Needed: An economic response plan for a green transition shock
PremiumClimate action can cause a supply shock that’ll demand clarity on cost sharing and the role of fiscal and monetary policy tools
The ferocious heat wave in many parts of the country is a reminder that the risks from climate change are rising. Government surveys show that only around a fifth of Indian households have access to either air-conditioners or coolers in their home. Abhishek Jha and Roshan Kishore have estimated in a recent Hindustan Times article that nearly half of the Indian labour force works outdoors in the sun. The impact of excess heat on India’s wheat crop is an advance indication that climate change can lead to other supply shocks in the coming years, as the existing capital stock in several sectors such as energy or mobility will become prematurely obsolescent because of tax policy or regulations that seek to reduce carbon emissions—and extreme climate events.
A green transition can only be achieved over time. Any sudden action will almost certainly lead to economic collapse. Most countries have committed to reaching carbon neutrality between 2050 and 2070, which means that the costs of the transition will be spread over multiple generations. Yet, how to distribute the costs over time is a tricky issue. There used to be a popular view that future generations should bear most of the costs, since they will be richer than us, but that argument has considerably weakened as recent work by climate scientists has shown that the window available for serious action is closing by the year.
Economists have been engaged in fierce debates on the discount rate that should be used in models that estimate how the costs borne to tackle climate change should be spread over time. Much depends on how a society either values or should value benefits that will be available only many years down the line. The general principle is that a lower discount rate in effect means that today’s generation bears a bigger burden of the costs. And a higher discount rate means that the costs of mitigation can be pushed further into the future for coming generations to pay. It is somewhat akin to the ‘present value’ calculations in financial models.
The landmark report written by economist Nicholas Stern in 2006 used a discount rate of 1.4% to argue in favour of immediate action on climate change. William Nordhaus, who won the Nobel Prize for economics in 2018, has plugged a much higher discount rate of 4.3% in his model. Stern used a discount rate derived from broadly ethical considerations. Nordhaus argues that the discount rate should be based on actual observed behaviour, and especially real interest rates in financial markets.
The issue of a ‘green interest rate’ is based on a longer debate in economics about how the welfare of future generations is to be treated while decisions are made today. The technical debate began with a remarkable paper written in 1928 by Frank Ramsey, a Cambridge University polymath who tragically died at the age of 26. Ramsey developed a mathematical framework to think about how much a nation should optimally save from its income, but his insights have since been used for a range of other applications, including climate change computations.
In an essay on Ramsey, Partha Dasgupta has pointed out: “At the risk of generalising wildly, economists have favoured the use of positive rates to discount future well-beings, whereas philosophers have insisted that the well-being of future people should be given the same weight as that of present people." The growing risks from climate change perhaps tilt the debate in favour of the philosophers rather than economists.
The green transition will be a supply shock that will reduce potential growth but also open up opportunities in new technologies, better infrastructure and the redesign of cities. In other words, the coming decade should see a significant reallocation of both capital as well as labour, assuming factor markets are flexible. What should the policy response be from fiscal authorities as well as central banks? Fiscal policy over the next decade will be constrained by the fact that public debt across the world had bloated because of government spending during the pandemic. Creating fiscal space for green investments will be as much a political challenge as it is an economic one.
Central banks will face their own dilemma about interest rate policy. There is much debate about whether climate change mitigation should be added to the set of targets that modern central banks have to meet, along with inflation, growth and financial stability. A more practical call will be whether to maintain low interest rates to help new investments in a green economy but also effectively make it easier for enterprises with older technologies to survive; or go with higher interest rates that will kill polluting enterprises but also make investments in new technologies more expensive. Or whether central banks should abandon their sector agnosticism by choosing one interest rate for green activities and another one for brown activities, in effect bringing back credit planning. The idea that central bankers can make such technology choices better than the private sector is hard to believe.
Niranjan Rajadhyaksha is CEO and senior fellow at Artha India Research Advisors, and a member of the academic advisory board of the Meghnad Desai Academy of Economics.