## ch2

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### Introduction and motivation
- Objective: Examine effects of climate mitigation policies on the macroeconomy with emphasis on external sector impacts, leveraging the objective to eliminate carbon emissions by 2050.
- Gap: External sector impact of mitigation policies given cross-country structural differences (for example, fossil fuel dependence and renewables share) and differences in policy content and pace.
- Key research questions:
  - What are the consequences of climate mitigation policies on countries’ external sectors?
  - How do external sector outcomes depend on countries’ (sectoral) structural characteristics?
  - How does coordination of mitigation policies across countries impact external sector outcomes?
  - What effect does burden sharing of emission reductions between advanced and developing economies have on external sector adjustment?
  - What are the implications of mitigation policies for global current account balances, capital flows, and global interest rates?

### Scope, limitations, and interpretation
- Analysis limited to a specific mitigation scenario: the net-zero emissions by 2050 scenario analyzed in the October 2020 WEO using the G-Cubed global macroeconomic model.
- Findings are scenario-specific; literature debates remain on economy responses to carbon pricing, technological progress, input substitutability, and factor mobility.
- Global current account balances used descriptively (sum of absolute current account balances across all countries).
- Focus on medium-term external sector impacts over the next decade; longer-term climate damages are abstracted from in the chapter’s main analysis.

### Main findings (summary)
- A credible and globally coordinated carbon tax:
  - Decreases the current account in the greener advanced economies.
  - Increases the current account in more fossil-fuel-dependent developing countries.
  - Permanently reduces the return on carbon-intensive investment; investment falls globally, more so in fossil-fuel-dependent economies.
  - Global decline in investment reduces the global interest rate, decreasing saving across countries relatively uniformly; current account movements are driven primarily by investment responses and by country characteristics (initial carbon intensity and net fossil fuel exports).
- Coordinated supply-side policies (green subsidy for renewables and green infrastructure investment):
  - Boost investment and saving and increase the global interest rate.
  - Have a more limited impact on the external sector than the carbon tax because of limited pace of renewables expansion and identical size of green infrastructure boosts across countries, leaving current accounts broadly unchanged.
- Full coordinated policy package:
  - Reduces global current account balances by 25 percent by 2027.
  - Shifts capital flows toward greener advanced economies.
  - Global interest rate: initial rise from green infrastructure, then falls over time as rising carbon tax reduces investment, shifting activity toward more labor-intensive sectors.
- Partial implementation:
  - Can reverse or magnify external sector effects relative to coordinated implementation, depending on policy type and implementing country.
  - Unilateral carbon tax in Europe increases the current account in that region (rather than decreasing it under coordinated implementation) by reducing domestic investment and shifting capital abroad.
  - Unilateral green subsidy in Europe magnifies the external sector response in that region by further reducing the current account balance.
  - Partial implementation fails to address climate change effectively.
- Burden sharing:
  - Increased burden sharing in emission reductions between advanced and developing economies could reduce the size of the climate-policy-induced external sector adjustment between advanced and developing economies by a third.
  - Further moderation could result from policies accelerating investment in developing economies with less developed renewables sectors.
- Historical supporting estimate:
  - April 2022 WEO estimates investment in gas and oil sectors declined globally by 40 percent between 2014 and 2019.

### Model, scenario, and mechanisms
- Model: G-Cubed global macroeconomic model (intertemporal general equilibrium) with 10 countries/regions (AUS, CHN, EUW, IND, JPN, OEC, OPC, ROW, RUS, USA) and 20 sectors (detailed energy and power generation sectors).
- Key region-sector asymmetries:
  - Europe accounts for 62 percent of global renewable energy (solar, wind, other renewables); renewables ~20 percent of energy generation in Europe and the OEC; less than 5 percent in fossil fuel exporters.
  - Initial carbon intensity higher in fast-growing emerging markets such as China and India.
  - Russia and OPC are main fossil fuel exporters; Japan is a fossil fuel importer.
- Policy package components (October 2020 WEO calibration):
  - Carbon tax:
    - Calibrated to achieve an 80 percent reduction in emissions in each region by 2050 relative to 2018, after accounting for reductions from infrastructure investment and green subsidy.
    - Tax path: an initial tax rate followed by an annual increase of 7 percent.
    - Revenue recycling: a quarter of carbon tax revenue transferred to households; the remaining three-quarters recycled to reduce government debt.
    - Exception: OPC region emissions kept at the initial level.
    - Remaining 20 percent of emission reductions (to reach net-zero by 2050) assumed to come from factors not captured by the model (natural sinks and carbon removal technologies).
  - Green subsidy:
    - Output of renewables (solar and wind electricity generation sectors) subsidized by 80 percent.
    - Subsidy financed by government debt.
  - Low-carbon infrastructure investment:
    - Initial green public infrastructure investment of 1 percent of GDP gradually declines to zero over 10 years.
    - Productivity assumption: every 10 percent increase in aggregate infrastructure capital raises private sector productivity by 0.8 percent.
    - Additional spending of 0.2 percent of GDP sustains new infrastructure against depreciation.
- Mechanisms:
  - Carbon tax acts like a negative productivity shock for carbon-intensive sectors, shifting activity from capital-intensive high-carbon sectors to more labor-intensive low-carbon sectors; main channel for emission reductions and principal driver of investment declines.
  - Green subsidy and infrastructure policies raise relative returns and investment in renewables but are limited by the small initial size of the renewables sector and by pace-of-expansion constraints.
  - Credibility and anticipation: credible long-run carbon tax announcements induce immediate investment and dynamic responses.

### External sector response to a coordinated carbon tax (2023–33 average)
- Global aggregate effects:
  - Investment and saving decline by 2 percent of global GDP over the first decade.
  - The global interest rate declines by 0.25 percentage point.
- Cross-country heterogeneity:
  - Investment contraction largest in fossil-fuel-producing countries and regions (RUS, OEC, ROW, OPC).
  - Greener advanced regions (JPN, EUW) affected least.
  - China (CHN) and India (IND) more negatively affected than advanced economies because of carbon-intensive manufacturing.
- Current account:
  - Strong negative cross-country correlation of –0.94 between investment and current account responses.
  - Absence of correlation between the current account and aggregate saving (0.01).
  - Absolute value of the 10-year average current account response ranges from 0.3 to 3 percent of GDP.
- Real exchange rate (RER):
  - Cross-country correlation between current account and RER responses is –0.86.
  - Absolute RER adjustments range from 0 to 4.8 percent relative to the baseline path, with outsized response in initial years.

### External effects of green subsidy and infrastructure policies
- Green subsidy:
  - Acts like a positive sector-specific productivity shock for renewables.
  - Global investment (and saving) increase by 0.1 percent of GDP.
  - Global interest rate rises by 0.11 percentage point.
  - Renewables sector initially small (0.1 percent of global output); limits policy magnitude.
  - Europe: largest subsidy at 0.3 percent of GDP and 57 percent of the global green subsidy; Europe exhibits the largest decrease in the current account.
  - In regions where renewables sector is smallest (RUS, OPC), average green subsidy over first decade remains below 0.04 percent of GDP and current account increases the most.
- Infrastructure investment:
  - Front-loaded fiscal expansion: initial green public infrastructure investment of 1 percent of GDP declining to zero over 10 years.
  - Symmetric and coordinated implementation limits external sector impact: identical investment shifts across countries broadly offset in current-account terms while raising the global interest rate.
  - Public infrastructure boost offsets approximately half of the carbon-tax-induced decline in investment globally.

### Combined mitigation package and global aggregates
- Aggregate outcomes:
  - External sector impact of the package equals the sum of impacts of the three individual mitigation policies; carbon tax dominates.
  - Despite positive output growth globally during the initial decade, aggregate investment falls in all but the least carbon-intensive economies.
  - Global current account balances reduced by 25 percent by 2027 under the full coordinated package.
  - Carbon tax accounts for more than two-thirds (and for the model’s median region, 91 percent) of the total current account response to the mitigation package; it accounts for 46 percent of the overall RER adjustment.
- Capital flows and interest rates:
  - Capital flows shift toward greener advanced economies (Europe, Japan, United States) and away from lower-income oil-exporting developing economies, India, and the model’s “rest of the world” region.
  - Carbon taxes reduce investment and gradually decrease the global interest rate over three decades of coordinated mitigation.
  - The front-loaded green infrastructure policy raises the global interest rate in the short term; its effect is transitory and dissipates after the first decade.
  - Overall, following an initial infrastructure-induced rise, the mitigation policy package yields a sustained decline in the global interest rate.
- Quantitative snapshots and timelines:
  - Model reporting horizon and averages: 2023–33 average.
  - Carbon tax revenue in the first decade for the average country: 0.6 percent of GDP.
  - Coordinated package reduces global current account balances by 0.3 percent of global GDP by 2027 when added to April 2022 WEO projections.
  - Under a Europe-only implementation of the carbon tax and green subsidy: global investment (and saving) falls by 0.2 percent of GDP and the global interest rate decreases by 0.02 percentage point over the first decade relative to coordinated implementation.
  - Increased advanced-economy 2030 emission reductions in an alternative scenario: from 20 percent (baseline) to 40 percent by 2030; developing regions’ 2030 emission targets reduced from 32 percent (baseline) to 20 percent by 2030.
  - Under increased burden sharing, the shift in capital flows toward the five higher-income regions and countries is reduced by a third.
  - Increased burden sharing moderates the decline in global balances by 15 percent by 2027.

### Partial implementation, synchronization, and burden sharing
- Partial implementation effects:
  - Unilateral carbon taxes can reverse expected current-account adjustments and induce capital outflows from the implementing region (example: Europe-only carbon tax increases Europe’s current account vs. coordinated implementation where it decreases).
  - Europe-only green subsidy further boosts Europe’s activity and reduces Europe’s current account; because Europe dominates the global green subsidy, Europe-only subsidy results resemble coordinated implementation but with a smaller global interest rate rise.
  - Partial implementation fails to deliver required global emission reductions.
- Burden sharing:
  - Increasing advanced-economy mitigation effort relative to developing regions shifts capital flows and current-account responses; greater burden sharing can reduce cross-country external-sector adjustment by about a third and moderate the decline in global balances by 15 percent by 2027.
  - Policies accelerating renewables adoption in countries with less developed renewables sectors can further moderate external responses (financing via targeted recycling of carbon tax revenue, international financing, technology transfers).

### Policy implications and conclusions
- The carbon tax is the principal driver of heterogeneous external sector adjustments; it disproportionately reduces investment in more carbon-intensive economies and shifts capital toward greener advanced economies.
- Supply-side policies (green subsidies, infrastructure investment) have more limited external-sector impacts, due to constrained renewables sector size or symmetric global implementation.
- Policy synchronization across regions is crucial:
  - Unilateral carbon taxes can reverse current-account adjustments and induce capital outflows from implementing regions.
  - Partial implementation can magnify competitive disadvantages or economic boosts depending on the policy and region and fails to deliver global emission reductions.
- Targeted modifications and burden-sharing arrangements (for example, income-differentiated carbon price floors or sectoral carbon pricing, targeted recycling, international financing, technology transfers) can moderate adverse external-sector impacts while maintaining climate objectives.

*CHAPTER 2 CLIMATE POLICIES ANd EXTERNAL AdjuSTMENT, ch2 - CHAPTER 2 CLIMATE POLICIES ANd EXTERNAL AdjuSTMENT (source PDF).*

### Introduction

### ch2 - Introduction

### Introduction and Motivation
- Objective: Examine effects of climate mitigation policies on the macroeconomy with emphasis on external sector impacts, leveraging the objective to eliminate carbon emissions by 2050.
- Literature focus: impacts on economic activity, employment, international trade, distributional effects, commodity and financial markets, fiscal and monetary policies, and policy design given temperature limits and risks of catastrophic climate change.
- Identified gap: external sector impact of mitigation policies given cross-country structural differences (for example, fossil fuel dependence and renewables share) and differences in policy content and pace.

### Key Research Questions
- What are the consequences of climate mitigation policies on countries’ external sectors?
- How do external sector outcomes depend on countries’ (sectoral) structural characteristics?
- How does coordination of mitigation policies across countries impact external sector outcomes?
- What effect does burden sharing of emission reductions between advanced and developing economies have on external sector adjustment?
- What are the implications of mitigation policies for global current account balances, capital flows, and global interest rates?

### Scope, Limitations, and Interpretation
- Analysis limited to a specific mitigation scenario: the net-zero emissions by 2050 scenario analyzed in the October 2020 WEO using the G-Cubed global macroeconomic model.
- Findings are scenario-specific; literature debates remain on economy responses to carbon pricing, technological progress, input substitutability, and factor mobility.
- Global current account balances used descriptively (sum of absolute current account balances across all countries) without policy or normative implications.
- Focus on medium-term external sector impacts over the next decade; longer-term climate damages are abstracted from in this chapter’s main analysis.

### Main Findings (Summary)
- A credible and globally coordinated carbon tax:
  - Decreases the current account in the greener advanced economies.
  - Increases the current account in more fossil-fuel-dependent developing countries.
  - Permanently reduces the return on carbon-intensive investment; investment falls globally, more so in fossil-fuel-dependent economies.
  - Global decline in investment reduces the global interest rate, decreasing saving across countries relatively uniformly; current account movements are driven primarily by investment responses and by country characteristics (initial carbon intensity and net fossil fuel exports).
- Coordinated supply-side policies (green subsidy for renewables and green infrastructure investment):
  - Boost investment and saving and increase the global interest rate.
  - Have a more limited impact on the external sector than the carbon tax, because of limited pace of renewables expansion and identical size of green infrastructure boosts across countries, leaving current accounts broadly unchanged.
- Full coordinated policy package:
  - Reduces global current account balances by 25 percent by 2027.
  - Shifts capital flows toward greener advanced economies.
  - Global interest rate: initial rise from green infrastructure, then falls over time as rising carbon tax reduces investment, shifting activity toward more labor-intensive sectors.
- Partial implementation:
  - Can reverse or magnify external sector effects relative to coordinated implementation, depending on policy type and implementing country. Examples:
    - A unilateral carbon tax in Europe increases the current account in that region (rather than decreasing it under coordinated implementation) by reducing domestic investment and shifting capital abroad.
    - A unilateral green subsidy in Europe magnifies the external sector response in that region by further reducing the current account balance.
  - Critical shortcoming: partial implementation fails to address climate change effectively.
- Burden sharing:
  - Increased burden sharing in emission reductions between advanced and developing economies could reduce the size of the climate-policy-induced external sector adjustment between advanced and developing economies by a third.
  - Further moderation could result from policies accelerating investment in developing economies with less developed renewables sectors.
- Historical and supporting estimates:
  - April 2022 WEO estimates investment in gas and oil sectors declined globally by 40 percent between 2014 and 2019, supporting the model scenario’s reduction in fossil-fuel investment.

### The Approach: The Model-Based Mitigation Scenario

#### The G-Cubed Model (features and partitioning)
- Model: G-Cubed global macroeconomic model (intertemporal general equilibrium) used for simulations.
- World partition: 10 countries and regions (AUS, CHN, EUW, IND, JPN, OEC, OPC, ROW, RUS, USA) with major economies and fossil-fuel-producing countries separated.
- Sectors: 20 sectors with detailed energy and power generation sectors, including coal, natural gas, petroleum extraction, and renewables-based electricity generation (wind, solar, hydroelectric, other generation).
- Key region-sector asymmetries captured:
  - Initial carbon intensity varies across regions; higher in fast-growing emerging markets such as China and India due to heavier coal reliance.
  - Renewables importance: Europe accounts for 62 percent of global renewable energy (solar, wind, other renewables); renewables ~20 percent of energy generation in Europe and the OEC; less than 5 percent in fossil fuel exporters.
  - Energy trade differences: Russia and OPC are main fossil fuel exporters; countries like Japan are fossil fuel importers.
- Model features highlighted:
  - Intertemporal general equilibrium with standard optimization.
  - Rigidities (limits on pace of investment).
  - Cross-border capital and trade flows and bilateral input linkages.
  - Heterogeneous households and firms (some hand-to-mouth households; some backward-looking firms).
  - Monetary and fiscal policy rules.
- External sector: full-fledged external sector where saving-investment gap determines current account; real interest rate affects saving, investment, and human wealth via discounting.
- Assumptions: flexible exchange rates and open capital accounts for the 10 regions.

#### Climate Change Mitigation Scenario (policy package and calibration)
- Policy package components and calibration (October 2020 WEO):
  - Carbon tax:
    - Calibrated to achieve an 80 percent reduction in emissions in each region by 2050 relative to 2018, after accounting for reductions from infrastructure investment and green subsidy.
    - Tax path: an initial tax rate followed by an annual increase of 7 percent.
    - Revenue recycling: a quarter of carbon tax revenue transferred to households to protect poorest households’ purchasing power; the remaining three-quarters recycled to reduce government debt.
    - Exception: OPC region emissions kept at the initial level because of outsized negative economic impact from global decline in fossil fuel demand.
    - Note: the remaining 20 percent of emission reductions (to reach net-zero by 2050) assumed to come from factors not captured by the model (natural sinks and carbon removal technologies).
  - Green subsidy:
    - Output of renewables (solar and wind electricity generation sectors) subsidized by 80 percent.
    - Subsidy financed by government debt.
  - Low-carbon infrastructure investment:
    - Initial green public infrastructure investment of 1 percent of GDP gradually declines to zero over 10 years.
    - Investment directed to renewables and other low-carbon energy sectors, transport infrastructure, and services.
    - Productivity assumption: every 10 percent increase in aggregate infrastructure capital raises private sector productivity by 0.8 percent.
    - Additional spending of 0.2 percent of GDP sustains new infrastructure against depreciation, locking in productivity gains.
- Role of policies:
  - Carbon tax accounts for 80 percent of emission reductions by 2050 but negatively impacts economic growth.
  - Green supply-side policies provide limited direct emissions reductions but make the green transition growth neutral.
  - Scenario is designed to be employment-neutral and public-debt-neutral for the global economy.
- Baseline (without mitigation policies):
  - Baseline projects global carbon emissions rising at an average annual pace of 1.7 percent, reaching 57.5 gigatons by 2050.
  - Baseline abstracted from 2020 COVID-19 fall in output; assumes rebound brings 2021 close to 2019 levels.

#### Mechanisms of Macroeconomic Impact
- Two main channels:
  1. Carbon tax increases the relative price of fossil fuel energy:
     - Encourages energy efficiency and discourages energy usage.
     - Main channel for emission reductions.
     - Drives shift from capital-intensive high-carbon sectors to more labor-intensive low-carbon sectors, making decarbonization more negative for investment than for output and employment.
     - Less energy-intensive activity limits the size of carbon tax revenues.
  2. Carbon tax and green supply policies increase the price of fossil fuel energy relative to renewables:
     - Contribute to growth and investment in renewables sector.
     - Transition is slow due to limits on pace of sectoral expansion; targeted policies may be needed to accelerate renewables.
- Credibility and anticipation matter: credible carbon tax announced and implemented over decades can trigger large immediate investment and dynamic responses even if initial tax is small.
- Additional considerations:
  - Global transformation is gradual and orderly in the scenario; fossil fuel prices increase persistently but no abrupt adjustments assumed.
  - No technological breakthroughs assumed beyond spillovers from green infrastructure investment.
  - Results abstract from long-term climate damages; model extension incorporating damages suggests very limited economic and external sector impact over the next decade.

### External Sector Impact: Carbon Tax (Mechanics and Outcomes)
- Carbon tax functions like a negative productivity shock varying by sector and country based on carbon dependence and anticipated tax path.
- Greener countries are least affected; fossil fuel extraction activities are permanently reduced.
- Economic impact is back-loaded as tax levels increase gradually until 2050 to meet emission targets.
- Investment channel:
  - Returns to carbon-intensive investment permanently reduced; investment falls, with larger falls in fossil-fuel-dependent economies.
  - Investment responses drive current account movements given relatively uniform saving responses via global interest rate changes.
- Saving channel:
  - Global decline in investment lowers the global interest rate and decreases saving across countries in a relatively uniform manner.

### External Sector Impact: Supply-Side Policies and Full Package
- Green subsidy and green infrastructure:
  - Boost both investment and saving; increase global interest rate in the short run.
  - Because of limits to renewables expansion and identical green infrastructure boosts across countries, current accounts remain broadly unchanged relative to baseline.
- Full coordinated package:
  - Global current account balances reduced by 25 percent by 2027.
  - Capital flows shift toward greener advanced economies.
  - Global interest rate initially rises (green infrastructure) then falls (rising carbon tax reduces investment), reshaping sectoral activity toward labor-intensive sectors.

*Source: ch2 - Introduction*

### 1. Global CO

### ch2 - 1. Global CO

### Impact on Real GDP and Policy Composition
- The reduction in emissions is achieved through a carbon tax, a green subsidy, and infrastructure investment.
- Infrastructure investment and the green subsidy are described as growth friendly, while the carbon tax has a negative impact on growth but generates the bulk of emission reductions.
- Initially there is a boost in global activity, followed by a decline.
- Illustration: policy components labeled as (1) Baseline, (2) 1 + impact of carbon tax, (3) 2 + impact of green subsidy, (4) 3 + impact of infrastructure.

### External Sector Response to a Coordinated Carbon Tax (2023–33 average)
- Global aggregate effects:
  - Investment and saving decline by 2 percent of global GDP over the first decade.
  - The global interest rate declines by 0.25 percentage point.
- Cross-country heterogeneity:
  - Investment contraction is most pronounced in fossil-fuel-producing countries and regions (RUS, OEC, ROW, OPC).
  - Relatively greener advanced economies and regions (Japan (JPN), EUW) are affected the least.
  - China (CHN) and India (IND) are more negatively affected than advanced economies because of carbon-intensive manufacturing activities.
- Saving:
  - Saving declines more evenly across countries, dominated by the decline in the global interest rate.
- Current account:
  - The current account decreases where investment contracts the least and increases in countries where the carbon tax decreases investment the most, as capital relocates toward greener economies.
  - Strong negative cross-country correlation of –0.94 between investment and current account responses.
  - Absence of correlation between the current account and aggregate saving (0.01).
  - The absolute value of the 10-year average current account response ranges from 0.3 to 3 percent of GDP.
- Real exchange rate (RER):
  - RER depreciates in countries with the most negative economic impact (largest declines in investment and capital outflows).
  - The RER adjustment facilitates expenditure switching—reducing imports and increasing exports.
  - Strong link between current account and RER adjustment: cross-country correlation of –0.86 for responses.
  - Absolute RER adjustments, relative to the baseline path, range from 0 to 4.8 percent, with an outsized response in initial years.
- Note on fossil-fuel-exporting countries:
  - Increased current accounts in fossil-fuel-dependent economies result from permanent nature of the carbon tax and structural adjustment as aggregate investment declines.
  - Model does not capture intergenerational equity considerations from exhaustible fossil fuels, which could decrease the current account of fossil-fuel-exporting countries in response to a globally coordinated carbon tax.

### Country Characteristics Shaping the Carbon Tax Response
- Key determinants:
  - Initial carbon intensity.
  - Projected labor force and productivity growth rates.
  - Substitutability of carbon-intensive inputs (proxied by carbon tax revenue).
- Empirical relationships reported:
  - Collected carbon tax revenues exhibit a strong positive correlation with the change in the current account: where tax revenues (and projected carbon emissions) are highest, the current account increases the most.
  - Net fossil fuel exporters face reduced foreign demand for fossil fuels, further depressing investment and increasing the current account—even if the exporter does not impose a carbon tax.

### Green Subsidy: Macro and External Effects
- Mechanism:
  - The green output-based subsidy to the renewables sector (solar and wind generation) acts like a positive sector-specific productivity shock and complements the carbon tax.
- Global effects:
  - Investment (and saving) increase globally by 0.1 percent of GDP.
  - The global interest rate rises by 0.11 percentage point.
  - Limited magnitude relative to the carbon tax because the renewables sector is initially small (0.1 percent of global output) and there are limits on the pace of investment.
- Cross-country heterogeneity:
  - Europe has the strongest investment boom due to abundant renewable generation and limits to the pace of investment favoring regions with existing capital for renewables.
  - Fossil-fuel-producing countries and regions with small renewables sectors (RUS, OPC) see decreased investment in fossil fuels as the relative price of fossil-fuel-based energy rises.
  - Saving increases in all regions in tandem with the rise in the global interest rate.
- Current account and RER:
  - Changes in the current account mainly driven by heterogeneity in investment responses.
  - Outsized decrease in Europe’s current account reflecting the investment boom; current accounts increase most in fossil-fuel-dependent countries.
  - Cross-country correlation between investment and current account responses is –0.91.
  - RER responses: largest appreciation in Europe and depreciations for fossil fuel exporters.
  - Current account and RER adjustments from the green subsidy are a fraction of those generated by the carbon tax.
- Size and targeting of the green subsidy:
  - In countries where the initial renewables sector is smallest (RUS, OPC), the average size of the output-based green subsidy over the first decade remains below 0.04 percent of GDP, and the current account increases the most.
  - Europe provides the largest subsidy—at 0.3 percent of its GDP and 57 percent of the global green subsidy—and exhibits the largest decrease in the current account.
- Policy considerations to moderate cross-country dispersion:
  - Accelerating adoption of green energy in countries with less developed renewables sectors could moderate external responses.
  - Financing options include targeted recycling of carbon tax revenue, international financing, and technology transfers enabling technology leapfrogging.

### Infrastructure Investment: Design and External Effects
- Policy design:
  - The green public infrastructure component is a sizable and front-loaded fiscal expansion intended to counter the carbon tax’s negative growth impact.
  - Assumed private sector productivity spillover from increased public infrastructure capital stock (Calderón, Moral-Benito, and Servén 2015).
  - Aggregate size of both components—temporary fiscal expansion and private sector productivity spillover—is assumed identical across countries.
- External sector impact:
  - The symmetric and coordinated nature of the infrastructure investment policy limits its impact on the external sector.
  - When policy-induced shifts in the investment curve are identical across countries, the resulting increase in investment and saving broadly offsets, increasing the interest rate but leaving the current account unchanged.
- Caveats:
  - Findings depend crucially on the assumed symmetric size of infrastructure investment across countries.
  - External sector results could be sensitive to assumed symmetry in productivity spillovers and their sectoral distribution.

### Mitigation Policy Package (Combined Carbon Tax, Green Subsidy, Infrastructure)
- Design objective:
  - The mitigation policy package is designed to be growth and public debt neutral by 2050.
- Aggregate outcomes:
  - The external sector impact of the package equals the sum of impacts of the three individual mitigation policies.
  - Despite positive output growth globally during the initial decade, aggregate investment falls in all but the least carbon-intensive economies.
  - The public infrastructure boost offsets approximately half of the carbon-tax-induced decline in investment globally.
  - The remaining negative impact on investment is mainly due to the higher capital intensity of fossil-fuel-producing sectors, whose role declines significantly as carbon emissions are reduced and economic activity shifts toward more labor-intensive sectors.
  - The external sector impact is dominated by the carbon tax; the other policies have much smaller external sector effects.

*Source: IMF staff calculations (simulations based on a net-zero emissions by 2050 scenario run using the G-Cubed global macroeconomic model; October 2020 World Economic Outlook).*

### 4. Real Exchange Rate

### ch2 - 4. Real Exchange Rate

### External-sector impacts of the mitigation policy package
- The overall external sector impact is dominated by the carbon tax.
- For the model’s median region, the carbon tax accounts for 91 percent of the total current account response to the mitigation policy package (Figure 2.7, panel 3).
- The carbon tax accounts for 46 percent of the overall real exchange rate (RER) adjustment.
- The relatively small initial size of the renewables sector—and any resultant subsidy to the sector—constrains the green subsidy’s external sector impact.
- The sizable infrastructure investment is symmetric across countries, limiting the external sector response.
- In greener advanced countries and regions (JPN, EUW), investment increases while saving remains broadly unchanged, generating a Dutch-disease-type effect with export activity shrinking as a share of GDP.

### Alternative scenarios: role of policy synchronization (Europe-only partial implementation)
- Under globally coordinated implementation, the carbon tax drives large intertemporal adjustments in investment and saving.
- If only Europe implements the carbon tax and the green subsidy:
  - Global investment (and saving) falls by 0.2 percent of GDP over the first decade relative to coordinated implementation.
  - The global interest rate decreases by 0.02 percentage point over the first decade.
  - Investment and saving fall in Europe; upstream fossil-fuel-supplying countries (Russia and OPC group) experience depressed upstream investment due to reduced demand for fossil fuels.
  - For regions without the carbon tax, investment increases marginally while saving declines.
  - Capital flows shift out of Europe and its fossil-fuel suppliers and into regions without the carbon tax, producing current account surpluses in Europe and fossil-fuel producers and deficits elsewhere (Figure 2.8, panel 2).
  - The fall in investment in Europe is magnified relative to coordinated implementation because the smaller global interest rate decline leads to a larger competitiveness loss; the current account response in Europe reverses from a decline (under coordination) to an increase (under Europe-only).
- Europe-only green subsidy:
  - Further boosts economic activity in Europe and raises investment there, decreasing Europe’s current account.
  - Because Europe dominates the global green subsidy, results resemble coordinated implementation except that the global interest rate rises by less when the subsidy is Europe-only.
  - Where the subsidy under coordinated implementation is small (OPC, Russia), the interest rate effect dominates (increasing investment and reducing the current account). Where the subsidy is sizable (JPN, USA), the absence of the subsidy in the Europe-only case reduces investment and increases the current account (Figure 2.8, panel 4).

### Differentiated mitigation efforts (advanced vs developing countries)
- Alternative scenario: increase the carbon tax for the five advanced regions/countries to double emission reductions from an average of 20 percent to 40 percent by 2030 relative to baseline; developing regions’ 2030 emission targets reduced from an average of 32 percent to 20 percent.
- Under increased burden sharing:
  - Current accounts in advanced economies increase relative to the baseline net-zero by 2050 scenario (Figure 2.9).
  - Current accounts in developing economies decrease relative to the same benchmark.
  - The size of the shift in capital flows toward the five higher-income regions and countries is reduced by a third.
- The differentiated mitigation scenario is broadly consistent with advanced-economy 2030 pledges and aligns with an international burden-sharing approach.

### Fiscal revenue recycling assumptions
- Baseline assumption: the carbon tax policy transfers a quarter of the tax revenues back to households; the remaining three-quarters is recycled to reduce government debt.
- Alternative recycling scenarios examined: (1) revenues used entirely to reduce public debt; (2) revenues fully transferred to households.
- Quantitative findings:
  - Current account responses are larger when revenue is recycled to reduce government debt.
  - The average difference in the absolute current account response across the 10 countries and regions when comparing the two extreme revenue-recycling assumptions is smaller than 0.25 percent of GDP.
  - Carbon tax revenue is relatively small during the first decade, at 0.6 percent of GDP for the average country.
  - Because of the small carbon tax revenue, external sector findings are not driven by the specific revenue-recycling assumption.

### Global implications
- Coordinated mitigation package effects:
  - Adds model-based current account and output deviations to April 2022 WEO projections, showing a 0.3 percent of global GDP reduction in global current account balances by 2027, with contributions from each of the three mitigation policies (Figure 2.10, panel 1).
  - The carbon tax accounts for more than two-thirds of the decline in global balances by 2027.
  - Current account surplus countries and regions (including Europe and Japan) are the main contributors to the decline.
- Partial implementation effects:
  - Europe-only carbon tax increases global balances (Figure 2.10, panel 2) because Europe’s current account increases under unilateral implementation.
  - Partial implementation of the green subsidy in Europe reduces global balances by more than coordinated implementation, driven by the magnified decrease in Europe’s current account (Figure 2.8, panel 4).
- Burden sharing:
  - Increased burden sharing moderates the decline in global balances by 15 percent by 2027.
- Capital flows and interest rates:
  - The mitigation package shifts global capital flows toward advanced economies (Europe, Japan, United States) and away from lower-income oil-exporting developing economies, India, and the model’s “rest of the world” region (Figure 2.11).
  - Carbon taxes reduce investment and gradually decrease the global interest rate over three decades of coordinated mitigation (Figure 2.12).
  - The front-loaded green infrastructure policy raises the global interest rate in the short term; its effect is transitory and dissipates after the first decade.
  - Overall, following an initial infrastructure-induced rise, the mitigation policy package yields a sustained decline in the global interest rate.

### Key quantitative snapshots and timelines
- Model reporting horizon and averages: 2023–33 average cited for many deviations.
- Investment and saving global drop under Europe-only carbon tax: 0.2 percent of GDP.
- Global interest rate decrease under Europe-only carbon tax: 0.02 percentage point over the first decade.
- Carbon tax revenue in the first decade for the average country: 0.6 percent of GDP.
- Global current account balances reduction by 2027 under coordinated package: 0.3 percent of global GDP.
- Increased advanced-economy 2030 emission reductions in scenario: from 20 percent (baseline) to 40 percent by 2030.
- Developing regions’ 2030 emission targets in differentiated scenario: from 32 percent (baseline) to 20 percent by 2030.
- Moderation of the shift in capital flows toward higher-income regions under burden sharing: reduced by a third.
- Moderation of decline in global balances under burden sharing by 2027: 15 percent.

### Conclusions and policy implications
- The carbon tax is the principal driver of heterogeneous external sector adjustments; it disproportionately reduces investment in more carbon-intensive economies and shifts capital toward greener advanced economies.
- Supply-side policies (green subsidies, infrastructure investment) have more limited external-sector impacts, due to constrained size or symmetric global implementation.
- Policy synchronization across regions is crucial:
  - Unilateral carbon taxes can reverse expected current-account adjustments and induce capital outflows from the implementing region.
  - Partial implementation can magnify competitive disadvantages or economic boosts depending on the policy and region.
  - Partial implementation fails to deliver required global emission reductions, highlighting the need for cooperation and burden-sharing arrangements (for example, income-differentiated carbon price floors or sectoral carbon pricing).
- Targeted modifications and burden-sharing can moderate adverse external-sector impacts while maintaining climate objectives.

*Source: IMF staff calculations, based on a net-zero emissions by 2050 scenario run using the G-Cubed global macroeconomic model (October 2020 WEO); figures and numeric values as reported in the original chapter content.*

### CHAPTER 2 CLIMATE POLICIES ANd EXTERNAL AdjuSTMENT

### CHAPTER 2 CLIMATE POLICIES ANd EXTERNAL AdjuSTMENT

### Coordinated mitigation policy effects and external adjustment
- A coordinated net-zero emissions by 2050 mitigation policy package would reduce global balances one-quarter by 2027.
- Carbon taxes would account for three-fourths of this reduction.
- Increased burden sharing, whereby advanced economies undertake a heavier load of emission reductions by 2030, can reduce the external sector adjustment by muting the differences in investment responses across countries.
- Policies that expand the renewables sector in countries where the sector is the smallest can accelerate investment where it is constrained the most, moderating external sector responses across countries.
- Results reveal a shift in cross-border capital flows toward the greener economies, which can be moderated by increased burden sharing in carbon emission reductions.
- The mitigation policy package affects global interest rates: following an initial rise reflecting the front-loaded infrastructure investment policy, the global interest rate falls over time as carbon tax levels increase.

*Author note: box author mentioned in source: Luciana Juvenal (Box 2.1).*

### Oil discoveries and the external sector (empirical cases)
- Common transmission mechanism following significant oil discoveries:
  - Investment booms at the time of the oil discovery and during subsequent years to build extraction and production facilities.
  - The investment boom results in a current account decline.
- Norway (North Sea oil discoveries):
  - In the four years following the oil discovery (between 1974 and 1978), investment increased on average by 17 percent.
  - The current account deficit more than doubled.
  - Investment and current account deficits peaked three years after the oil discovery; afterward, growth in oil exports increased the current account while investment returned to preboom levels.
- Equatorial Guinea (Zafiro oil field discovery in 1995):
  - Investment surge of 74 percent on average between 1995 and 1998.
  - The current account reached a deficit of 90 percent of GDP in 1998.
- Mexico (Ku-Maloob-Zaap field discovery in 1979):
  - Average investment increase of 11 percent between 1979 and 1982.
  - The current account as a share of GDP peaked with a deficit of 5.5 percent in 1981.
- Interpretation:
  - The transmission mechanism for oil discovery fits the narrative analyzed in the chapter and the G-Cubed model simulations, with the sign flipped when analyzing mitigation policies (mitigation policies lead to an overall reduction in investment instead of an increase).

*Author note: box author mentioned in source: Luciana Juvenal (Box 2.1).*

### Metzler-diagram intuition for carbon tax effects (Box 2.2)
- Setup:
  - Current account: CA = S − I.
  - Saving depends positively on interest rates; investment depends negatively on interest rates.
  - The saving-investment relationship can be illustrated with a Metzler diagram.
- Carbon tax impact under coordinated implementation (two-region world: Region 1 green/low carbon intensity; Region 2 carbon-intensive):
  - The carbon tax shifts the investment curve left in both regions, with a larger shift in the more carbon-intensive region (Region 2).
  - Takeaways:
    - The global interest rate falls (r* → r* ́) until the global current account adding-up constraint holds (CA1 + CA2 = 0).
    - In the new equilibrium, saving falls in both regions by an equal amount, as there is movement along the identical S(r) curve.
    - Investment also falls in both regions, but by less in the greener region (Region 1).
    - The current account falls in the greener economy, with an offsetting increase in the more carbon-intensive economy; the current account response is driven by heterogeneity in the investment response.
  - Additional points:
    - If carbon intensities are identical in the two regions, declines in investment and saving coincide and the current account stays at zero (CA1 = CA2 = 0).
    - In a richer setting (such as the G-Cubed model), the saving curve can differ across countries (for example, owing to differences in labor force projections), generating variation in the saving response between regions; the saving curve could also shift to varying degrees across countries in response to the tax (for example, reflecting intertemporal smoothing). Nevertheless, the carbon-tax-induced shift in the investment curve remains the main driver of the current account response.
- Carbon tax impact under partial implementation (greener Region 1 acts alone):
  - The interest rate falls and saving is reduced by the same amount in both regions, although partial implementation reduces the magnitude of the required adjustment for both variables.
  - Investment falls by more in Region 1, while increasing in Region 2 (Region 2 takes advantage of the reduced interest rate).
  - As a result, the current account impact is reversed under partial implementation: it decreases in Region 1 and increases in Region 2.
- Footnote clarification:
  - In a richer modeling environment, the magnitude of the adjustment for the interest rate and saving will depend on the relative size of the region that implements the carbon tax. If Region 1 is small enough not to affect the global interest rate, then only investment in Region 1 would decrease in response to the tax shock.

*Author note: box author mentioned in source: Rudolfs Bems (Box 2.2).*

### The green energy transition and impacts on metal producers (Box 2.3)
- Not all commodity exporters will face a demand contraction from the green transition; while demand for fossil fuels will decline, demand for metals critical for green energy transitions is projected to rise under IEA net-zero scenarios.
- Example projections and implications:
  - The International Energy Agency’s net-zero emissions by 2050 scenario projects a significant rise in demand for metals critical for green energy transitions.
  - The value of annual copper production could more than double in main exporting countries over the next two decades under such a scenario.
  - Projected increases for nickel, cobalt, and lithium are even more dramatic.
- Implications for global external balances:
  - The advent of metals critical for the energy transition could strengthen the impact of global commodity cycles on global current account balances.
  - Commodity cycles are an important driver of global current account balances because of cross-border trade and pronounced commodity price cycles.
  - The geographic concentration of production and reserves for the four critical metals is even higher than that for fossil fuels.
  - Hence, as metals replace fossil fuels, the role of cross-border trade in satisfying global demand for commodities could increase, strengthening their impact on global current account balances.
- Data and sources noted in the box:
  - The scenario value of production is based on reserves data and the IEA net-zero emissions scenario.
  - Production and reserves concentration comparisons use US Geological Survey data and IMF staff calculations.
  - Cobalt and lithium production data are for 2019; all other data are for 2020.

*Authors noted in source: Rudolfs Bems and Martin Stuermer (Box 2.3).*

*Italicized source attribution: CHAPTER 2 CLIMATE POLICIES ANd EXTERNAL AdjuSTMENT, ch2 - CHAPTER 2 CLIMATE POLICIES ANd EXTERNAL AdjuSTMENT (source PDF).*

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_Source: https://www.imf.org/-/media/files/publications/esr/2022/english/ch2.pdf_