Climate change, policy, and finance

William Nordhaus Sterling Professor of Economics Yale University

October 19, 2020 European Central Bank

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Three key issues for today

1. Very little progress in slowing emissions 2. Challenges for climate policy 3. Green finance and banking

2 Global CO2 emissions

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1 1900 1920 1940 1960 1980 2000

3 CO2 and the pandemic 420 CO2 Concentrations (ppm, Hawaii) 415

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395 Not seasonally adjusted Seasonally adjusted 390 2012 2013 2014 2015 2016 2017 2018 2019 2020

5 Role of Economics in Climate Policy

6 Key Economic Insights (1): Inadequate investment in low-carbon technologies

• Innovation has big spillovers • Public return on innovation many times larger than private returns • But even worse: there is double externality for low-carbon innovations: • innovation externality • climate impacts externality • Policy requires fixing climate externality (next slide) and special incentives for low-carbon technologies 7 Key Economic Insights (2): Harmonized Carbon Prices

• High price on CO2 emissions is the key to sharp emissions reductions. • Level of price should be harmonized to meet climate target (such as cost-benefit optimum or 2 ˚C temperature target) • However, in reality, prices are fragmented and very low (see next slide).

8 The carbon price landscape, 2019

Percent of region Carbon price Effective price % of global Region covered by price ($/tCO2) ($/tCO2) emissions

Sweden 40 127 50.8 <1 Norway 60 59 35.4 <1 Switz 33 96 31.7 <1 BC 70 26 18.2 <1 France 33 50 16.5 1 Calif 85 16 13.6 2 ETS 43 25 10.8 8 Japan 70 3 2.1 5 Argentina 20 6 1.2 <1 Chinese cities 40 3 1.2 1 Northeast US 18 5 0.9 1 Mexico 45 1 0.5 1.5 Uncovered 100 0 0.0 80

Global average 1.7

9 Key Economic Insights (3): The Global Free Rider Problem • After 30 years, international policy is at a dead end. • Why? Climate change policy is hampered by the free rider problem: – The agreements are voluntary. – So there are no penalties for (costly) non- participation • Verdict based on actual carbon prices today and minimal emissions reductions.

10 A Climate Compact to Overcome Free-Riding

• Replace current structure with “club” structure. • Club structure has privileges and obligations. • Proposal here involves a regime with two features:

– Target carbon price, perhaps $50 per ton CO2 – Penalty tariff on non-participants, say 3% penalty tariff • Modeling at Yale suggests that this could be effective way to combat free-riding

11 Green Finance

12 Tradeoff of profits and ESG B C A Profits, returns D

ESG/carbon reductions 13 Challenges for Financial Institutions Companies need to incorporate climate risks into their long-term planning. - Optimizing and reducing the carbon footprint is good corporate citizenship. - But it is also good management. Institutional investors should… - Analyze and hedge climate-induced risks. - Face squarely the tradeoff between return and ESG goals. But governmental action is the essential component

Green Central Banking • Is there a role for climate change in central banking? Yes and no. • Yes, because climate change is one of the major long-term risks (along with pandemics, demography, artificial intelligence, …) and needs careful study. • No, because it should be derivative of the dual mandates of inflation and real activity.

15 Summary 1. Little progress to date on climate policy. 2. Key policies are invest in low-carbon technologies and high carbon prices. 3. Combat free riding with a climate compact. 4. Green finance can support but collective action is essential.

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