## CHAPTER 3 NEAR-TERM MACROECONOMIC IMPACT OF DECARBONIZATION POLICIEs

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### Introduction and context
- Scientific consensus (IPCC 2022) implies immediate and ambitious action is required to limit warming to well below 2°C and preferably 1.5°C and to achieve net carbon neutrality by 2050.
- By 2030, global emissions have to be reduced by at least 25 percent compared with today’s emissions to have a fighting chance of meeting those goals.
- Decades of procrastination have made the transition more abrupt and costly.
- Authors: Mehdi Benatiya Andaloussi, Benjamin Carton (co-lead), Christopher Evans, Florence Jaumotte, Dirk Muir, Jean-Marc Natal (co-lead), Augustus J. Panton, and Simon Voigts, with support from Carlos Morales, Cynthia Nyakeri, and Yiyuan Qi.

### Modeling approach and scope (GMMET)
- Model: Global Macroeconomic Model for the Energy Transition (GMMET), a multicountry, microfounded, nonlinear dynamic general equilibrium model.
- Key modeled activities: fossil fuel mining and trade; electricity generation (intermittent renewables and storage); transportation (electric vehicles and conventional cars); energy use in production and residential heating; non-fossil-fuel GHG activities such as agriculture.
- Regions: China, the euro area, the United States, and a rest-of-the-world block.
- Focus: near-term macroeconomic costs and budget-neutral climate policies; abstracts from long-term costs and benefits; two alternative calibrations for elasticities of substitution in electricity generation to reflect uncertainty.

### Key quantitative findings and projections
- Global growth: could be lower by 0.15 to 0.25 percentage point annually as a result of the transition.
- Inflation: could be 0.1 to 0.4 percentage point higher globally.
- Regional GDP growth costs (China, Europe, United States): in a range between 0.05 and 0.20 percentage point annually.
- Global GDP by 2030: could be between 0.9 and 2.0 percent below baseline.
- China, euro area, US (alternative low-elasticity calibration, Policy Package 1): GDP reduced by 1–2 percent by 2030.
- Credibility effects on GDP by 2030 (partial vs full credibility):
  - United States: GDP declines by 1.0 percent (partially credible) rather than 0.6 percent (fully credible).
  - Euro area: GDP declines by 1.0 percent rather than 0.5 percent.
  - China: GDP declines by 1.2 percent rather than 0.6 percent.
- Elasticity calibration impact:
  - In the most pessimistic substitution case, GHG taxes needed are about twice as large as in the benchmark case, and macroeconomic costs (lost output and higher inflation) are about twice as large.
- Delay scenario:
  - If decarbonization is delayed and then done faster, the resulting inflationary impulse is about three times stronger, and preventing it would require sacrificing roughly 1 percent of GDP over the course of four years.
- Contextual fiscal example:
  - 1.5 percent of US GDP is about $320 billion and corresponds to the climate portion of that country’s recently passed Inflation Reduction Act; the costs would be spread over eight years, or $40 billion a year.
- Under current policies, the IPCC projects emissions in 2030 will be more than 42 percent higher than those required to reach the Paris Agreement target.

### Mechanisms and distinctions from fossil-fuel price shocks
- GHG taxes:
  - Put a price on the right to pollute, increasing the cost of fossil fuels (an adverse supply shock).
  - Lead to lower net-of-tax prices for fossil fuel producers, deterring investment in fossil fuels.
  - Generate fiscal revenues (unlike fossil fuel price surges that transfer revenues to exporters).
  - Are intended to be permanent and implemented gradually, affecting forward-looking investment and consumption decisions.
- Fossil-fuel price shocks:
  - Often temporary and sudden, do not necessarily change relative prices by carbon content, and usually transfer revenues to exporters.
- Macro channel summary:
  - A GHG tax raises energy prices and implies a permanent decline in future productivity for firms; forward-looking agents anticipate lower future profits and cut investment and consumption.
  - In the short to medium term, lower aggregate demand can dominate the direct energy-cost effect; a central bank focused on stabilizing core inflation may want to accommodate the shock.
  - Investment in carbon-intensive capital drops; investment in renewables rises but may not fully offset the drop.

### Policy design, revenue recycling, and distributional implications
- All assessed policy packages are financed by GHG taxation only.
- Three recycling strategies contrasted:
  1. Lump-sum transfers to households (“Trans.”) — supports short-term consumption, compensates low-income households.
  2. Labor income tax cuts (Policy Package 1, “P1”) — reduces distortions, raises labor supply (labor supply elasticity = 0.15), increases wages net of tax, supports higher consumption, investment, and output.
  3. Production subsidies (feebate-style) to support sectoral production and investment — facilitates investment in low-carbon technologies but uses revenues away from households.
- Trade-offs across policy packages:
  - Policy Package 1:
    - Uses two-thirds of GHG tax revenues to cut labor taxes; one-third transferred to households.
    - Focus: limit consumption penalty; requires relatively higher GHG taxes and leads to larger investment declines.
  - Policy Package 2:
    - Combines support for households with subsidies to low-emission sectors; one-third of revenue to labor tax cuts, one-third to transfers, one-third to green subsidies.
    - Allows required emission reduction with lower GHG taxes and therefore less inflation.
  - Policy Package 3:
    - Rebates revenue at sectoral level; revenue from households’ activities transferred back to households; regulates share of electric vehicles.
    - Investment declines much less than in Policy Package 1; households bear more of the tax-induced slowdown.
- Distributional policy recommendations:
  - Rebating tax revenues to low-income households bolsters acceptance and credibility but can reduce output growth relative to other recycling options.
  - Recycling to reduce distortionary taxes (for example, labor income taxes) enhances growth and investment.

### Credibility, monetary policy, and the output-inflation trade-off
- Credible, gradual implementation minimizes near-term macroeconomic costs:
  - Gives agents time to adjust, induces mild inflationary pressures that require modest monetary adjustments, and preserves anchored expectations.
  - May allow some short-term easing to facilitate transition without large GDP costs.
- Lack of credibility or stop-and-go policies:
  - Require sharper adjustments later, generate stronger inflationary pressures, and make monetary policy’s task more difficult.
  - Eroded monetary policy credibility materially increases costs, as larger inflationary pressures demand stronger policy responses.
- Monetary policy targeting options:
  - Targeting core inflation (excluding energy) yields slightly higher headline inflation because of the tax’s direct impact on noncore CPI components.
  - Targeting core plus GHG price reduces headline inflation but has a larger output cost.
  - Including the GHG price in the CPI has limited macroeconomic implications as long as inflation expectations remain anchored.
- Wage indexation:
  - Wage indexation worsens the output-inflation trade-off; stabilizing core plus GHG price under wage indexation has a significantly higher output cost; stabilizing output risks a wage-price spiral.

### Costs of further delay and transition speed
- Delaying action amplifies transition costs:
  - Requires higher and faster increases in GHG taxes than in gradual scenarios.
  - Produces much larger economic costs in terms of output loss and inflation.
- Delayed mitigation example (Policy Package 1 starting 2023 vs starting 2027):
  - Delayed package is phased in more rapidly and requires a higher GHG tax for some years to offset emissions accumulated from 2023 to 2026.
  - A faster transition after delay significantly worsens the output-inflation trade-off: larger annual increments in the GHG tax generate larger headline inflation increases.
  - Rapid fall in utilization of capital in fossil fuel production imposes large costs to firms and profitability.
- Policy implication: delaying climate policy until after inflation is tamed is not reasonable; implement GHG taxes right away and lean against their impact on headline inflation to minimize risks to monetary credibility.

### Intermittent renewables, system requirements, and operational challenges (Box 3.2 continued)
- Historical and required penetration:
  - Intermittent renewables have "surpassed 20 percent in some countries."
  - Simulations suggest intermittent-renewables penetration will need to reach between 34 and 47 percent of power generation by 2030 to bring emissions in line with the 2°C goal.
- Operational and market impacts:
  - Intermittence creates electricity price variability and system-stability challenges; in marginal pricing markets, renewables can push wholesale prices down to zero on high-renewables days and produce sharp price jumps on low-renewables days.
  - Gas-fired backup risks exposing electricity prices to swings in gas markets even if gas is a small share of generation (example: Denmark—gas "less than 10 percent of production"; wind "close to 60 percent of power production in 2021").
- System-wide requirements and policy options:
  - Regulations to ensure adequate investment in backup capacity (for example, capacity markets).
  - Demand management (for example, time-of-day pricing) and public investment in grid interconnections.
  - Support for storage R&D, low-cost dispatchable backup technologies (for example, hydrogen, modular nuclear), and investments to limit gas price volatility (for example, liquefied natural gas terminals).
  - Diversified mix of decarbonized power sources (renewables, hydropower, nuclear) to enhance resilience.
- Key statistics cited:
  - Country group examples:
    - Insular group (Ireland, Portugal, Spain): gas dependence "32 percent of generation in 2019"; renewables penetration "29 percent".
    - Continental group: renewables penetration "23 percent"; gas dependence "16 percent".
    - Nordic group (Denmark, Finland, Norway, Sweden): hydro as backup "12 percent of production"; gas dependence "2.6 percent".
  - Time windows referenced: 2015–19 and "2021–22".

### Empirical evidence, country experiences, and lessons
- Empirical findings on carbon pricing effectiveness:
  - EU ETS reduced EU-wide emissions by 3.8 percent between 2008 and 2016 (market covered 50 percent of EU carbon emissions; price remained below €20 a ton up to 2018).
  - ETS-regulated manufacturing plants reduced emissions by close to 15–20 percent in France and Germany.
  - A northeastern US regional market contributed more than half of power-sector emission reductions in the late 2000s and early 2010s; power-sector emissions dropped by close to 25 percent between 2000 and 2011; carbon prices averaged $2–$3 a ton.
- Micro evidence:
  - A UK energy tax led targeted manufacturing plants to reduce energy use by 23 percent without reducing production, employment, or productivity.
  - British Columbia’s carbon taxation led to employment declines in carbon-intensive and trade-intensive sectors.
  - The 1970 US Clean Air Act reduced employment in pollution-intensive industries by 15 percent over the 10 years following increased regulatory stringency rolled out in the 1990s.
- Country cases and institutional lessons:
  - Sweden:
    - Carbon tax introduced in 1991; tax rate increased to $130 a ton (as of 2022) and covered 40 percent of total emissions.
    - Rules-based framework via the 2018 Climate Act (for example, 63 percent emission reduction by 2030 relative to 1990 levels; independent Climate Policy Council reviews every four years).
    - Carbon tax revenues not directly earmarked; reduction in labor income taxes implemented alongside the carbon tax.
  - South Africa:
    - Carbon-pricing regime in 2019 with carbon tax starting at $9.20 a ton of CO2 covering 80 percent of total emissions.
    - Transitional phase (2020–25) with carbon-tax-free allowances (60–95 percent of firms’ emissions) and further allowances for trade-exposed firms; exemption of Eskom weakens effectiveness.
    - Full implementation depends on external climate finance; extension of transitional phase to 2025 risks weakening credibility and locking in fossil-fuel investments.
  - Uruguay:
    - Converted gasoline excise into a formal carbon tax in 2022 with rate set at $137 a ton of CO2; tax covers about half of CO2 emissions.
    - Earmarked portion of carbon tax revenues for subsidies for electric vehicles and green public transport.
    - Lack of rules-based mitigation path and dependence on external finance create uncertainty; delegating periodic evaluation to an independent body is suggested.

### Cross-model comparisons and sensitivity
- Cross-model comparison (changes in GDP in 2030, percent deviation from baseline) — model results cited:
  - E3: Lump-Sum −0.8; Labor Income Tax Cuts −0.7; Capital Income Tax Cuts −0.6
  - DIEM: Lump-Sum −0.4; Labor Income Tax Cuts −0.2; Capital Income Tax Cuts 0.8
  - IGEM: Lump-Sum −0.8; Labor Income Tax Cuts 0.2; Capital Income Tax Cuts 0.5
  - NewERA: Lump-Sum −0.5; Labor Income Tax Cuts −0.4; Capital Income Tax Cuts 0.2
  - RTI-ADAGE: Lump-Sum −0.8; Labor Income Tax Cuts −0.6; Capital Income Tax Cuts 0.9
  - ReEDS-USREP: Lump-Sum −0.3; Labor Income Tax Cuts −0.1; Capital Income Tax Cuts 0.0
  - Model average: Lump-Sum −0.6; Labor Income Tax Cuts −0.3; Capital Income Tax Cuts 0.3
- Modeling sensitivities:
  - Lower elasticities of substitution and larger frictions imply higher and faster GHG tax increases and larger implications for growth and inflation (example: under alternative calibration and core plus GHG price targeting, by 2030 GDP would be about 1¼ percent lower than under the benchmark calibration).
  - Policy credibility materially affects required GHG tax levels and GDP outcomes.

### Policy priorities and recommendations
- Implement required climate policies immediately to allow gradual GHG tax increases in small and predictable increments.
- Ensure climate policy credibility to drive private investment and consumption shifts toward low-emission technologies:
  - Clearly defined rules-based commitments, transparency of instruments and analysis, and institutional insulation from political pressures strengthen credibility.
  - Pragmatic design can sacrifice some efficiency for equity (for example, carve out transfers for the poor from GHG tax revenues).
- Preserve monetary policy credibility to prevent de-anchoring of inflation expectations and avoid amplified output-inflation trade-offs.
- Use comprehensive policy packages and coordinated approaches to reduce short-term output costs:
  - Complement carbon taxes with green public investments to boost aggregate demand and reduce energy supply bottlenecks.
  - International coordination (for example, an international carbon price floor with differentiation) to address carbon leakage and competitiveness concerns.
- Consider packages that combine GHG prices with subsidies for low-emission technologies (for example, in electricity or transportation) where central bank credibility concerns exist.

### Conclusions
- To keep the Paris Agreement’s goal within reach, GHG emissions must decline by 25 percent, with respect to current levels, by 2030.
- How costly the transition is depends strongly on how quickly electricity generation can be decarbonized; greater difficulty implies larger required GHG tax increases and higher macroeconomic costs.
- Near-term macroeconomic impacts (global):
  - Global GDP could be between 0.9 and 2.0 percent below baseline by 2030.
  - This would amount to a slowdown of 0.15 to 0.25 percentage point in yearly growth.
  - Inflation could increase to reach 0.1 to 0.4 percentage point above baseline.
- Near-term costs are manageable relative to long-term benefits in output, financial stability, and health of arresting climate change.

*Source: https://www.imf.org/-/media/files/publications/weo/2022/october/english/ch3.pdf*

### 0.4 percentage point of inflation a year with respect to

### 0.4 percentage point of inflation a year with respect to

### Introduction and context
- Scientific consensus (IPCC 2022) implies immediate and ambitious action is required to limit warming to well below 2°C and preferably 1.5°C and to achieve net carbon neutrality by 2050.
- By 2030, global emissions have to be reduced by at least 25 percent compared with today’s emissions to have a fighting chance of meeting those goals.
- Decades of procrastination have made the transition more abrupt and costly.
- Authors: Mehdi Benatiya Andaloussi, Benjamin Carton (co-lead), Christopher Evans, Florence Jaumotte, Dirk Muir, Jean-Marc Natal (co-lead), Augustus J. Panton, and Simon Voigts, with support from Carlos Morales, Cynthia Nyakeri, and Yiyuan Qi.

### Modeling approach and scope
- Uses the IMF’s Global Macroeconomic Model for the Energy Transition (GMMET).
- Voluntary focus on near-term macroeconomic costs and budget-neutral climate policies.
- Abstracts from long-term costs and benefits; focuses on effects on GDP and inflation arising from different policy designs and credibility scenarios.
- Two alternative calibrations for the elasticity of substitution between renewables and fossil fuels in electricity generation are considered to reflect uncertainty about how fast electricity generation can decarbonize.

### Key quantitative findings
- Global growth could be lower by 0.15 to 0.25 percentage point annually as a result of the transition.
- Inflation could be 0.1 to 0.4 percentage point higher globally.
- For China, Europe, and the United States, GDP growth costs are expected to be in a range between 0.05 and 0.20 percentage point annually.
- In the most pessimistic substitution case, GHG taxes needed are about twice as large as in the benchmark case, and macroeconomic costs (lost output and higher inflation) are about twice as large.
- If decarbonization is delayed and then done faster, the resulting inflationary impulse is about three times stronger, and preventing it would require sacrificing roughly 1 percent of GDP over the course of four years.
- Under current policies, the IPCC projects emissions in 2030 will be more than 42 percent higher than those required to reach the Paris Agreement target.

### Mechanisms and distinctions from fossil-fuel price shocks
- GHG taxes:
  - Put a price on the right to pollute, increasing the cost of fossil fuels (an adverse supply shock).
  - Lead to lower net-of-tax prices for fossil fuel producers, deterring investment in fossil fuels.
  - Generate fiscal revenues (unlike fossil fuel price surges that transfer revenues to exporters).
  - Are intended to be permanent and implemented gradually, affecting forward-looking investment and consumption decisions.
- Fossil-fuel price shocks:
  - Are often temporary and sudden, do not necessarily change relative prices by carbon content, and usually transfer revenues to exporters.

### Policy design and distributional implications
- All policy packages assessed are financed by GHG taxation only.
- Recycling GHG tax receipts to cut labor income taxes:
  - Reduces distortions, raises labor supply, increases wages net of tax, and supports higher consumption, investment, and output.
- Recycling receipts into subsidies for investment in low-carbon technologies (renewables, nuclear, hydroelectric, electric vehicles):
  - Facilitates the transition, allowing the same decarbonization level with lower GHG taxes and smaller inflationary impact.
- Transferring revenues to low-income households:
  - Helps increase acceptance of climate policies but comes at a cost in terms of output growth.

### Credibility, monetary policy, and the output-inflation trade-off
- Gradual and credible implementation minimizes near-term macroeconomic costs:
  - Gives agents time to adjust, induces mild inflationary pressures that require modest monetary adjustments, and preserves anchored expectations.
  - May allow some short-term easing to facilitate transition without large GDP costs.
- Lack of credibility or stop-and-go climate policies:
  - Require sharper adjustments later, generate stronger inflationary pressures, and make monetary policy’s task more difficult.
  - Eroded monetary policy credibility materially increases costs, as larger inflationary pressures demand stronger policy responses.

### Costs of further delay
- Further delay amplifies transition costs:
  - Requires higher and faster increases in GHG taxes than in gradual scenarios.
  - Produces much larger economic costs in terms of output loss and inflation.
- The chapter stresses that postponing action because "now is not the time" will only exacerbate the toll.

*Source: https://www.imf.org/-/media/files/publications/weo/2022/october/english/ch3.pdf*

### CHAPTER 3 NEAR-TERM MACROECONOMIC IMPACT OF DECARBONIZATION POLICIEs

### CHAPTER 3 NEAR-TERM MACROECONOMIC IMPACT OF DECARBONIZATION POLICIEs

### Credibility and design of climate policy
- New climate policy measures and commitments to future carbon-reducing policies must be perceived as credible and irreversible to affect long-horizon investment and R&D decisions.
- Credibility—including effectiveness—is enhanced if:
  - There is a clearly defined rules-based commitment rather than pure discretion.
  - Instruments and analysis of policies to reach targets are transparent.
  - Targets are implemented independently, insulated from the political process.
- Institutional independence akin to central banks’ mandates is an ideal but remains a high bar even in advanced mitigation countries.
- To address political-economy constraints, pragmatic design may sacrifice some efficiency for equity; for example, carve out transfers for the poor from GHG tax revenues to amplify support and credibility.

### Model framework: GMMET and scope of analysis
- Model used: Global Macroeconomic Model for the Energy Transition (GMMET), a multicountry, microfounded, nonlinear dynamic general equilibrium model sharing features with the IMF’s GIMF model.
- Key modeled activities: fossil fuel mining and trade; electricity generation (with intermittent renewables and storage considerations); transportation (electric vehicles and conventional cars, network externalities between electric vehicles and charging stations); energy use in production and residential heating; non-fossil-fuel GHG activities such as agriculture.
- Regions configured: China, the euro area, the United States, and a rest-of-the-world block.
- Purpose: analyze short- and medium-term macroeconomic impact of curbing GHG emissions, capturing nominal and real frictions and forward-looking expectations to study cyclical fluctuations and stabilization policies.

### Simulation design and baseline caveat
- Policy scenario: GHG taxes increased gradually and globally over the next eight years, such that every region decreases its GHG emissions by about 25 percent.
- Each region chooses different GHG price levels reflecting emission intensity differences.
- A key caveat: scenarios are implicitly compared against a no-catastrophe, no-action baseline that is environmentally not feasible; delayed mitigation has much higher long-term costs and risks.
- Delayed-action exercises compare mitigation today with rushed delayed action.

### Energy transition pace and key elasticities
- Two key elasticities drive the pace of electricity decarbonization in GMMET:
  - Elasticity of substitution of fossil fuels—especially coal—for renewables in electricity generation.
  - Elasticity of substitution of electricity for other fossil fuels in production of goods and services.
- Benchmark calibration outcome: the share of renewables in electricity generation increases by 20 percentage points by 2030.
- Alternative calibration: pace of electricity decarbonization roughly half as fast under same policies (reflecting China and United States experience); European Union example: increase in share of renewables by about 15 percentage points.
- Under the alternative calibration:
  - Elasticities of substitution related to fossil fuels are lower: reduced to one-fourth in electricity generation, halved in the manufacturing sector (see Annex Table 3.1.2).
  - Industry and consumers shoulder a larger part of decarbonization; required GHG taxes may be as much as twice as large to reach a 25 percent emissions drop by 2030.
- Range of macroeconomic effects across calibrations: span of 0.15–0.25 percentage point of annual growth.
- Under the alternative calibration, Policy Package 1 reduces GDP by 1–2 percent in China, the euro area, and the US by 2030.
- Contextual note: 1.5 percent of US GDP is about $320 billion and corresponds to the climate portion of that country’s recently passed Inflation Reduction Act; the costs would be spread over eight years, or $40 billion a year.

### Analytical simulation results and mechanisms
- Mechanisms: a GHG tax increases energy prices and implies a permanent decline in future productivity for firms; forward-looking agents anticipate lower future profits and cut investment and consumption.
- In the short to medium term, lower aggregate demand can dominate the direct energy-cost effect; a central bank focused on stabilizing core inflation will want to accommodate the shock.
- Investment in carbon-intensive capital drops; investment in renewables and associated capital increases but may not fully offset the drop in carbon-intensive investment.
- If lump-sum transfers are large, consumption increases in the short term but declines in the medium to long term owing to the tax’s impact on households’ permanent income.

### Options for recycling GHG tax revenues and macroeconomic impacts
- Three recycling strategies contrasted:
  1. Lump-sum transfers to households (labelled “Trans.”)
  2. Labor income tax cuts (Policy Package 1, “P1”)
  3. Production subsidies (feebate-style) to support sectoral production and investment
- Common effect: the tax has a very similar impact on inflation across different recycling strategies, reflecting assumed central bank credibility.
- Differential effects:
  - Labor tax cuts: boost employment and output by reducing disincentives to work.
  - Lump-sum transfers: compensate low-income households and mitigate regressive effects of the GHG tax, boosting consumption in the short term.
  - Production subsidies: support investment at the expense of consumption because they use revenues to subsidize firms rather than transfer to households or cut labor taxes.
- Technical calibration detail: the labor supply elasticity is 0.15.

### Feasible and balanced policy packages to meet Paris-aligned 2030 goals
- Objective: align emissions by 2030 with Paris Agreement while balancing employment, output growth, investment in renewables, and compensation for low-income households.
- Three policy packages examined (summary of trade-offs):
  - Policy Package 1:
    - Uses two-thirds of GHG tax revenues to cut labor income taxes; one-third presumably for transfers.
    - Focus: engineer decarbonization without overly penalizing consumption.
    - Requires relatively higher GHG taxes and leads to larger investment declines than other packages.
  - Policy Package 2:
    - Combines support for households with subsidies to low-emission sectors (renewables, nuclear and hydro power plants, and purchase of electric vehicles).
    - Subsidies support investment more than Policy Package 1.
    - Allows required emission reduction with lower GHG taxes and therefore less inflation.
    - Trade-off: subsidies reduce allocations to tax cuts and transfers, lowering consumption relative to investment.
  - Policy Package 3:
    - Focuses on supporting firms during the transition by rebating tax receipts to firms.
    - Investment declines much less than in Policy Package 1.
    - Households bear more of the tax-induced slowdown; the consumption-to-investment ratio declines.
- Regional differences reflect starting energy use, fossil-fuel share in the consumption basket, and required GHG tax increases to reach a 25 percent reduction by 2030.
  - Example: China’s CPI is less affected by the GHG tax because households’ direct energy consumption is a lower share of CPI; demand-contracting effects may push core inflation down in China.
  - The rest-of-the-world region (aggregate dominated by fossil fuel exporters and oil-intensive economies) experiences larger growth impacts due to assumed rapid energy transition and reduced demand for fossil fuels.

*International Monetary Fund | October 2022*

### Annex 3.3 analyzes the global impact on emissions,

### ch3 - Annex 3.3 analyzes the global impact on emissions,

### Three Policy Packages Reducing Emissions by 25 Percent in 2030
- Package 1
  - Gradual GHG price increase from 2023 to 2030
  - Two-thirds of revenue used to reduce labor taxes
  - One-third of revenue transferred to households
  - One-third of revenue used to subsidize low-emission sectors:
    - Renewables investment
    - Nuclear and hydro power plants
    - Electric-vehicle purchase
- Package 2
  - Gradual GHG price increase from 2023 to 2026
  - One-third of revenue used to reduce labor taxes
  - One-third of revenue transferred to households
  - One-third of revenue used to subsidize low-emission sectors (green subsidies)
- Package 3
  - Gradual GHG price increase from 2023 to 2030
  - GHG revenue rebated at the sectoral level (electricity generation, manufacturing, services)
  - GHG revenue from households’ activities (residential energy and individual transportation) transferred back to households
  - Regulation of share of electric vehicles
- Note: GHG = greenhouse gas.
- Source: IMF staff compilation.

### Credibility of Climate Policy
- Scenarios assume fully credible climate policies unless otherwise noted; private sector anticipates current and future policy paths when credible.
- Under partial credibility (future increments of the GHG price path come as a surprise and do not affect current decisions):
  - The cumulative emission reduction by 2030, expressed as a share of 2022 emissions, is about 20 percent lower under partial credibility than under full credibility.
  - Investment in emission-intensive capital does not decline as rapidly; adjustment in the electricity sector is key.
  - Partially credible policy requires higher GHG taxes to reach the same decarbonization goal, leading to larger GDP losses by the end of the decade:
    - United States: GDP declines by 1.0 percent (partially credible) rather than 0.6 percent (fully credible).
    - Euro area: GDP declines by 1.0 percent rather than 0.5 percent.
    - China: GDP declines by 1.2 percent rather than 0.6 percent.

### Credibility of Monetary Policy
- If central banks retain inflation-fighting credibility, climate-policy-induced output-inflation trade-offs are small; gradual climate policy is easier to manage than sudden energy price shocks.
- If monetary policy loses credibility, trade-offs amplify and second-round effects (wage-price spirals) become more likely.
- Comparison of monetary policy rules:
  - Targeting core inflation (excluding energy) yields slightly higher headline inflation because of the tax’s direct impact on noncore CPI components.
  - Targeting a modified version (core plus GHG price) reduces headline inflation but has a larger output cost.
  - Including the GHG price in the CPI has limited macroeconomic implications as long as inflation expectations remain anchored.
- Sensitivity to electricity transition frictions:
  - Larger frictions (lower elasticities) imply higher and faster GHG tax increases, with larger implications for growth and inflation.
  - Example: under the alternative (lower-elasticity) calibration and core plus GHG price targeting, by 2030 GDP would be about 1¼ percent lower than under the benchmark calibration.
- Wage indexation environment:
  - Wage indexation worsens the output-inflation trade-off.
  - Stabilizing core plus GHG price under wage indexation has a significantly higher output cost; stabilizing output risks triggering a wage-price spiral.

### Transition Costs under Further Delays
- Comparison: Policy Package 1 starting in 2023 versus a delayed mitigation package starting in 2027 that achieves the same long-term cumulative emissions reduction.
  - The delayed package is phased in more rapidly and requires a higher GHG tax for some years to offset emissions accumulated from 2023 to 2026.
  - A faster transition (after delay) significantly worsens the output-inflation trade-off:
    - Larger annual increments in the GHG tax generate larger headline inflation increases.
    - Rapid fall in utilization of capital in fossil fuel production imposes large costs to firms and profitability.
  - Policy implication: delaying climate policy until after inflation is tamed is not reasonable; starting now allows gradual, predictable increments that limit inflationary pressures.
  - Risk-management suggestion: implement GHG taxes right away and lean against their impact on headline inflation to minimize risks to monetary credibility.

### Conclusions and Policy Implications
- To keep the Paris Agreement’s goal within reach, GHG emissions must decline by 25 percent, with respect to current levels, by 2030.
- How costly the transition is depends strongly on how quickly electricity generation can be decarbonized; greater difficulty implies larger required GHG tax increases and higher macroeconomic costs.
- Global macroeconomic projections and ranges:
  - Global GDP could be between 0.9 and 2.0 percent below baseline by 2030.
  - This would amount to a slowdown of 0.15 to 0.25 percentage point in yearly growth.
  - Inflation could increase to reach 0.1 to 0.4 percentage point above baseline.
- Regional distribution of effects: largest effects concentrated among fossil fuel exporters; considerable variation across regions is expected.
- Policy priorities and conditions for a manageable transition:
  - Implement required climate policies immediately to allow gradual GHG tax increases in small and predictable increments.
  - Ensure climate policy credibility to drive private investment and consumption shifts toward low-emission technologies.
  - Preserve monetary policy credibility to prevent de-anchoring of inflation expectations and to avoid amplified output-inflation trade-offs.
  - Consider policy packages with smaller pass-through to headline inflation (for example, combining GHG price with subsidies for low-emission technologies in electricity or transportation) where central bank credibility is a concern.
- Long-term perspective: Near-term costs, while not trivial, are manageable and are dwarfed by the long-term benefits in output, financial stability, and health of arresting climate change.

*Source: IMF staff compilation.*

### 2. Excess GHG Emissions from Delaying Policies

### ch3 - 2. Excess GHG Emissions from Delaying Policies

### Key findings on emissions and macroeconomic impacts
- Delaying credible, transparent, and ambitious action increases excess greenhouse gas (GHG) emissions and raises the cost of keeping temperature increases well below 2°C.
- Monetary policy credibility complements climate policy credibility and is essential to keep output-inflation trade-offs low.
- Concerns about current high inflation offer no justification for delaying necessary actions.

### Empirical evidence on carbon pricing effectiveness
- The European Union Emissions Trading System (ETS) has been found to have reduced EU-wide emissions by 3.8 percent between 2008 and 2016, although the market covered only 50 percent of EU carbon emissions and the price remained below €20 a ton up to 2018.
- ETS-regulated manufacturing plants reduced emissions by close to 15–20 percent in France and Germany.
- An emission market in northeastern US states contributed more than half of emission reductions in the power sector in the late 2000s and early 2010s, with power sector emissions dropping by close to 25 percent between 2000 and 2011.
- During the same US state market period, carbon prices averaged $2–$3 a ton.

### Microeconomic evidence on abatement and sectoral effects
- Targeted energy taxes and carbon-pricing programs have led firms to reduce the carbon intensity of production through improvements in energy efficiency.
- An energy tax implemented in the UK resulted in energy use reductions of 23 percent in targeted manufacturing plants, cutting emissions without reducing production, employment, or productivity.
- Carbon pricing can affect sectors differently; British Columbia’s carbon taxation led to a fall in employment in carbon-intensive and trade-intensive sectors.
- The 1970 US Clean Air Act had a negative impact on employment in pollution-intensive industries over the medium term, with employment in polluting sectors falling by 15 percent in the 10 years following increased regulatory stringency rolled out in the 1990s.

### Modeling evidence and GDP impacts
- Past empirical evidence refers to policies much smaller in scale and scope than needed to achieve Paris Agreement goals; impacts will vary depending on policy design and complementary measures.
- Models with low elasticities of substitution between carbon-intensive and green technologies, high capital adjustment costs, limited public subsidization of green technologies, and difficulty scaling up green energy typically show higher output costs.
- Recycling carbon tax revenues as lump-sum transfers supports consumption; using revenues to reduce distortionary taxes, including labor income taxes, enhances growth and investment.

- Goulder and Hafstead (2018) comparison (economy-wide carbon tax starting at $25 a ton in 2020 and increasing by 5 percent annually until 2050; carbon price close to $38 a ton in 2030):
  - Under a lump-sum recycling scheme: model averaging suggests a cost of 1.2 percent of GDP by 2030 in the US.
  - Under a labor income tax cut: model averaging implies a 0.6 percent loss in GDP by 2030; the GMMET suggests essentially no loss in output over this horizon, thanks to an increase in labor supply.
- Cross-model comparison of changes in GDP in 2030 (Percent deviation from baseline):
  - E3: Lump-Sum −0.8; Labor Income Tax Cuts −0.7; Capital Income Tax Cuts −0.6
  - DIEM: Lump-Sum −0.4; Labor Income Tax Cuts −0.2; Capital Income Tax Cuts 0.8
  - IGEM: Lump-Sum −0.8; Labor Income Tax Cuts 0.2; Capital Income Tax Cuts 0.5
  - NewERA: Lump-Sum −0.5; Labor Income Tax Cuts −0.4; Capital Income Tax Cuts 0.2
  - RTI-ADAGE: Lump-Sum −0.8; Labor Income Tax Cuts −0.6; Capital Income Tax Cuts 0.9
  - ReEDS-USREP: Lump-Sum −0.3; Labor Income Tax Cuts −0.1; Capital Income Tax Cuts 0.0
  - Model average: Lump-Sum −0.6; Labor Income Tax Cuts −0.3; Capital Income Tax Cuts 0.3

### Policy design and recommended complementary measures
- Use comprehensive policy packages and coordinated approaches to reduce short-term output costs.
  - Complement carbon taxes with green public investments to boost aggregate demand and reduce energy supply bottlenecks.
  - Internationally coordinated action—such as an international carbon price floor with equitable differentiation—can address carbon leakage and competitiveness concerns for energy-intensive and trade-exposed industries.
  - Central bank responses to climate-policy-related supply shocks affect the magnitude of output and inflation effects.
- Distributional measures increase political acceptability:
  - Rebating tax revenues to low-income households bolsters acceptance and credibility.
  - Recycling revenues to reduce distortionary taxes (for example, labor income taxes) enhances growth and investment.
  - Gradualism, targeted exemptions during transition phases, and clear, rules-based targets strengthen credibility.

### Country experiences: Sweden, South Africa, Uruguay
- Sweden:
  - Introduced a carbon tax in 1991; carbon tax rate increased to $130 a ton (as of 2022) and covered 40 percent of total emissions.
  - Early two-tier regime included exemptions and reduced rates (for example, some industries faced 25 percent of the general rate); most exemptions removed in 2019.
  - Sweden implemented a rules-based framework via the 2018 Climate Act: transitional targets (for example, 63 percent emission reduction by 2030 relative to 1990 levels), national review every four years by the independent Swedish Climate Policy Council, and a net-zero emissions target by 2045.
  - Carbon tax revenues were not directly earmarked; a reduction in labor income taxes was implemented alongside the carbon tax.

- South Africa:
  - Implemented a formal carbon-pricing regime in 2019 with a carbon tax rate starting at $9.20 a ton of carbon dioxide and covering 80 percent of total emissions.
  - Transitional phase (2020–25) features carbon-tax-free allowances ranging from 60 to 95 percent of firms’ emissions, with a further 10 percent for trade-exposed firms.
  - Transitional incentives include an electricity price neutrality commitment; enforcement of carbon budgets is expected only after the transition period.
  - Exemption of Eskom, the state-owned power company and South Africa’s largest emitter, weakens effectiveness.
  - Full implementation depends on external climate finance support; extension of the transitional phase to 2025 risks weakening credibility and locking in fossil-fuel investments.
  - Establishment of the Presidential Climate Commission in 2020 aims to strengthen credibility; further insulating the commission from political influence is recommended.

- Uruguay:
  - Converted its gasoline excise tax into a formal carbon tax in 2022 with the tax rate set at $137 a ton of carbon dioxide; the tax covers about half of carbon dioxide emissions and a lower share of total GHG emissions.
  - Uruguay is earmarking a portion of carbon tax revenues for subsidies for electric vehicles and investment in green public transport.
  - Lack of a rules-based mitigation path and dependence on external climate finance create uncertainty for long-term private investment decisions.
  - Delegating periodic evaluation of climate policy and progress to an independent body is suggested to enhance transparency and trust; Uruguay’s Sovereign Sustainability-Linked Bond Framework (launched on September 20, 2022) would help in that direction.

### Figures, data sources, and notes
- Sources referenced: Global Macroeconomic Model for the Energy Transition; IMF staff estimates; International Carbon Action Partnership; World Bank (2022); Goulder and Hafstead (2018).
- Notes:
  - Results based on Policy Package 1 with benchmark elasticities.
  - Monetary policy targets Core + GHG price under “Gradual” and “Delayed”; under “Delayed (GDP target),” monetary policy targets the same GDP as in “Gradual.”
  - GHG = greenhouse gas; tCO2e = metric ton of carbon dioxide equivalent.

*Source: ch3 - 2. Excess GHG Emissions from Delaying Policies (chapter content).*

### Box 3.2 (continued)

### Box 3.2 (continued)

### Intermittent renewables: penetration and operational challenges
- Intermittent renewables, such as solar and wind, have increased steadily over the past two decades, "surpassing 20 percent in some countries."
- Simulations in this chapter suggest intermittent-renewables penetration will need to reach between 34 and 47 percent of power generation by 2030 to bring emissions in line with the 2°C goal.
- Intermittence creates challenges for:
  - Electricity price variability.
  - Power system stability, because power systems must be balanced at every point in time with generation matching fluctuating demand.
- Market mechanics:
  - Power plants are turned on to satisfy demand; priority is given to those with the lowest cost of production.
  - Renewables’ cost of production is "close to zero" because their fuel is free, so they are always prioritized.
  - In markets that follow marginal pricing, wholesale electricity prices are set equal to the operational cost of the costliest unit selected to satisfy demand at any point in time; increased renewables can push prices down and can even lead to zero prices when renewables become the marginal unit.
  - Conversely, when renewables underproduce, electricity prices can jump sharply if the marginal units have high production costs, producing price volatility within days and across seasons.

### Historical dampening of intermittence impacts and recent disruptions
- Measures that have dampened intermittence’s impact on price variability so far include:
  - Enhanced electricity grid interconnections.
  - Low-cost backup technologies (for example, hydro or gas power plants).
- Empirical observations (Europe, pre-pandemic and 2015–19):
  - Before the pandemic, monthly price variability was similar in countries with high and low penetration of intermittent renewables.
  - Between 2015 and 2019, electricity prices remained low and varied little day to day, approaching zero on days with larger renewables shares, while remaining low even on days with low renewables penetration because backup gas unit costs were low.
- Recent shocks:
  - Disruption in gas supplies during Russia’s invasion of Ukraine produced sharp rises in wholesale electricity prices amid gas price spikes, especially in countries that rely heavily on intermittent renewables (Denmark, Ireland, Portugal, Spain).
  - Where renewables are backed up by hydro (for example, Norway and Sweden), price volatility increased only partly in response to the gas price spike.
  - Countries with high renewables penetration that use gas as backup experienced pronounced volatility: high prices on low-renewables days (when gas units are marginal) and low prices on high-renewables days.
  - This outcome occurs even where gas is a small share of generation (example: Denmark—gas < 10 percent of production; wind close to 60 percent in 2021), because market prices are set by the marginal unit.
- Implication: gas-fired backup, envisioned to enable higher renewables penetration, risks exposing electricity prices to swings in gas markets.

### System-wide requirements and policy options to manage intermittence and decarbonize the power sector
- As many sectors electrify, electricity prices will become central to price setting across the economy; ensuring affordable and reliable electricity is crucial.
- Sector-level regulations and investments needed to accommodate higher intermittent-renewables penetration include:
  - Regulations to ensure adequate investment in backup capacity (for example, capacity markets).
  - Demand management to align peak demand with peak supply from renewables (for example, time-of-day pricing).
  - Public investment in grid interconnections.
  - Support for research and development on storage (including from electric vehicles) and low-cost dispatchable backup technologies (for example, hydrogen, modular nuclear power plants).
- Further investments to limit price volatility in gas markets (for example, liquefied natural gas terminals).
- Using a diversified mix of decarbonized power sources (for example, renewables, hydropower, and nuclear energy) will enhance power sector resilience.
- Note on retail pass-through: "Pass-through to retail electricity prices has been more limited so far as a result of regulations (Ari and others, 2022)."

### Key statistics and exact figures cited
- "Surpassing 20 percent in some countries" — intermittent renewables historic penetration.
- Required penetration by 2030 to align with 2°C goal: between 34 and 47 percent of power generation.
- Examples of country statistics:
  - Insular group (Ireland, Portugal, Spain): gas dependence "32 percent of generation in 2019"; renewables penetration "29 percent".
  - Continental group: renewables penetration "23 percent"; gas dependence "16 percent".
  - Nordic group (Denmark, Finland, Norway, Sweden): hydro as backup "12 percent of production"; gas dependence "2.6 percent".
  - Denmark example: gas accounts for "less than 10 percent of production"; wind represented "close to 60 percent of power production in 2021".
- Time windows and comparisons:
  - Monthly price variability compared across 2015–19 and "2021–22" (figures and plots referenced).
  - Daily price–renewables relationships illustrated for Denmark, Ireland, Portugal and Spain (plots described).

*Source: Box 3.2 (continued), CHAPTER 3, World Economic Outlook, October 2022.*

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_Source: https://www.imf.org/-/media/files/publications/weo/2022/october/english/ch3.pdf_