatic conditions—may also be required to reduce societies’ risk exposure through better infrastructure, coastal protection, education, health and water services, and meet other challenges of changing climate. Such expenditure is expected to rise as climate change progresses and could reach more than US$100 billion annually, by 2030 or earlier.

Implications for financial markets - Climate change has implications for financial markets to, with innovative instruments—such as catastrophe bonds and weather derivatives—providing a way to manage some climate-related risks. These too are discussed in the WEO chapter and policy paper, and also in an article in the March 2008 issue of Finance & Development, which contains several articles on macroeconomic aspects of climate change.

The Fund continues to contribute to key fiscal policy issues relating to climate change, including as part of recent policy analysis on food and fuel price subsidies. In the case of fuel markets for example, reducing subsidies is a key first step towards more positive emissions pricing. In addition, Fund staff are preparing a Special Issues paper on the public economics of climate change.

Other environmental work in the IMF

Though it has come to dominate the policy agenda, climate change is not the only environmental issue of potential macroeconomic significance. Others may include:

• local pollution, which can be addressed through environmental tax policy;
• forest and other renewable resource management involving resource tax and concession policies; and
• the appropriate structure of environmental tax systems.

Some of these issues may interact with climate policy issues (such as when reduced deforestation also leads to lower carbon emissions, and when less local pollution is associated with less burning of fossil fuels).However, to some degree, they are also stand-alone issues which, when they become significant to macroeconomic performance, warrant IMF attention.