Needed: An economic response plan for a green transition shock 

News: India is facing severe heat waves in many parts of the country. This is a reminder that the risks from climate change are rising.  

What are the issues involved in transition towards a green economy? 

Around a fifth of Indian households have access to either air-conditioners or coolers in their home. Nearly half of the Indian labour force works outdoors in the sun during heat waves month.  

This excess heat will have an impact on India’s wheat crop. This can lead to other supply shocks in the coming years 

The existing capital stock in several sectors such as energy or mobility will become prematurely obsolete because of the government’s tax policy or regulations that seek to reduce carbon emissions to mitigate climate events. 

The debate on how the costs (based on discount rate) should be borne to tackle climate change should be spread over time  

If a lower discount rate is imposed. It means today’s generation bears a bigger burden of the costs.  

If a higher discount rate is imposed, It means that the costs of mitigation can be pushed further into the future for coming generations to pay. 

The ‘green interest rate’ refers to how the welfare of future generations is to be treated while decisions are made today.

– Frank Ramsey developed a mathematical framework for a proportion a nation should optimally save from its income. His insights have been used for a range of other applications, including climate change computations. He insisted that the well-being of future people should be given the same weight as that of present people.  

What are the challenges? 

The climate scientists have shown that the window available for serious action is closing by the year. 

A green transition can only be achieved over time. Any sudden action will almost certainly lead to economic collapse.  

The costs of the transition will be spread over multiple generations, as most commitments to reach carbon neutrality are between 2050 and 2070. The challenges are how to distribute the costs (discount rate) over time, or who will bear than burden, i.e., present or future generation? 

There is a different viewpoint on discount rates. For example, Nicholas Stern argued for a discount rate of 1.4%. William Nordhaus (the Nobel Prize Winner for economics in 2018), has argued for 4.3% in his model. He argued that the discount rate should be based on actual observed behaviour, and especially real interest rates in financial markets. On the contrary, Stern used a discount rate which was derived broadly on ethical considerations.  

The green transition will involve a supply shock that will reduce potential growth.  

Over the next decade, the fiscal policy will be constrained because the public debt across the world had bloated because of government spending during the pandemic. Therefore, the green investments will be a political and economic challenge. 

Way Forward 

The green transition will open up opportunities in new technologies, better infrastructure and the redesign of cities.  

In the coming future, there should be significant reallocation of both capital as well as labour, assuming factor markets are flexible.  

In addition to fiscal policy, the central banks will have a dilemma about whether they should add climate change mitigation to the policy targets to address inflation, growth and financial stability.  

The fiscal authorities as well as central banks should maintain low interest rates to help new investments in a green economy. It will effectively make it easier for enterprises with older technologies to survive. The higher interest rates will kill polluting enterprises and make investments in new technologies more expensive.  

The central banks can also choose one interest rate for green activities and another one for brown activities. This will lead to credit planning.  

Much depends on how a society either values or should value benefits that will be available only many years down the line.  

Source: The post is based on an article “An economic response plan for a green transition shock” published in the Live Mint on 18th May 2022.