Larger climate ambitions, bigger hit to economic growth?

Faced with more climate change-related disasters, several countries across the world have increased their climate ambitions for 2030. Among the three largest economies, the U.S. and EU committed to reduce net greenhouse gas (GHG) emissions 51% (relative to 2005) and 55% (relative to 1990 or 51% relative to 2005) in April 2021 and September 2020 (see table 1). China also pledged to lower its CO2 emissions per unit of output by over 65% from 2005 levels in December 2020, which would lead to its emissions peaking in 2026 (see "China's Carbon Program Provides Additional Tool For Decarbonization," published on July 16, 2021, by S&P Global Platts Analytics). In August 2020, China announced its ambition to carbon neutrality by 2060.

Table 1

Being among the first to adopt climate targets, the EU is ahead of the U.S. and China in the green transition. For similar levels of GDP per capita, the EU has emitted less CO2 per unit of GDP than the U.S. (see chart 1), even if the latter is catching up at higher GDP per capita levels. China has more to do to catch up but already seems to be on a lower GDP per capita emissions path than the EU. What's more, that's as China boosts levels of wealth with less CO2 emissions than what was the case for the EU before 1990. This suggests that either stricter environmental rules in some countries may have had positive environmental spillovers abroad or that China may have started its green transition at lower GDP per capita levels than its U.S. and EU peers.

Chart 1

The latest report by the Intergovernmental Panel on Climate Change calls for more aggressive environmental measures to avoid the worst climate change impacts. For that reason, countries are considering a wider range of policy tools, prompting some to question whether they may come at the expense of economic growth.

Taking a look at green public spending, environmental regulation, and carbon taxes in the EU, U.S., and China, S&P Global Ratings finds that combining different types of policy tools can soften the hit to growth --even for the most vulnerable sectors and households, but current commitments are unlikely to be enough to reach more ambitious climate targets.

Green public spending to boost EU and U.S. GDP by 2030

For now, public spending seems to be the main environmental policy lever that governments are using to reach their targets, since in any case they need to finance the recovery from COVID-19. The U.S. and EU have unveiled large fiscal stimulus packages with green spending that we estimate at about 1.4% to 3.9% of 2019 GDP (see table 2).

Table 2

The EU  has committed more resources to fighting climate change than its peers, with about 3.9% of 2019 GDP of green public spending over the next seven years. A minimum of 30% of the combined EU budget and COVID-19 recovery fund (Next Generation EU) has been earmarked to fighting climate change. These are more significant means to underpin the EU Green Deal (its road map to carbon neutrality), which was meant to generate €1 trillion of green spending from the public and private sector over the next decade back in early 2020 (See "EU Green Deal: Greener Growth Doesn't Necessarily Mean Lower Growth," Feb. 10, 2020, S&P Global Ratings).

In the U.S.,  two separate federal plans have been proposed with large amounts of green allocations: the House of Representative's Invest in America Act and the Senate's Bipartisan Infrastructure Deal. On average, close to 50% of those plans are green, representing 1.4% of 2019 GDP.

China's  five-year plan does reference a low-carbon transition but does not mention any specific public spending initiatives. However, the Politburo has hinted in its July meeting that authorities are likely to release an "action plan" to achieve peak carbon emissions by 2030 soon.

There are several reasons why green stimulus will lift GDP. First, the IMF (2021) estimates that green multipliers are higher than traditional ones. For example, renewable energy investment multipliers are about 1.1-1.5 compared with 0.5-0.6 for fossil fuel investment. Abstracting from the co-benefits of a greener environment (for example, improved health and biodiversity), green investment spending is also often infrastructure spending (for example, public transportation), that tends to have crowding-in effects on private-sector investment and boosts productivity in the long run. Even spending to increase energy efficiency, such as building renovation, can improve resource allocation because energy cost savings can be used for other means over the longer term.

Second, the green stimulus measures are taking place during a time of economic slack and low financing costs, which means that the fiscal multiplier and therefore the potential for economic growth are at their highest (see "The Case For Bold Fiscal Stimulus In The Eurozone," S&P Global Ratings, Nov. 17, 2020). For the EU, we estimate that the current government spending multiplier lies around 1.6 after four years and for the U.S. at about 1.4 (see "How U.S. Infrastructure Investment Would Boost Jobs, Productivity, And The Economy," Aug. 23, 2021). As a result, green fiscal spending is set to add at least 6.6 percentage points to EU GDP and close to 2 points to U.S. GDP (in 2020 terms) by 2030 (see chart 2). This may not yet meet the 2 point increase in energy investment needed globally to reach net zero by 2050 according to the IEA (2021). Yet, we believe it is a powerful step in this direction because it will encourage more private investment in the green transition.

Chart 2

Environmental regulation is likely to be felt the most at the sector level

Alongside public investment, governments are using regulation and some carbon pricing to underpin their green strategies.

the EU is ahead of others on this score, having instituted climate policies starting in the 1990s. It designed the first international emissions trading system (ETS) to price carbon and has set renewable, energy efficiency, as well as national reduction targets for non-ETS sectors. Carbon pricing in the EU is already significantly higher than in the U.S. and China (see chart 3).

To keep the 2030 transition on track, the European Commission has already proposed another set of policies in July: the Fit for 55 package. Those include extending the ETS to include more sectors (such as maritime, building, and transport), revised energy taxation, more ambitious renewable and energy efficiency targets, and a new carbon border adjustment mechanism (CBAM). Inside the EU, Sweden emits four times less carbon for each unit of output than Estonia and Poland.

Chart 3

In the U.S., federal environmental regulations are implemented at the state level. Some states, such as California, have additional environmental regulations over and above federal regulation. Congress passed the American Innovation and Manufacturing Act in Dec. 27, 2020. The objective is to phase down the production and consumption of listed hydrofluorocarbons (HFCs), manage these HFCs and their substitutes, and facilitate the transition to next-generation technologies. The president signed an executive order on Jan. 27, 2021, to eliminate fossil fuel subsidies by 2022.

Until now, China has mainly relied on top-down command and control policies (environmental targets set at the national level, see Yin et al. 2019) to propel the switch to a low-carbon growth path. But it has recently developed some market-based instruments: an Environmental Protection Tax (EPT) law in 2018 and an emissions trading scheme (ETS) this year. The latter is much less developed than the EU ETS. It only covers the energy sector and has a significantly lower entry price (around $7 versus €60 in the EU), but it is a first step in pricing carbon.

Chart 4

Historical evidence suggests that environmental regulation can achieve meaningful environmental goals with only a small overall impact on aggregate economic output (see chart 4). To start with, there is no evidence to back the pollution haven hypothesis, positing that stricter regulation leads to offshoring (or carbon leakage). The OECD (2021) finds that a 10% increase in environmental policy stringency (EPS) leads to a 5%-10% reduction in carbon intensity and even triggers a small increase in productivity. This means stricter regulation triggers innovation, in line with the Porter hypothesis. While manufacturing employment declines by 1% , it does not result in lower net manufacturing exports.

Chart 5

Chart 6

That said, the heterogeneous impacts of environmental policies tend to be less pronounced for market-based instruments (for example, taxes, ETS). Historically, the latter tend to promote positive economic effects (like productivity growth), while dampening negative ones (Albrizio et al. 2017). Non-market instruments (bans, technology standards) are generally less cost-effective, as they give companies less flexibility to adapt. Command and control policies in China appear to weigh on growth (see Si et al. 2020), whereas financial incentives tend to boost output in some energy-related industries and sectors. This also applies for households. Fuel efficiency standards for vehicles and energy efficiency standards for appliances are more regressive than a carbon tax, according to Levison (2019).

More broadly speaking, the research emphasizes that the revenues generated by environmental policies can also be used to foster their positive effects, while cushioning the negative ones.

Carbon taxes are not very popular due to their more likely negative impact on growth

While the consensus among economists is that pricing carbon is the first best policy lever to reduce negative environmental consequences, most countries have taken a pass. According to the OECD, about 60% of carbon emissions from energy use in the OECD and Group of 20 countries were not priced in 2018, and those that are priced are most often not priced at the recommended level. Even the EU, with its 15-year-old ETS, has no concrete plans for reaching a carbon price of $100 tons CO2 equivalent by 2030, as recommended in 2017 by the HCCP (High-Level Commission On Carbon Prices). What's more, the latest Fit for 55 package proposes to enlarge ETS coverage but not yet to cover all sectors of the economy. Much has been said about the global free-rider problem to find fault with carbon taxes as an instrument for raising carbon prices. We also find that for some countries, carbon taxes, if raised substantially, are likely to be the instrument that may cause more direct economic losses. This suggests, that while carbon taxes may be the "first best" policy lever to tackle environmental problems, it can lead to some trade-offs in terms of growth, contrasting with green spending, which is growth enhancing. A way to deal with this issue may be the introduction of different levels of carbon taxes, depending on countries' ability to make the green transition, something which was recently suggested by the IMF.

We have developed a carbon tax scenario, which shows that a high carbon tax reduces GDP by 2030 by 1.2 percentage points in the EU, 2.3 points for the U.S., to 7.3 points for China (see chart 7 and the appendix for the methodology). We model an effective carbon tax that encompasses all sectors of the economy, similar to the OECD's carbon pricing score. There is a way to dampen and, in the case of the EU, almost completely offset the impact by redistributing the carbon tax's proceeds to households or government investment in green-related spending. Using carbon revenues for spending that would speed up the transition to a low-carbon economy, something the model doesn't account for, would likely dampen the impact even further. Interestingly, redistributing the proceeds to households with no conditionality on the use of those funds (something the model doesn't allow us to specify) appears to be less efficient at reducing the negative aggregate economic impact of carbon pricing. That's because households would save instead of spend some of those funds, and the model estimates that government investment spending is more likely to boost productivity than household consumption. Furthermore, we note, the sectoral impact of such a policy would vary by sector, with heavy emitters facing steeper cost increases than greener companies.

Chart 7

That said, our modeling exercise highlights that first movers in the green transition will have an easier time of withstanding a higher carbon tax than other economies. As such, the impact would be more muted for the EU simply because it is ahead in the green transition. Aside from higher carbon prices than the U.S. or China (see chart 3), the EU also relies on less polluting sources of energy. This contrasts with China, where coal still made up 58% of energy sources in 2019.

Second, the model shows a greater impact within countries, that is, for households--the voters--because higher energy prices reduce their purchasing power (see chart 8).

Chart 8

Finally, the model suggests that if all countries do not impose a carbon tax simultaneously, carbon leakage may partly offset the reduction of emissions, undermining its original goal. Leakages occur through two main channels:

Country competitiveness: Firms move energy-intensive production lines to countries with lower carbon prices, and thus imports become relatively more carbon intensive.

Lower world energy prices: Prices fall on the back of lower global demand, triggered by the carbon tax, creating a boon for other oil-importing countries, which in turn boosts their demand for oil, thereby offsetting some of the direct impact of a carbon tax in the U.S., EU, and China (see chart 9).

Chart 9

Carbon border adjustment taxes are likely to help reduce carbon leakage only if domestic carbon taxes are high

The potential for carbon leakages undermined the effectiveness of the EU ETS in the past, giving rise to free carbon allowances for big European polluters. This is why the EU, but also some U.S. senators, have proposed a CBAM. That would discourage import substitution of energy-intensive goods by ensuring external producers are subject to the same carbon tax as the domestic ones. However, it is unlikely to tackle carbon leakages linked to lower oil prices. Nonetheless, it may still serve as an incentive for firms not covered by strict environmental rules to adopt more ambitious targets and generate fiscal revenues that could be used to tackle the green transition.

Chart 10

However, implementing a CBAM presents some trade-offs. First, it risks being viewed as a protectionist policy if no significant domestic carbon price is in force (which is the case in the U.S. currently), giving rise to potential retaliation from trading partners and pushback from the World Trade Organization. Plus, firms may react only by adjusting their value chains to import, instead of source locally, carbon-heavy goods that CBAMs may not cover. These kinds of supply chain adjustments, which happened after the U.S. placed higher trade tariffs on Chinese goods, would offset some of the intended reduction on global emissions.

Second, the EU ETS experience between 2005 and 2011 suggests that low and slowly rising carbon prices--the strategy that governments have adopted thus far to price carbon without damaging growth, are likely to lead to modest carbon leakage. But this impact might change as the EU ETS price has since increased to around €60. The 15% drop in demand for oil from the EU between 2005 and 2019 has not influenced world oil prices, due to offsetting demands from countries such as China, which doubled its demand for oil in the same period, surpassing the EU's consumption in 2015. Companies also face steep relocation costs that may not make it financially prudent to move their production lines abroad in the face of higher border taxes. Data on emissions embedded in trade shows that, even for Sweden, which has had a carbon tax since 1991 and the highest in 2021, the rise in imported emissions has been nonexistent or very limited for sectors covered by the ETS in the first 16 years (see chart 11). Even the rise in net imported emissions by the chemicals sector, the industry that recorded the highest increase between 2011 and 1995, resulted from Swedish companies becoming cleaner, that is, Sweden exporting less emissions through its chemical industry. This suggests a CBAM would mainly make sense for industries with a history of carbon leakage--emissions-intensive and trade-exposed industries such as cement, aluminum, steel, and iron . Nonetheless, the recent rise in the EU ETS price and the plan to remove free allowances for high emitters might prompt companies to leak more carbon offshore.

Chart 11

The rise in sustainable finance could boost green innovation

Market dynamics appear to be much more aligned with the move to the green transition, especially in the U.S. and EU, regardless of the wide variety of government strategies. The private sector continues to advance green innovation and green investment. From 2010 to 2018, the EU, the U.S. and China contributed an average of 52.7% of all global green innovations. It is noteworthy that green patents in the U.S. constituted 22.3% (three times that of China) of all such patents globally, not far off from the EU, which developed 23.3% of environment-related technologies worldwide. However, patent intensity shows clear gap to be filled. Green patent intensity since 2014 has stalled in the three regions (see chart 12). There is a visible disconnect between NDCs agreed under the Paris Agreement of 2015 and green innovation. On the other hand, private-sector investment in renewable energy has increased threefold according to the IEA in the last decade to $2.6 trillion with China accounting for 29%, Europe 27% (22% including the U.K.), and the U.S. 13%. Notwithstanding the increase in overall investment, innovation and green R&D spending have been declining.

Chart 12

Meanwhile, the importance of ESG factors has risen exponentially among financial market players. The mainstreaming of ESG has had a galvanizing impact on how sustainability factors are incorporated into investment decisions as well as in financial instruments. S&P Global Ratings believes that sustainable bond issuance, including green, social, sustainability, and sustainability-linked bonds, could collectively exceed $1 trillion in 2021, a near 5x increase over 2018 levels (see chart 13 and "The Fear Of Greenwashing May Be Greater Than The Reality Across The Global Financial Markets," Aug. 23, 2021). More finance geared toward sustainability could boost private-sector investment, backing public-sector efforts to green the economy.

Chart 13

Green transition policies are likely to enhance growth, but more is needed to reach net zero

The current green transition policies in the EU, U.S., and China so far mostly rely on public spending, private- sector initiatives, and some environmental regulations to achieve their 2030 environmental goals. Taken together, these are rather likely to enhance growth, thanks to high fiscal multipliers--even more so for countries that are ahead in the green transition. That said, they may present some distributional challenges within countries, as resources are reallocated across sectors, forcing some companies to face much steeper costs and disruptive forces than others, raising questions about what would be a "just transition."

Nonetheless, scientists have highlighted that current policies are not sufficient to avert warming of more than 2 degrees Celsius (S&P Global Platts' base case scenario is closer to RCP 4.5 then RCP 3, leading to 2.8C warming rather than 2C). If countries move to more aggressive environmental policies, like raising the price of carbon to HCCP-recommended levels, those may offset some of the positive growth impacts of current policies, especially in countries more reliant on carbon-intensive energy sources and at an early stage in the green transition. Whereas past experience and political economy considerations suggest carbon pricing is likely to occur only very gradually, growing awareness of physical climate change risks could push for more rapid changes than historically seen.

There is a great deal of uncertainty about predictions for technological change. So far, green innovation has surprised on the upside, with the cost of renewable energies or lithium batteries falling dramatically in recent years. This suggests that the transition may speed up as demand--the primary force stimulating technological change--reaches a tipping point (Wright's law), something that will be helped by public spending and regulation, as well as private market considerations as ESG becomes mainstream.

Contributors: 

Research: Joseph Arthur and Maxime Brun. Editor: Rose Marie Burke. Digital Design: Joe Carrick-Varty.

Related Research

S&P Global Ratings research

• The Fear Of Greenwashing May Be Greater Than The Reality Across The Global Financial Markets, Aug. 23, 2021
• How U.S. Infrastructure Investment Would Boost Jobs, Productivity, And The Economy, Aug. 23, 2021
• The Case For Bold Fiscal Stimulus In The Eurozone, Nov. 17, 2020

Other research

• IEA "Global status of clean energy innovation in 2020"
• Si et al. (2020) The Effects of Environmental Policies in China on GDP, Output and Profits
• Albrizio, S., T. Kozluk and V. Zipperer (2017), "Environmental policies and productivity growth: Evidence across industries and firms," Journal of Environmental Economics and Management, Vol. 81, pp. 209-226.
• Cosbey, A., Droege, S., Fischer C. and Munnings, M. (2019). "Developing Guidance for Implementing Border Carbon Adjustments: Lessons, Cautions, and Research Needs from the Literature," Review of Environmental Economics and Policy, Association of Environmental and Resource Economists, vol. 13(1), pages 3-22.
• Franzen, A. and Mader S. (2018), Consumption-based versus production-based accounting of CO2 emissions: Is there evidence for carbon leakage?, Environmental Science & Policy 84: 34-40.
• Haitao Yin, Xuemei Zhang & Feng Wang, (2019) Environmental Regulations in China
• IEA (International Energy Agency). 2021. Net Zero by 2050: A Roadmap for the Global Energy Sector. Paris.
• IMF (2021), Building Back Better: How Big Are Green Spending Multipliers?, WP/21/87
• IMF (2021), Proposal for an International Carbon Price Floor Among Large Emitters, Staff Climate Note No. 2021/001.
• Levinson, A. (2019) Energy efficiency standards are more regressive than energy taxes: theory and evidence. Journal of the Association of Environmental and Resource Economists.
• Naegele, H. and Zaklan, A. (2019), Does the EU ETS cause carbon leakage in European manufacturing? Journal of Environmental Economics and Management, ISSN 0095-0696, Elsevier, Amsterdam, Vol. 93, pp. 125-147
• OECD (2021), Assessing the Economic Impacts of Environmental Policies: Evidence from a Decade of OECD Research
• Pizer & Sexton (2019), The Distributional Impacts of Energy Taxes
• S&P Global Platts Analytics, "China's Carbon Program Provides Additional Tool For Decarbonization," July 16, 2021
• X. Hu et al. (2020), Impacts of Potential China's Environmental Protection Tax Reforms on Provincial Air Pollution Emissions and Economy

Appendix 1: U.S. Infrastructure Bill – Green Targets

Table 3

Appendix 2: Methodology And Key Assumptions For S&P Global Ratings' Carbon Tax Scenario

We assume that a carbon tax is set in the U.S., EU, and China at the start of 2022 at $72 and rises to $100 by 2030 in 2019 prices. These prices are based on the recommendation of the 2017 HCCP, which suggested a price of $50/ton rising to $100/ton by 2030, as well as OECD research, which considers that pricing all emissions at least at €60 in 2020 ($72) would put a country on a good track to decarbonize its economy by 2050. The carbon price shock we calibrate takes into account an estimate of effective carbon prices that already exist in each country in 2018 (based on OECD data; see chart 2).

We run three types of scenarios. The "no offset" scenario assumes that the proceeds of the carbon tax only go to decrease the debt burden of a country. The two other scenarios assume that all tax revenues are either directly transferred to households' income or used by the government to invest.

We use the Oxford Economics model to compute this macroeconomic scenario. The impact of the shock runs through two channels:

• The carbon tax has an impact on the energy sector through demand and supply effects. This means that the composition of a country's energy sources plays an important role for the impact of the shock.
• The carbon tax affects energy and producer prices directly, leading to higher inflation and thus lower purchasing power for households. So, the bigger the relative increase in prices, the bigger the damage for the economy.