As the urgency to combat global warming grows, many nations are implementing policies to reduce emissions. These strategies often rely on substantial fiscal measures, such as increased public investment and subsidies for renewable energy. While these efforts are crucial for decarbonization, they can come with significant fiscal burdens.
Policymakers are facing complex trade-offs in their pursuit of climate action. Over-reliance on spending measures and their escalation to achieve climate goals can lead to rising debt levels, potentially reaching 45 to 50 percent of gross domestic product (GDP) by midcentury. High debt, coupled with increasing interest rates and diminished economic growth prospects, can strain public finances. However, maintaining a “business-as-usual” approach leaves the world vulnerable to worsening climate impacts.
Countries have the option to generate revenue to reduce their debt through carbon pricing, but relying solely on this approach may encounter political resistance. Consequently, governments are confronted with a policy trilemma, where achieving climate objectives, ensuring fiscal sustainability, and securing political feasibility require balancing act. Pursuing any two of these objectives may come at the cost of sacrificing the third.
The latest Fiscal Monitor provides insights on managing this trilemma. It calls for decisive, coordinated action from governments and advocates for an optimal mix of both revenue- and spending-based climate mitigation measures.
Carbon pricing, while crucial, is not always sufficient to achieve emission reductions. It should be a fundamental part of any climate policy package. Successful experiences in countries like Chile, Singapore, and Sweden demonstrate that political obstacles associated with carbon pricing can be overcome. These insights can benefit both the nearly 50 advanced and emerging market economies with existing carbon pricing schemes and the over 20 countries considering their implementation.
However, carbon pricing should be complemented by other mitigation measures that address market failures, stimulate innovation, and promote the adoption of low-carbon technologies. A pragmatic and equitable approach suggests establishing an international carbon price floor, differentiated across countries based on their economic development levels. The associated carbon revenues could be shared among nations to facilitate the transition to a green economy. Additionally, a just transition should include robust fiscal support for vulnerable households, workers, and communities.
The fiscal costs associated with emission reduction vary depending on the combination of revenue and spending policies. Analysis shows that an appropriate mix of these measures, enacted promptly, can limit the fiscal burden of emission reductions while achieving climate targets. Without additional measures, public debt in advanced economies is projected to increase by 10 to 15 percent of GDP by 2050. Delaying carbon pricing would add significant costs, with each year of delay contributing 0.8 to 2 percent of GDP to public debt. Emerging market economies face similar challenges, with varying impacts from different revenue and spending measures. To accommodate such a policy mix, economies with ample fiscal space must be prepared. However, for most emerging market and developing countries already burdened with high debt and rising interest costs, alongside significant adaptation needs and sustainable development goals, an increase in debt presents formidable challenges.
To navigate these complexities, governments must enhance spending efficiency and improve their capacity to raise tax revenues by broadening the tax base and enhancing fiscal institutions.
Addressing the climate threat requires collective effort. No single country or the public sector alone can mitigate climate change. The private sector plays a vital role in financing the transition to a low-carbon economy. The Fiscal Monitor discusses the role of businesses in the energy transition and highlights their resilience in response to energy price spikes, often by reducing energy consumption and investing in efficiency measures.
Policymakers must coordinate their actions, with emerging market and developing countries needing concessional financing and knowledge transfer to support the green transition. Initiatives such as the IMF’s Resilience and Sustainability Trust can provide long-term financing to enhance economic resilience and support reforms. Governments should seize the momentum generated by recent initiatives like the Nairobi Declaration and the participation of the African Union in the Group of Twenty to advance a practical global agreement on an international carbon price floor and to support developing nations in their efforts to combat climate change.
