## Public Debt Dynamics during the Climate Transition

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### Introduction: context and research questions
- 2023 was the warmest on record; climatic “tipping points” risk rises with global warming (IPCC 2021; McKay and others 2022; Ditlevsen and Ditlevsen 2023).
- Countries have committed to net-zero targets by about midcentury, but large gaps in ambition and implementation remain.
- Transition requires fundamental transformation of production, consumption, and investment and will impose uneven transition costs across households and firms.
- Key fiscal dilemma: design fiscal policies to incentivize decarbonization while balancing tradeoffs, equitable burden sharing, and fiscal sustainability, especially in fiscally-constrained developing countries.

### Contribution and scenarios analyzed
- Main contributions:
  - Quantify dynamic implications for deficits and public debt of policy packages to achieve net zero for two country groups: advanced economies (AE) and emerging market economies (EM).
  - Assess evolving desirable mix of climate instruments from a macro-fiscal perspective.
- Six scenarios analyzed (policies achieve net zero emissions by around midcentury):
  1. Scaled-up spending: countries primarily scale up spending (green subsidies, public investment).
  2. Reliance on carbon pricing: climate policies rely primarily on carbon pricing.
  3. Balanced policy mix: balanced mix of revenue and expenditure measures.
  4. Cost of delaying carbon pricing.
  5. Technology spillovers.
  6. Investment bottlenecks.
- Key quantitative findings:
  - Heavily relying on spending measures could increase debt by 45-50 percent of GDP by mid-century.
  - A balanced approach combining carbon pricing with spending-based policies can limit the rise in public debt to 10-15 percent of GDP by 2050.
  - Carbon pricing functions both as an emissions-reduction tool and as a source of revenue.
  - Postponing carbon pricing is costly; technology spillovers reduce costs; investment bottlenecks can cause debt-to-GDP ratios to rise further.
- Emissions and baseline targets used in simulations:
  - Policy scenarios reduce emissions by 80 percent by 2050 in advanced economies and by 2060 in emerging market economies.
  - Baseline paths for output, population, and government debt are based on IMF World Economic Outlook database projections, OECD long-term projections, and UN population projection.

### Model framework: structure and key mechanisms
- Base: two-agent New Keynesian dynamic general equilibrium model with fiscal block (à la Traum and Yang 2015).
- Core features:
  - Two household types: savers (forward-looking, access to asset and capital markets) and non-savers (liquidity-constrained, consume all income each period).
  - Final-good price subject to nominal rigidity (quadratic adjustment costs); investment subject to adjustment costs.
  - Fiscal instruments: consumption tax, labor and capital income taxes, government expenditure, transfers; debt stabilized by lump-sum tax on savers.
  - Monetary policy: Taylor rule responding to inflation gap and output gap.
- Climate and technology extensions:
  - Energy used in production of final goods; energy generated from green and brown sources.
  - Each energy source employs private capital and labor; green energy also uses public capital (e.g., electricity grids).
  - Carbon emissions proportional to brown energy output (unit elasticity).
  - Learning-by-doing externalities: productivity in each energy source grows in proportion to existing capital stock.
  - Private investment subject to quadratic adjustment costs to capture bottlenecks (scarcity of critical minerals, geopolitics, divesting stranded brown assets).
  - Sovereign interest rates increase with debt-to-GDP ratio via a convenience-yield formulation following Mian, Straub, and Sufi (2022).

### Key equations and mechanisms (as presented)
- Final goods production combines energy and non-energy inputs via CES with elasticity 휂௙ and energy share 휍௙.
- Energy production is a CES bundle of green and brown sources with elasticity 휂 and brown energy share 휔.
- Green energy production includes public capital; brown energy share of public capital set to zero.
- Learning-by-doing: log(퐴௧௜) = 훼௜ log(푘௧ ି ଵ௜ / 푘ௌௌ௜) + 휖௧௜ (productivity evolves with cumulative capital).
- Capital accumulation with quadratic adjustment costs:
  - 푘௧௝(1+푔)(1+푛) = (1−훿)푘௧ ି ଵ௝ + 푖௧௝ [1 − 훾௝/2 ( (푖௧௝/푘௧ ି ଵ௝ − 훿 )^2 ) ] 푘௧ ି ଵ௝
- Convenience yield of holding government debt deviation:
  - 퐶푌෢௧ = − φ (푏௧ / 푏ത)^푏ത , linking higher government debt to increased interest rates.

### Data, baseline, and calibration highlights
- Baseline “business-as-usual” based on current policies; baseline paths from IMF WEO, OECD, UN population projections; emissions path and initial carbon prices consistent with Climate Policy Assessment Tool; initial energy shares from US EIA.
- Emissions reduction targets in scenarios: 80 percent by 2050 (AE) and by 2060 (EM).
- Selected calibrated parameter values (as presented in Table 1):
  - Elasticity of energy in final goods production 휂௙ = 0.21
  - Elasticity between green and brown energy 휂 = 3.5
  - Elasticity between private green capital and public green capital ηீ = 0.9
  - Share of energy in final goods production 휍௙ = 0.07
  - Share of brown source in energy production 휔 = 0.8 (AE)/0.9 (EM)
  - Share of public green capital in green capital 푤ீ = 0.16
  - Discount factor 훽 = 0.99
  - Intertemporal elasticity of substitution 휎 = 1
  - Depreciation rate 훿 = 0.025
  - Inverse Frisch elasticity = 2
  - Share of labor in green, brown, and non-energy production 휶௜ = 0.68
  - Debt elasticity 휑 = 0 (AE)/0.003 (EM)
  - Price elasticity 휖௣ = 10
  - Capital adjustment cost 훾௜ = 4
  - Price adjustment cost 휅 = 52.9 (matches average frequency of price changes every three quarters)
  - Consumption tax rate 휏௖ = 12 percent
  - Labor income tax rate 휏௪ = 20 percent
  - Capital income tax rate 휏௞ = 20 percent
  - Lump-sum tax response to debt-to-GDP ratio 휙஻ = 0.01
  - Taylor rule smoothing 휌 = 0.5
  - Taylor rule response to inflation 훾గ = 2

### Representative economies and additional calibration
- Representative economies:
  - Advanced economy calibrated to Group of Seven.
  - Representative emerging market economy is an average of Argentina, Brazil, China, India, Indonesia, Mexico, South Africa, and Türkiye.
- Initial carbon price:
  - $40 for representative advanced economy.
  - $5 for representative emerging market economy.
- Share of liquidity-constrained households:
  - 30 percent in advanced economies.
  - 50 percent in emerging market economies.
- Debt elasticity of the convenience yield (휑): 0 for advanced economies; calibrated for emerging markets so equilibrium interest rate increases by 20 basis points when government debt increases by 10 percent.
- Debt-stabilization channel:
  - Suspended in the model until 2050 for advanced economies and 2060 for emerging market economies; a lump-sum tax is set to gradually increase in response to debt to GDP to ensure the government’s intertemporal budget constraint is met.
- Preferred net zero package outcome (advanced economies):
  - Ex post annual cost on output: about 0.03 percent of GDP to 2050 on average.
  - Total cost between 2023–50: 0.8 percent of GDP.

### Scenario 1: Scaling up spending to meet climate goals
- Policy design:
  - Scale up public investment and subsidies by an additional 2 percent of GDP per year on average to reach net zero by midcentury.
  - Carbon price capped at $75 a ton for representative advanced economy and $45 a ton for representative emerging market economy in illustrated simulations.
- Advanced economy simulation outcomes:
  - Debt-to-GDP increase by 45 percentage points by 2050 (solid line scenario).
  - Moderate spending alternative (additional ½ percent of GDP per year): emissions fall by about 40 percent by 2050 relative to current levels (dashed line scenario).
- Emerging market simulation outcomes:
  - Cap carbon price at $45 a ton during 2030–50 and scale up green investment/subsidies to reach net zero by 2060.
  - Debt-to-GDP surge of more than 50 percentage points by 2050 (solid red line).
  - Moderate increase in spending yields emissions fall of 10 percent from current levels and is insufficient to reach net zero (dashed red line).
- Interpretation:
  - Relying largely on expenditure measures to achieve net-zero emissions by midcentury would sharply raise public debt-to-GDP ratios and put debt sustainability at risk.

### Scenario 2: Relying primarily on carbon pricing
- Advanced economy carbon-pricing-only calibration:
  - Carbon prices required to reach net zero: $150 per ton by 2030 and $280 per ton by 2050.
  - Effects:
    - Carbon pricing generates revenue and reduces deficits, lowering the real interest rate and the debt ratio.
    - High carbon prices could lower output and cause uneven transition costs among households, necessitating targeted transfers.
- Emerging market carbon-pricing-dominant calibration:
  - Modest public investment at ¼ percent of GDP per year and no green subsidies.
  - Carbon price required: $165 per ton by 2050.
  - Effects:
    - Generates revenue and leads to a small primary surplus of 0.4 percent of GDP.
    - Reduces debt ratio but at the expense of smaller output and uneven decline in consumption across households.

### Scenario 3: Combination of well-sequenced policy instruments
- Policy components:
  - Carbon pricing to reduce emissions and generate fiscal revenues.
  - Green public investment to complement private green capital.
  - Green subsidies to encourage innovation and deployment, front-loaded and phased out after 2030 in simulations.
  - Targeted transfers to mitigate adverse impacts: transfers equal to 30 percent of carbon revenue to protect vulnerable households.
- Operationalization of net-zero:
  - Advanced economies: 80 percent reduction in 2023 emission levels by 2050 (remainder offset by carbon capture and storage).
  - Emerging market economies: 80 percent reduction in 2023 emission levels by 2060.
- Advanced economy calibration and outcomes:
  - Annual green public investment permanently higher by 0.4 percent of GDP (with frontloaded trajectory).
  - Annual green subsidy 0.2 percent of GDP higher relative to baseline until 2030, then gradually fades.
  - Initial carbon price set to $40.
  - Emission trajectory aims: decline of 40–50 percent by 2030 and 80 percent by 2050 relative to 2023.
  - Carbon-pricing path to meet package: $130 per metric ton by 2030 and $235 per metric ton by 2050.
  - Revenues from carbon peak around 2030 and decline as decarbonization reduces the tax base; carbon revenues as a share of GDP decline during 2030–50 absent tax-base shifts.
  - Private sector green investment doubles relative to business-as-usual; endogenous private green investment accounts for majority of total green investment.
  - No earmarking of carbon revenues except transfers equal to 30 percent of carbon revenues to hand-to-mouth households.
  - Fiscal outcomes: debt-to-GDP increases by 10–15 percentage points by 2050; primary deficit rises by 0.4 percent of GDP a year relative to business-as-usual. Interest-rate effects relatively muted.
- Emerging market calibration and outcomes:
  - Carbon price path: reaches $45 a ton by 2030, rises to $150 a ton by 2050.
  - Green investment needs larger at ¾ percent of GDP per year.
  - Green subsidy increase is half the value in advanced economies.
  - Transfers to vulnerable households equal to 30 percent of carbon revenue.
  - Emission reduction efforts are backloaded to achieve net zero by 2060.
  - Private green investment triples the green private capital stock by 2050 relative to business-as-usual.
  - Simulation indicates public debt would increase by about 15 percent of GDP by 2050 relative to business-as-usual, equivalent to a rise in primary deficits by [text truncated in source].

### Key quantitative takeaways across scenarios
- Scenario 1 (expenditure-heavy):
  - Advanced economy: debt-to-GDP could rise by 45 percentage points by 2050 under a 2 percent of GDP per year spending ramp-up.
  - Emerging market: debt-to-GDP could rise by more than 50 percentage points by 2050 under analogous fiscal scaling.
- Scenario 2 (carbon pricing only):
  - Advanced economy carbon prices needed: $150 per ton by 2030; $280 per ton by 2050.
  - Emerging market carbon price needed: $165 per ton by 2050.
  - Emerging market primary surplus outcome under carbon pricing scenario: 0.4 percent of GDP.
- Scenario 3 (well-sequenced mix):
  - Advanced economy package carbon-pricing path: $130 per metric ton by 2030; $235 per metric ton by 2050.
  - Advanced economy fiscal impact: debt-to-GDP up by 10–15 percentage points by 2050; primary deficit up by 0.4 percent of GDP per year relative to business-as-usual.
  - Emerging market package: public green investment at ¾ percent of GDP per year; carbon price $45 by 2030 and $150 by 2050; simulated debt increase about 15 percent of GDP by 2050 relative to business-as-usual.

### Simulated debt rise and composition
- Simulated rise in debt: 0.4 percentage points a year on average.
- Range of projected increase in debt-to-GDP ratio for emerging market economies by 2050: 8−25 percent of GDP, depending on public investment, subsidies, and targeted transfers, and fossil-fuel producer status.
- Composition differences versus advanced economies:
  - Larger contributions from interest costs and higher public investment needs.
  - Carbon revenues are higher in emerging market simulations.
- Implication: Many emerging market economies, especially those with high existing debt and rising borrowing costs, would face higher interest payments and constrained fiscal capacity to redistribute carbon revenues or meet public investment needs.

### Scenario 4: Delays in Carbon Pricing
- Setup: Carbon pricing postponed by three years relative to the preferred policy package (delay from 2023 to 2026), with public investment and subsidies boosted to achieve same emission reduction path.
- Two simulations:
  1. Carbon prices raised quickly after the initial 3-year delay to catch up by 2030.
  2. Carbon prices do not fully catch up with the baseline price path until 2050.
- Debt impacts by 2050 in advanced economies:
  - Case 1 (quick catch-up): debt increases by 3 percentage points of GDP.
  - Case 2 (no full catch-up until 2050): debt increases by almost 6 percentage points of GDP.
- Emerging market economies:
  - Debt worsens substantially if carbon price fails to catch up promptly; by slightly less than advanced economies otherwise.
- Per-year delay effect:
  - Each year of delay increases public debt by 0.8–2.0 percentage points of GDP in advanced economies (depending on post-delay adjustment speed and assuming spending-based policies scaled up to deliver same emission reductions by 2050).
  - For emerging market economies: about 0.9 percentage point per year of delay when carbon prices catch up quickly after the initial delay.
- Conclusion: Longer delays to transition raise costs and debt burdens.

### Scenarios 5 and 6: Technology spillovers and investment bottlenecks
- Scenario 5 (learning-by-doing externality):
  - Assumption: a 1 percent increase in energy capital raises total factor productivity (TFP) by 0.1 percent in the energy sector.
  - Effect: Green subsidies are more effective when learning-by-doing is present—faster emissions reductions, limited output costs, and contained public debt.
- Scenario 6 (investment bottlenecks):
  - Adjustment cost parameter increased to 100.
  - Result: annual adjustment cost rises to 0.25 percent of GDP on average; green capital stock grows by half as much by 2050; stronger policy action needed to achieve net zero.
  - Bottlenecks (limited institutional capacity, supply-chain disruptions, stranded assets) make green subsidies less effective and cause debt-to-GDP ratios to rise further; emission targets may not be reached without higher carbon prices or other measures.
- International spillovers (closed-economy simulation):
  - Assumed: each 1 percentage point of TFP increase in advanced economy energy sector spills over to a 0.1 percentage point increase in emerging market energy sector.
  - Learning-by-doing elasticity assumptions:
    - Emerging markets: 2 percent elasticity of TFP to capital accumulation.
    - Advanced economies: 10 percent elasticity.
  - Result: Technological spillovers help emerging markets achieve net zero with a smaller increase in carbon price, mitigating output loss and consumption decline.

### Sensitivity analysis and robustness
- Debt dynamics sensitive to:
  - Elasticity of substitution between energy sources.
  - Fiscal outlays on green investment and subsidies.
- Specific parameter findings:
  - Lower elasticity of substitution requires much higher carbon price: US$660 compared with US$235 in the main scenario.
  - If carbon price increase is capped at US$350, green investment and subsidies must be higher, leading to greater debt accumulation.
  - Higher investment and subsidies raise debt but require a smaller carbon price and lower output cost.
  - Higher transfers (50 percent of carbon revenues) would slightly increase debt compared to the main scenario.
- Public investment and transfer sensitivity examples for emerging markets:
  - If government transfers are 50 percent of revenue from carbon taxes: debt would rise by 25 percentage points of GDP by 2050, with an increase in primary deficits of 0.6 percentage point of GDP a year on average.
  - If public mitigation investment and subsidy are reduced by about ¼ percent of GDP per year: debt would increase by 8 percentage points of GDP.
- Baseline assumptions referenced:
  - Range of simulated rise in debt for emerging markets: 8−25 percent of GDP by 2050 for transfers at 30-50 percent of carbon revenues and public investment about ½ and ¾ percent of GDP.
  - Baseline well-sequenced policy package for emerging markets: transfers at 30 percent of carbon revenues and public investment at about ¾ percent of GDP; alternatives explored include transfers at 50 percent and public investment at ½ percent of GDP per year.

### Policy implications and conclusions
- Tradeoffs: Achieving climate goals involves balancing climate objectives, fiscal sustainability, and political feasibility.
- Key conclusions:
  - Relying mostly on spending-based policies to reach net zero leads to fast-rising debt and elevated fiscal-sustainability risks.
  - Relying solely on carbon pricing is likely politically unpalatable and insufficient on its own.
  - A calibrated mix of revenue- and spending-based mitigation instruments is required: carbon pricing combined with transfers, green subsidies and investment, and regulatory measures.
  - Advanced economies with fiscal space could accommodate a small increase in debt; many emerging market and developing economies with high debt face greater challenges.
  - Actions called for: enhance domestic revenue mobilization, improve spending efficiency, catalyze private financing, and undertake structural reforms to accelerate growth.
  - Policy sequencing matters: timing carbon-tax revenue to coincide with front-loaded green subsidies can contain deficit impacts.
  - Technology spillovers increase the effectiveness of green subsidies; investment bottlenecks increase decarbonization costs.
- Uncertainty and next steps:
  - Projected debt levels are subject to considerable uncertainty from investment size, elasticity of substitution between energy sources, and fiscal policy impacts.
  - Need to develop tools to incorporate climate policies into debt sustainability analysis and identify country-specific optimal policy mixes.

*Source: IMF Working Paper “Public Debt Dynamics during the Climate Transition,” Working Paper No. WP/2024/071.*

### References .............................................................................................................

### Public Debt Dynamics during the Climate Transition

### Introduction: context and research questions
- 2023 was the warmest on record; climatic “tipping points” risk rises with global warming (IPCC 2021; McKay and others 2022; Ditlevsen and Ditlevsen 2023).
- Countries have committed to net-zero targets by about midcentury, but large gaps in ambition and implementation remain.
- Transition requires fundamental transformation of production, consumption, and investment and will impose uneven transition costs across households and firms.
- Key fiscal dilemma: design fiscal policies to incentivize decarbonization while balancing tradeoffs, equitable burden sharing, and fiscal sustainability, especially in fiscally-constrained developing countries.

### Contribution and scenarios analyzed
- Main contributions:
  - Quantify dynamic implications for deficits and public debt of policy packages to achieve net zero for two country groups: advanced economies (AE) and emerging market economies (EM).
  - Assess evolving desirable mix of climate instruments from a macro-fiscal perspective.
- Six scenarios analyzed (policies achieve net zero emissions by around midcentury):
  1. Scaled-up spending: countries primarily scale up spending (green subsidies, public investment).
  2. Reliance on carbon pricing: climate policies rely primarily on carbon pricing.
  3. Balanced policy mix: balanced mix of revenue and expenditure measures.
  4. Cost of delaying carbon pricing.
  5. Technology spillovers.
  6. Investment bottlenecks.
- Key quantitative findings:
  - Heavily relying on spending measures could increase debt by 45-50 percent of GDP by mid-century.
  - A balanced approach combining carbon pricing with spending-based policies can limit the rise in public debt to 10-15 percent of GDP by 2050.
  - Carbon pricing functions both as an emissions-reduction tool and as a source of revenue.
  - Postponing carbon pricing is costly; technology spillovers reduce costs; investment bottlenecks can cause debt-to-GDP ratios to rise further.
- Emissions and baseline targets used in simulations:
  - Policy scenarios reduce emissions by 80 percent by 2050 in advanced economies and by 2060 in emerging market economies.
  - Baseline paths for output, population, and government debt are based on IMF World Economic Outlook database projections, OECD long-term projections, and UN population projection.

### Related literature and model positioning
- Bridges two literatures:
  - New-Keynesian fiscal-policy modelling with rich fiscal instruments and debt dynamics (building on Traum and Yang 2015; Mian, Straub, and Sufi 2022).
  - Climate-macro literature using dynamic general-equilibrium models to examine environmental policy effects (references include Acemoglu and others 2012, 2016; Barrage 2019; Ferrari and Landi 2020).
- Distinguishing features of this paper:
  - Analyzes implications of climate policies on public debt dynamics using a dynamic general equilibrium model with a rich fiscal instrument set.
  - Models intertemporal behavioral responses to expected changes in climate policy and includes price rigidities to capture transition dynamics.
  - Focuses on a closed economy (not equipped to analyze cross-border issues such as carbon-border adjustments).

### Model framework: structure and key mechanisms
- Base: two-agent New Keynesian dynamic general equilibrium model with fiscal block (à la Traum and Yang 2015).
- Core features:
  1. Two household types: savers (forward-looking, access to asset and capital markets) and non-savers (liquidity-constrained, consume all income each period).
  2. Final-good price subject to nominal rigidity (quadratic adjustment costs); investment subject to adjustment costs.
  3. Fiscal instruments: consumption tax, labor and capital income taxes, government expenditure, transfers; debt stabilized by lump-sum tax on savers.
  4. Monetary policy: Taylor rule responding to inflation gap and output gap.
- Climate and technology extensions:
  - Energy used in production of final goods; energy generated from green and brown sources.
  - Each energy source employs private capital and labor; green energy also uses public capital (e.g., electricity grids).
  - Carbon emissions proportional to brown energy output (unit elasticity).
  - Learning-by-doing externalities: productivity in each energy source grows in proportion to existing capital stock.
  - Private investment subject to quadratic adjustment costs to capture bottlenecks (scarcity of critical minerals, geopolitics, divesting stranded brown assets).
  - Sovereign interest rates increase with debt-to-GDP ratio via a convenience-yield formulation following Mian, Straub, and Sufi (2022).

### Key equations and mechanisms (as presented)
- Final goods production combines energy and non-energy inputs via CES with elasticity 휂௙ and energy share 휍௙.
- Energy production is a CES bundle of green and brown sources with elasticity 휂 and brown energy share 휔.
- Green energy production includes public capital; brown energy share of public capital set to zero.
- Learning-by-doing: log(퐴௧௜) = 훼௜ log(푘௧ ି ଵ௜ / 푘ௌௌ௜) + 휖௧௜ (productivity evolves with cumulative capital).
- Capital accumulation with quadratic adjustment costs:
  - 푘௧௝(1+푔)(1+푛) = (1−훿)푘௧ ି ଵ௝ + 푖௧௝ [1 − 훾௝/2 ( (푖௧௝/푘௧ ି ଵ௝ − 훿 )^2 ) ] 푘௧ ି ଵ௝
- Convenience yield of holding government debt deviation:
  - 퐶푌෢௧ = − φ (푏௧ / 푏ത)^푏ത , linking higher government debt to increased interest rates.

### Data, baseline, and calibration highlights
- Baseline “business-as-usual” based on current policies; baseline paths from IMF WEO, OECD, UN population projections; emissions path and initial carbon prices consistent with Climate Policy Assessment Tool; initial energy shares from US EIA.
- Emissions reduction targets in scenarios: 80 percent by 2050 (AE) and by 2060 (EM).

- Selected calibrated parameter values (as presented in Table 1):
  - Elasticity of energy in final goods production 휂௙ = 0.21 (Labandeira, Labeaga, and López-Otero (2017))
  - Elasticity between green and brown energy 휂 = 3.5 (Acemoglu and others (2012))
  - Elasticity between private green capital and public green capital ηீ = 0.9
  - Share of energy in final goods production 휍௙ = 0.07 (Känzig (2023))
  - Share of brown source in energy production 휔 = 0.8 (AE)/0.9 (EM) (IEA’s World Energy Balances)
  - Share of public green capital in green capital 푤ீ = 0.16 (based on Traum and Yang (2015))
  - Discount factor 훽 = 0.99
  - Intertemporal elasticity of substitution 휎 = 1
  - Depreciation rate 훿 = 0.025
  - Inverse Frisch elasticity = 2
  - Share of labor in green, brown, and non-energy production 휶௜ = 0.68
  - Debt elasticity 휑 = 0 (AE)/0.003 (EM)
  - Price elasticity 휖௣ = 10
  - Capital adjustment cost 훾௜ = 4
  - Price adjustment cost 휅 = 52.9 (matches average frequency of price changes every three quarters)
  - Consumption tax rate 휏௖ = 12 percent
  - Labor income tax rate 휏௪ = 20 percent
  - Capital income tax rate 휏௞ = 20 percent
  - Lump-sum tax response to debt-to-GDP ratio 휙஻ = 0.01 (Gomes, Jacquinot, and Pisani (2012))
  - Taylor rule smoothing 휌 = 0.5
  - Taylor rule response to inflation 훾గ = 2

### Implications emphasized in the text
- A predominantly spending-based approach to meet climate goals is fiscally costly (debt increases of 45-50 percent of GDP by mid-century).
- A balanced policy mix with carbon pricing substantially reduces fiscal costs (debt rise of 10-15 percent of GDP by 2050).
- Timely adoption of carbon pricing is important; delays are costly.
- Technology spillovers can mitigate transition costs; investment bottlenecks can exacerbate fiscal pressure.
- Model limitations: closed-economy focus—does not model cross-border issues such as carbon-border adjustments or international spillovers.

*IMF WORKING PAPERS — Public Debt Dynamics during the Climate Transition.*

### 0.125                             Standard                             value

### Public Debt Dynamics during the Climate Transition

### Model setup and calibration
- Representative economies:
  - Advanced economy calibrated to Group of Seven.
  - Representative emerging market economy is an average of Argentina, Brazil, China, India, Indonesia, Mexico, South Africa, and Türkiye.
- Initial carbon price:
  - $40 for representative advanced economy.
  - $5 for representative emerging market economy.
- Key parameters and shares:
  - Share of public capital in green capital (푤ீ): 0.16.
  - Elasticity between private green capital and public green capital: 0.9.
  - Share of liquidity-constrained households: 30 percent in advanced economies; 50 percent in emerging market economies.
  - Capital adjustment cost parameter: 4.
  - Debt elasticity of the convenience yield (휑): 0 for advanced economies; calibrated for emerging markets so equilibrium interest rate increases by 20 basis points when government debt increases by 10 percent.
- Debt-stabilization channel:
  - Suspended in the model until 2050 for advanced economies and 2060 for emerging market economies; a lump-sum tax is set to gradually increase in response to debt to GDP to ensure the government’s intertemporal budget constraint is met.
- Preferred net zero package outcome (advanced economies):
  - Ex post annual cost on output: about 0.03 percent of GDP to 2050 on average.
  - Total cost between 2023–50: 0.8 percent of GDP.

### Scenario 1: Scaling up spending to meet climate goals
- Policy design:
  - Scale up public investment and subsidies by an additional 2 percent of GDP per year on average to reach net zero by midcentury.
  - Carbon price capped at $75 a ton for representative advanced economy and $45 a ton for representative emerging market economy in illustrated simulations.
- Advanced economy simulation outcomes:
  - Large fiscal cost and significant rise in debt-to-GDP: increase by 45 percentage points by 2050 (solid line scenario).
  - Moderate spending alternative (additional ½ percent of GDP per year):
    - Emissions fall by about 40 percent by 2050 relative to current levels (dashed line scenario).
- Emerging market simulation outcomes:
  - Cap carbon price at $45 a ton during 2030–50 and scale up green investment/subsidies to reach net zero by 2060.
  - Debt-to-GDP surge of more than 50 percentage points by 2050 (solid red line).
  - Moderate increase in spending yields emissions fall of 10 percent from current levels and is insufficient to reach net zero (dashed red line).
- Interpretation:
  - Relying largely on expenditure measures to achieve net-zero emissions by midcentury would sharply raise public debt-to-GDP ratios and put debt sustainability at risk.

### Scenario 2: Relying primarily on carbon pricing
- Advanced economy carbon-pricing-only calibration:
  - Carbon prices required to reach net zero: $150 per ton by 2030 and $280 per ton by 2050.
  - Effects:
    - Carbon pricing generates revenue and reduces deficits, lowering the real interest rate and the debt ratio.
    - High carbon prices could lower output and cause uneven transition costs among households, necessitating targeted transfers.
- Emerging market carbon-pricing-dominant calibration:
  - Modest public investment at ¼ percent of GDP per year and no green subsidies.
  - Carbon price required: $165 per ton by 2050.
  - Effects:
    - Generates revenue and leads to a small primary surplus of 0.4 percent of GDP.
    - Reduces debt ratio but at the expense of smaller output and uneven decline in consumption across households.

### Scenario 3: Combination of well-sequenced policy instruments
- Policy components:
  - Carbon pricing to reduce emissions and generate fiscal revenues.
  - Green public investment to complement private green capital.
  - Green subsidies to encourage innovation and deployment, front-loaded and phased out after 2030 in simulations.
  - Targeted transfers to mitigate adverse impacts: transfers equal to 30 percent of carbon revenue to protect vulnerable households.
- Operationalization of net-zero:
  - Advanced economies: 80 percent reduction in 2023 emission levels by 2050 (remainder offset by carbon capture and storage).
  - Emerging market economies: 80 percent reduction in 2023 emission levels by 2060.
- Advanced economy calibration and outcomes:
  - Annual green public investment permanently higher by 0.4 percent of GDP (with frontloaded trajectory).
  - Annual green subsidy 0.2 percent of GDP higher relative to baseline until 2030, then gradually fades.
  - Initial carbon price set to $40.
  - Emission trajectory aims: decline of 40–50 percent by 2030 and 80 percent by 2050 relative to 2023.
  - Carbon-pricing path to meet package: $130 per metric ton by 2030 and $235 per metric ton by 2050.
  - Revenues from carbon peak around 2030 and decline as decarbonization reduces the tax base; carbon revenues as a share of GDP decline during 2030–50 absent tax-base shifts.
  - Private sector green investment doubles relative to business-as-usual; endogenous private green investment accounts for majority of total green investment.
  - No earmarking of carbon revenues except transfers equal to 30 percent of carbon revenues to hand-to-mouth households.
  - Fiscal outcomes: debt-to-GDP increases by 10–15 percentage points by 2050; primary deficit rises by 0.4 percent of GDP a year relative to business-as-usual. Interest-rate effects relatively muted.
- Emerging market calibration and outcomes:
  - Carbon price path: reaches $45 a ton by 2030, rises to $150 a ton by 2050.
  - Green investment needs larger at ¾ percent of GDP per year.
  - Green subsidy increase is half the value in advanced economies.
  - Transfers to vulnerable households equal to 30 percent of carbon revenue.
  - Emission reduction efforts are backloaded to achieve net zero by 2060.
  - Private green investment triples the green private capital stock by 2050 relative to business-as-usual.
  - Simulation indicates public debt would increase by about 15 percent of GDP by 2050 relative to business-as-usual, equivalent to a rise in primary deficits by [text truncated in source].

### Key quantitative takeaways across scenarios
- Scenario 1 (expenditure-heavy):
  - Advanced economy: debt-to-GDP could rise by 45 percentage points by 2050 under a 2 percent of GDP per year spending ramp-up.
  - Emerging market: debt-to-GDP could rise by more than 50 percentage points by 2050 under analogous fiscal scaling.
- Scenario 2 (carbon pricing only):
  - Advanced economy carbon prices needed: $150 per ton by 2030; $280 per ton by 2050.
  - Emerging market carbon price needed: $165 per ton by 2050.
  - Emerging market primary surplus outcome under carbon pricing scenario: 0.4 percent of GDP.
- Scenario 3 (well-sequenced mix):
  - Advanced economy package carbon-pricing path: $130 per metric ton by 2030; $235 per metric ton by 2050.
  - Advanced economy fiscal impact: debt-to-GDP up by 10–15 percentage points by 2050; primary deficit up by 0.4 percent of GDP per year relative to business-as-usual.
  - Emerging market package: public green investment at ¾ percent of GDP per year; carbon price $45 by 2030 and $150 by 2050; simulated debt increase about 15 percent of GDP by 2050 relative to business-as-usual.

*Source: wpiea2024071-print-pdf - 0.125 Standard value.*

### 0.4 percentage points a year on average (Figure 6, panel 4). The simulated rise in debt is subject to a

### Public Debt Dynamics during the Climate Transition

### Simulated debt rise and composition
- Simulated rise in debt: 0.4 percentage points a year on average.
- Range of projected increase in debt-to-GDP ratio for emerging market economies by 2050: 8−25 percent of GDP, depending on public investment, subsidies, and targeted transfers, and fossil-fuel producer status.
- Composition differences versus advanced economies:
  - Larger contributions from interest costs and higher public investment needs.
  - Carbon revenues are higher in emerging market simulations.
- Implication: Many emerging market economies, especially those with high existing debt and rising borrowing costs, would face higher interest payments and constrained fiscal capacity to redistribute carbon revenues or meet public investment needs.
- Recommended fiscal responses highlighted:
  - Improve spending efficiency.
  - Mobilize alternative sources of finance, including other domestic tax revenues.
  - Greater role for private financing to crowd-in investment and jumpstart growth.
  - Prioritize reducing energy intensity and adaptation in low-income developing countries with limited access to financing and modest emissions contributions.

### Scenario 4: Delays in Carbon Pricing
- Setup: Carbon pricing postponed by three years relative to the preferred policy package (delay from 2023 to 2026), with public investment and subsidies boosted to achieve same emission reduction path.
- Two simulations:
  1. Carbon prices raised quickly after the initial 3-year delay to catch up by 2030.
  2. Carbon prices do not fully catch up with the baseline price path until 2050.
- Debt impacts by 2050 in advanced economies:
  - Case 1 (quick catch-up): debt increases by 3 percentage points of GDP.
  - Case 2 (no full catch-up until 2050): debt increases by almost 6 percentage points of GDP.
- Emerging market economies:
  - Debt worsens substantially if carbon price fails to catch up promptly; by slightly less than advanced economies otherwise.
- Per-year delay effect:
  - Each year of delay increases public debt by 0.8–2.0 percentage points of GDP in advanced economies (depending on post-delay adjustment speed and assuming spending-based policies scaled up to deliver same emission reductions by 2050).
  - For emerging market economies, a notable increase of about 0.9 percentage point per year of delay is found when carbon prices catch up quickly after the initial delay.
- Conclusion: Longer delays to transition raise costs and debt burdens.

### Scenarios 5 and 6: Technology spillovers and investment bottlenecks
- Scenario 5 (learning-by-doing externality):
  - Assumption: a 1 percent increase in energy capital raises total factor productivity (TFP) by 0.1 percent in the energy sector.
  - Effect: Green subsidies are more effective when learning-by-doing is present—faster emissions reductions, limited output costs, and contained public debt.
- Scenario 6 (investment bottlenecks):
  - Adjustment cost parameter increased to 100.
  - Result: annual adjustment cost rises to 0.25 percent of GDP on average; green capital stock grows by half as much by 2050; stronger policy action needed to achieve net zero.
  - Bottlenecks (limited institutional capacity, supply-chain disruptions, stranded assets) make green subsidies less effective and cause debt-to-GDP ratios to rise further; emission targets may not be reached without higher carbon prices or other measures.
- International spillovers (closed-economy simulation):
  - Assumed: each 1 percentage point of TFP increase in advanced economy energy sector spills over to a 0.1 percentage point increase in emerging market energy sector.
  - Learning-by-doing elasticity assumptions:
    - Emerging markets: 2 percent elasticity of TFP to capital accumulation.
    - Advanced economies: 10 percent elasticity.
  - Result: Technological spillovers help emerging markets achieve net zero with a smaller increase in carbon price, mitigating output loss and consumption decline.

### Sensitivity analysis and robustness
- Debt dynamics sensitive to:
  - Elasticity of substitution between energy sources.
  - Fiscal outlays on green investment and subsidies.
- Specific parameter findings:
  - Lower elasticity of substitution requires much higher carbon price: US$660 compared with US$235 in the main scenario.
  - If carbon price increase is capped at US$350, green investment and subsidies must be higher, leading to greater debt accumulation.
  - Higher investment and subsidies raise debt but require a smaller carbon price and lower output cost.
  - Higher transfers (50 percent of carbon revenues) would slightly increase debt compared to the main scenario.
- Public investment and transfer sensitivity examples for emerging markets:
  - If government transfers are 50 percent of revenue from carbon taxes: debt would rise by 25 percentage points of GDP by 2050, with an increase in primary deficits of 0.6 percentage point of GDP a year on average.
  - If public mitigation investment and subsidy are reduced by about ¼ percent of GDP per year: debt would increase by 8 percentage points of GDP.
- Baseline assumptions referenced:
  - Range of simulated rise in debt for emerging markets: 8−25 percent of GDP by 2050 for transfers at 30-50 percent of carbon revenues and public investment about ½ and ¾ percent of GDP.
  - Baseline well-sequenced policy package for emerging markets: transfers at 30 percent of carbon revenues and public investment at about ¾ percent of GDP; alternatives explored include transfers at 50 percent and public investment at ½ percent of GDP per year.

### Policy implications and conclusions
- Tradeoffs: Achieving climate goals involves balancing climate objectives, fiscal sustainability, and political feasibility.
- Key conclusions:
  - Relying mostly on spending-based policies to reach net zero leads to fast-rising debt and elevated fiscal-sustainability risks.
  - Relying solely on carbon pricing is likely politically unpalatable and insufficient on its own.
  - A calibrated mix of revenue- and spending-based mitigation instruments is required: carbon pricing combined with transfers, green subsidies and investment, and regulatory measures.
  - Advanced economies with fiscal space could accommodate a small increase in debt; many emerging market and developing economies with high debt face greater challenges.
  - Actions called for: enhance domestic revenue mobilization, improve spending efficiency, catalyze private financing, and undertake structural reforms to accelerate growth.
  - Policy sequencing matters: timing carbon-tax revenue to coincide with front-loaded green subsidies can contain deficit impacts.
  - Technology spillovers increase the effectiveness of green subsidies; investment bottlenecks increase decarbonization costs.
- Uncertainty and next steps:
  - Projected debt levels are subject to considerable uncertainty from investment size, elasticity of substitution between energy sources, and fiscal policy impacts.
  - Need to develop tools to incorporate climate policies into debt sustainability analysis and identify country-specific optimal policy mixes.

*Source: IMF Working Paper “Public Debt Dynamics during the Climate Transition,” Working Paper No. WP/2024/071.*

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_Source: https://www.imf.org/-/media/files/publications/wp/2024/english/wpiea2024071-print-pdf.pdf_