ECB - European Central Bank

02/08/2024 | Press release | Distributed by Public on 02/08/2024 03:27

Assessing the macroeconomic effects of climate change transition policies

Prepared by Marien Ferdinandusse, Friderike Kuik and Romanos Priftis

Published as part of the ECB Economic Bulletin, Issue 1/2024.

This box gauges the macroeconomic impact of climate change policies aimed at reducing greenhouse gas emissions. To meet the goal of reducing emissions in the European Union (EU) by at least 55% in 2030 compared with 1990 levels, governments have started implementing different sets of measures. The EU has recently adopted the "Fit for 55" package, which will be progressively implemented between 2024 and 2034.

This box first assesses the impact of green fiscal discretionary measures, as included in the latest December 2023 Eurosystem staff macroeconomic projections on euro area real GDP and inflation. Such measures are unlikely to be sufficient to fully achieve the EU's targets for emission reduction, energy efficiency and renewable energy production in the Fit for 55 package. The box therefore goes on to illustrate the medium-term impact of alternative transition policy scenarios using model simulations.

The impact of green fiscal measures included in the Eurosystem staff macroeconomic projections

Discretionary fiscal measures that have a positive effect on the green transition are classified as green measures. A fiscal measure, either on the revenue or the expenditure side, is classified as a green measure if it has a positive impact in terms of climate change prevention or adaptation.

These measures are principally discretionary decisions by national governments, such as increasing national energy taxes or fuel excises. They do not provide a view on the level of green revenues or expenditures or include the impact of fluctuations in emission permit prices under the EU Emissions Trading System (EU ETS). In line with the principles governing the ECB/Eurosystem staff macroeconomic projections, green measures need to be sufficiently detailed and likely to receive legislative approval for inclusion in the projections.

The combined effect of the green fiscal measures included in the December 2023 Eurosystem staff projections on both headline inflation and GDP growth is small over the projection horizon. The effect on euro area headline inflation is estimated to amount to around 0.1 percentage point in all years of the projection horizon, with minor variation (Chart A). For euro area real GDP growth, the effect is estimated to amount to around 0.07 percentage points in 2023 and to be negative at -0.01 percentage points in 2024, -0.06 percentage points in 2025 and -0.02 percentage points in 2026. The combined effect of the green fiscal measures on both headline inflation and real GDP growth are heterogenous across countries.

Chart A

Impact of green fiscal discretionary measures on real GDP growth and inflation

The fiscal measures included in the Eurosystem staff baseline projections are unlikely to be sufficient to fully achieve the EU targets for emission reduction, energy efficiency and renewable energy production. Some of the measures included in the Fit for 55 package are included in the baseline projections, in particular green fiscal measures that contribute to Member States meeting their national emission reduction targets. However, it is unlikely that the measures (and assumptions) included in the current projections will be sufficient to fully meet EU targets, for several reasons: (i) some of the measures geared to these targets will only be implemented after the end of the current projection horizon in 2026; (ii) some of the EU targets for energy efficiency and renewable energy production still need to be transposed into national and European legislation; and (iii) the national emission reduction targets that were strengthened under the Fit for 55 package, from -29% to -40% by 2030 compared with 2005, still need to be followed up by EU Member States. That is why recent emission projections by Member States still point to a large gap with the EU targets, and more measures will be needed to achieve the Fit for 55 targets.

Medium-term impact of transition policies consistent with EU emission reduction targets

Model simulations are used to explore the impacts of a number of transition scenarios that are consistent with the EU emission reduction targets. Simulations are performed using the New Area-Wide Model with a disaggregated energy sector (NAWM-E).

The benchmark reflects the current emission projections reported by euro area countries and is based on existing policies. To define the benchmark carbon price, the existing carbon tax-related measures are summarised in an effective carbon price as calculated by the Organisation for Economic Co-operation and Development (OECD) corresponding to 87 euro per tonne of CO2 in 2023. The simulations then target an additional emission reduction of 18% by 2030 on top of the reduction required under existing policies, consistent with the EU emission target for a -55% reduction by 2030 compared to 1990 levels (Chart B). As many combinations of instruments may achieve this reduction, this box considers carbon taxes and, in one scenario, assumes stronger increases in the productivity of the clean energy sector and a smoother transition away from dirty energy, without explicitly specifying how this can be achieved.

Chart B

EU greenhouse gas emissions

The model simulations consider the following scenarios (Table A):

  • IEA carbon tax scenario: This scenario considers carbon taxes as the only measure for reducing emissions. This assumption is based on the 2022 World Energy Outlook of the International Energy Agency (IEA) and implies a linear increase in the carbon tax to 140 euro per tonne of CO2 by 2030. Alone, this carbon tax path is insufficient to meet EU emission targets (IEA, 2022).
  • Fit for 55 carbon tax scenario: This scenario also considers carbon taxes only as the measure for reducing emissions. Carbon taxes increase linearly to 225 euro per tonne of CO2 by 2030. This means the model satisfies the EU emission reduction target in 2030, irrespective of additional carbon regulation or technological progress.
  • Fit for 55 policy mix scenario: This scenario considers a mix of rising carbon taxes and non-carbon tax elements. Carbon taxes increase linearly to 180 euro per tonne of CO2 by 2030. Non-carbon tax elements are proxied by a rise in the total factor productivity (TFP) of the clean energy sector by 1% over the simulation horizon, and by considering higher elasticities of substitution between dirty energy and clean energy as well as between energy and other inputs of production and consumption. These non-carbon tax elements capture possible changes in the technology mix in the clean energy sector (for example, stemming from green investment) and tighter environmental regulation. Given that changes in technology are expected to occur over a longer time horizon, this scenario is illustrative and designed to meet the EU's emission reduction target as well as the EU targets for clean energy production and energy consumption by 2030.

Table A

Overview of scenarios

  • Carbon taxes lower the demand for dirty energy and induce firms to substitute less costly clean energy for production of the aggregate energy good. The increase in the post-tax price of dirty energy, combined with the rise in the price of clean energy stemming from higher demand for it, causes aggregate energy prices to increase. Higher energy prices feed into the price of households' consumption bundles and firms' marginal costs, translating into an increase in headline inflation. On the real side, firms and households experience a fall in their current and expected future profitability and real income respectively, which lowers investment and consumption, and hence GDP. Being a by-product of dirty energy production, carbon emissions decline, while the economy experiences a "green transition" as firms use a higher share of clean energy, but less energy overall for production.

Depending on the scenario, HICP inflation is higher by 0.2 to 0.4 percentage points in 2025 and 2026 than the benchmark with no additional measures, while the level of real GDP is lower (Chart C). The results depend on the scenario: when only carbon tax policy is considered, the effects on GDP and inflation are driven by the magnitude of the carbon tax and the degree of substitution across the energy varieties. Consequently, the Fit for 55 carbon tax scenario amplifies the effects relative to the IEA carbon tax scenario. Under the Fit for 55 policy mix scenario, an increase in the TFP of the clean energy sector improves the efficiency of clean energy, allowing more energy to be produced per unit of clean energy. Higher elasticities of substitution between clean and dirty energy then strengthen the substitution across energy varieties. Together, these elements lead to a reduction in carbon emissions, an increase in the share of clean energy and a reduction in total energy consumption, while maintaining the carbon tax at a lower terminal level. Overall, the negative effects on GDP and inflation are mitigated, especially in the medium term, while GDP increases modestly on impact owing to the expansionary effect of the increase in TFP.

Chart C

Impact of transition policy scenarios on real GDP and inflation

The NAWM-E simulations suggest that the mix of transition policies is important in determining the extent of lower growth and higher inflation. A caveat of the model-based analysis is that the regulatory elements of the Fit for 55 package are not modelled explicitly, implying that the EU's emission reduction targets may in practice be attained through alternative combinations of policies with a range of different effects on growth and inflation. Similarly, the analysis does not explicitly model green investment activities, thereby abstracting from time-to-build delays and funding needs. Other modelling choices, such as how carbon revenues are redistributed or how tax policies are implemented (for example, frontloaded, backloaded or staggered) may also affect the results.

The scenarios used should therefore be seen as indicative. It should also be acknowledged that it is possible to define different scenarios using different instruments that would achieve the same goals in terms of reducing emissions but have potentially different macroeconomic implications.