Paradigms set the tone for public discussion and policymaking. By providing a set of dominant concepts, theories, and policy instruments, they influence how policymakers understand and address issues. Paradigm shifts are rare, but they can bring about significant change in the way states and their societies think about and respond to challenges.

Such a paradigm shift has occurred over the past few years in the area of climate economics. Green growth is no longer seen as an impossible dream, where environmental sustainability means forgoing wealth and growth. This contrasts with former theories that portray climate change mitigation as a cost, either because overconsumption is seen as the source of environmental problems (Meadows et al., 1972) or because policies, such as carbon pricing, constrain consumption (Nordhaus, 1992). This change has resulted from developments in three areas:

• Economic frameworks and theories have expanded comprehension of the dynamics associated with the green transition;
• Policymakers have successfully implemented these ideas, backed up by evidence; and
• Voters and firms are increasingly embracing green policies, showing a deeper understanding of climate change and its links to the energy transition.

S&P Global Ratings' economists expect this change in perspective to add momentum to the energy transition. But ramping up investments quickly to limit the impact of climate change is challenging in a more fragmented world.

A New Macroeconomic Transition Framework Has Emerged

Green growth theories recognize that technology is not static, and that innovation has a central role to play, as it does in traditional economic models. These theories show that technological change is endogenous, generated by investments and existing capital (Acemoglu et al. 2012). Consequently, green technologies appear costly and not competitive at the start of the transition, simply because of insufficient research and development and a lack of economies of scale. This leads to a tendency for markets to hold onto existing technologies, which are unlikely to change without public intervention.

Technology has a new role beyond shifting out the production possibility frontier.   It is also a means of reducing the emissions-to-GDP ratio (see "Could Green Growth be an Oxymoron?," published May 18, 2023, on RatingsDirect). The environmental role of technological innovation was not conceptualized in previous macroeconomic transition models. Those focused mainly on the negative externality of pollution, where private agents fail to take environmental damage into account in their investment and consumption decisions.

Green growth happens when economic and environmental efficiency are achieved at the same time. This is when investments and innovation to mitigate climate change are positive for economic growth. Improvements in energy efficiency (thereby saving resources) fall into that category, while carbon-capture technology tends to divert resources away from other economic uses (Leeuwen and Mohnen, 2016). Radical innovation can also have positive economic impacts in the longer term, even if immediate returns might be uncertain (Lanoie, 2008). A case in point is renewable electricity generation from solar and wind, which is now cheaper than power from fossil fuels (see chart 1).

Chart 1

Transition technology has the characteristic of a public good, meaning that it provides more benefits to society as a whole than to private investors alone, so governments may choose to support green growth policies.   There are two market failures to address: the negative externality of carbon emissions, and too little investment in green technology. Carbon pricing can correct the first of these, but it cannot address the innovation legacy of past fossil fuel investments. Subsidies are needed in the initial stages to redirect resources toward clean innovation (Acemoglu et al, 2012 and 2019).

Crucially, government investments and subsidies can speed up the transition by attracting more private investment in a greener economy. This has had a substantial impact on renewable energy, as measured by the fiscal multiplier. According to a 2021 study by the International Monetary Fund (IMF), the fiscal multiplier for such investments is estimated to be at least twice as large as that on fossil fuel investments and greater than one.

Market dynamics eventually take over.   The more green innovation can build on existing knowledge and resources, the easier it becomes to reallocate resources toward the renewables sector. Over time, environmentally friendly products may become cheaper, thanks to technological improvements and economies of scale, boosting consumer demand and profitability for firms and investors. The private sector increasingly steps in and the need for public subsidies decreases (see chart 2). This is when carbon taxing may play a bigger role, ensuring that green growth delivers emissions reductions and non-green technologies are replaced.

Chart 2

Trade-offs will still exist in a green growth economy.   Without viable, available alternatives to fossil fuels, it is not possible to transition quickly and smoothly to green power. This delay puts at risk both the 1.5 degree Celsius global warming target of the Paris agreement and the ability to contain physical climate risks. The choice of discount rate matters for undertaking the necessary investments. Discount rates measure the time preference for consumption and are used in climate economics models to estimate the present value of long-term investments. A low discount rate would therefore favor more investments today, even if they lead to reduced consumption, to limit economic losses from climate change in the future (Stern, 2006).

Directly linked to this, consumers' support for an economy that is expanding at the expense of the environment may decrease as they become more aware of the negative impacts of climate change. Recent surveys show that people are increasingly concerned about climate change and willing to forego some of their income to address it (Andre et al, 2024).

Green Growth Policies Have Already Had Some Success

Data shows that green growth ideas implemented so far work, and have helped the new paradigm take hold. Decoupling economic growth from emissions has already happened in some developed economies, both in production and consumption-based terms (see charts 3 and 4). This implies those economies have not offshored their carbon footprints by moving activity elsewhere. At the same time, losses caused by physical climate risks are increasing, providing another incentive to speed up mitigation efforts (see "Lost GDP: Potential Impacts Of Physical Climate Risks," published Nov. 27, 2023).

Chart 3

Chart 4

With increasing evidence that climate change mitigation can be associated with growth, the policy focus has evolved.   More countries are pledging to reach net zero (see chart 5). Public spending on "greening" the infrastructure and technology has surged too, particularly since the COVID-19 pandemic (see chart 6). In Europe, one-third of the NextGenerationEU Fund has been allocated to green spending. And in the U.S., the Inflation Reduction Act has earmarked $369 billion of subsidies for climate protection.

Another push came with the energy market disruptions following Russia's invasion of Ukraine and a renewed focus on achieving energy security, illustrating the energy trilemma. This led large energy importers (such as China and the EU) to accelerate the transition. As a result, global renewable energy capacity additions in 2023 have once again led the International Energy Agency (IEA) to revise its forecast of renewables growth upward, by 33%.

Chart 5

Chart 6

Green growth strategies are becoming apparent in trade as well.   Building competitiveness in green product markets is emerging as a way of capturing international market share. China, for example, has spent more on climate change mitigation than other countries, and by a wide margin (see charts 7 and 8). As a result, Chinese firms have dominated solar panel manufacturing for a long time. But they are now also disrupting incumbents in more traditional markets, like auto manufacturing, overtaking Germany as the world's second largest car exporter thanks to progress in producing electric vehicles. Although enacted only in 2022, the U.S. Inflation Reduction Act could help American companies catch up. Critical minerals, mainly sourced from emerging markets, are also becoming a strategic, highly valued asset in this context (see "China's global reach grows behind critical minerals," published Aug. 24, 2023, and World Bank 2021).

Chart 7

Chart 8

The relative attractiveness of carbon taxes is falling as green growth models emphasize the "carrot" rather than the "stick".   With subsidies forming an important part of the green growth paradigm, carbon pricing is becoming harder to implement in an international context. In almost every economy, carbon taxes are less popular than subsidies. They present distribution trade-offs and can curb growth when raised at an early stage of the transition (Fries, 2023).

In a global context, in countries where there is carbon taxing but no subsidies, this can also lead to capital flight, with companies taking advantage of green subsidies elsewhere. For example, the EU Emissions Trading Scheme may now provide insufficient incentives for some green innovation projects to happen within the EU, in the face of increased subsidies and lower carbon taxes elsewhere, such as the U.S. and China (World Bank, 2023). The EU has adjusted its policy mix, with the European Commission presenting its Green Deal Industrial Plan for the Net-Zero Age in February 2023. At the same time, the EU is seeking to export carbon pricing through its Carbon Border Adjustment Mechanism, which took effect (transitional phase) in October last year.

Time And Money Are Not The Only Impediments To Green Growth

Expanding the renewables sector is a challenge, and will take time. There's no doubt that more investments are needed for green growth to achieve sufficient scale in all sectors of the economy and across countries. Carbon dioxide emissions per unit of output have plateaued since 2010, but not yet declined (see chart 9). Technological progress has gone in the right direction, but we see three other factors that could prove to be stumbling blocks.

Chart 9

Offering sufficient amounts of green subsidies to achieve both emissions reduction and growth may not be feasible for governments.  A rise in financing for the transition in a context of high debt, low growth, and high interest rates implies increasing trade-offs. Voters may support spending on climate change mitigation, but not necessarily be willing to forego other needs. Government budget constraints are already hampering the transition in developing countries. Most of the investments in carbon-emission reductions and clean technologies have come from the EU, the U.S., and China (see chart 10). What's more, it is not clear whether the green transition is possible through spending alone. Without a price on carbon to account for the negative externality of emissions, a scenario is possible in which green energy prices fall, thanks to rapid technological change, and boost growth but with no climate benefits if that innovation doesn't lead to the removal of polluting technologies (Hassler et al, 2023).

Chart 10

Greening the economy in a fragmented global landscape adds trade frictions and slows progress toward net zero.   The rise of economic nationalism, state-led industrial policy, and the weaponization of trade has had a detrimental impact on the energy transition (see "End of the Washington Consensus," published Jan. 10, 2024). Trade frictions can lead to duplication of efforts and redundancies, resulting in a more costly and slower transition, at a time when scaling up green technologies and investments is key to preserving a global public good. We see for example that, in response to eroding competitiveness, the EU has announced an anti-subsidy investigation into electric vehicles coming from China. China has raised questions over the EU's Carbon Border Adjustment Mechanism's compliance with the World Trade Organization's rules, and the U.S. has issued local content guidelines for companies to benefit from subsidies under the Inflation Reduction Act.

We expect a politically sustainable green growth paradigm will aim to leave no one behind.   Distribution issues associated with the green transition matter, and not just the size of the economic pie, however defined. We believe that, if safeguarding the planet is not seen as making life better for all and preserving nature, political support for the green growth paradigm will be at risk. This lack of attention to distribution aspects has contributed to the backlash against globalization. Ensuring that the benefits from a green transition are shared as equitably as possible is critical for success, in our view, and is ultimately a political question.

Related Research

• Investment in climate adaptation needs have high returns on growth, Jan. 10, 2024
• End of the Washington Consensus, Jan. 10, 2024
• Lost GDP: Potential Impacts Of Physical Climate Risks, Nov. 27, 2023
• China's global reach grows behind critical minerals, 24 Aug. 24, 2023
• Could Green Growth Be An Oxymoron?, May 18, 2023
• Climate Change Will Heighten Output Volatility, Jan. 5, 2023
• Carbon Pricing, In Various Forms, Is Likely To Spread In The Move To Net Zero, Aug. 9, 2022
• Green Spending Or Carbon Taxes (Or Both): How To Reach Climate Targets, And Grow Too, By 2030?, Nov. 4, 2021

External Research

• Acemoglu, Daron, Philippe Aghion, Leonardo Bursztyn, and David Hemous. (2012). The Environment and Directed Technical Change, American Economic Review, 102 (1): 131-66.
• Acemoglu D, Aghion P, Barrage L, Hemous D. (2019), Climate Change, Directed Innovation, and Energy Transition: The Long-Run Consequences of the Shale Gas Revolution.
• Andre, P., Boneva, T., Chopra, F. et al. (2024), Globally representative evidence on the actual and perceived support for climate action. Nature Climate Change.
• Fries, S. (2023), Sequencing decarbonization policies to manage their macroeconomic impacts, PIIE, 23.12
• Hassler, Krusell and Olovsson (2023), The Macroeconomics of Climate Change: Starting Points, Tentative Results, and a Way Forward
• IMF (2021), Building Back Better: How Big Are Green Spending Multipliers?, Working Paper No. 2021/087
• Lanoie, P., M. Patry, and R. Lajeunesse (2008), Environmental Regulation and Productivity: New Findings on the Porter Hypothesis, Journal of Productivity Analysis 30, 121–128.
• Leeuwen, G. v. and Mohnen, P. (2016), Revisiting the Porter hypothesis: an empirical analysis of Green innovation for the Netherlands.
• Meadows, D. et al. (1972), The Limits to Growth; a Report for the Club of Rome's Project on the Predicament of Mankind. New York :Universe Books.
• Nordhaus W. D. (1992), Lethal Model 2: The Limits to Growth Revisited, Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 23(2), pages 1-60.
• N. Stern, (2006), The Economics of Climate Change: The Stern Review, Cambridge University Press, Cambridge.
• World Bank (2021), The Changing Wealth of Nations.
• World Bank (2023), State and Trends of Carbon Pricing report.