Research | Tobin Center for Economic Policy

Abstract

Enthusiasm for “greening the financial system” is welcome, but a fundamental challenge remains: financial decision makers lack the necessary information. It is not enough to know that climate change is bad. Markets need credible, digestible information on how climate change translates into material risks. To bridge the gap between climate science and real-world financial indicators, we simulate the effect of climate change on sovereign credit ratings for 109 countries, creating the world’s first climate-adjusted sovereign credit rating. Under various warming scenarios, we find evidence of climate-induced sovereign downgrades as early as 2030, increasing in intensity and across more countries over the century. We find strong evidence that stringent climate policy consistent with limiting warming to below 2 °C, honoring the Paris Climate Agreement and following representative concentration pathway (RCP) 2.6, could nearly eliminate the effect of climate change on ratings. In contrast, under higher emissions scenarios (i.e., RCP 8.5), 59 sovereigns experience climate-induced downgrades by 2030, with an average reduction of 0.68 notches, rising to 81 sovereigns facing an average downgrade of 2.18 notches by 2100. We calculate the effect of climate-induced sovereign downgrades on the cost of corporate and sovereign debt. Across the sample, climate change could increase the annual interest payments on sovereign debt by US$45–$67 billion under RCP 2.6, rising to US$135–$203 billion under RCP 8.5. The additional cost to corporations is US$10–$17 billion under RCP 2.6 and US$35–$61 billion under RCP 8.5.

Abstract

Climate policies vary widely across countries, with some countries imposing stringent emissions policies and others doing very little. When climate policies vary across countries, energy-intensive industries have an incentive to relocate to places with few or no emissions restrictions, an effect known as leakage. Relocated industries would continue to pollute but would be operating in a less desirable location. We consider solutions to the leakage problem in a simple setting where one region of the world imposes a climate policy and the rest of the world is passive. We solve the model analytically and also calibrate and simulate the model. Our model and analysis imply: (1) optimal climate policies tax both the supply of fossil fuels and the demand for fossil fuels; (2) on the demand side, absent administrative costs, optimal policies would tax both the use of fossil fuels in domestic production and the domestic consumption of goods created with fossil fuels, but with the tax rate on production lower due to leakage; (3) taxing only production (on the demand side), however, would be substantially simpler, and almost as effective as taxing both production and consumption, because it would avoid the need for border adjustments on imports of goods; (4) the effectiveness of the latter strategy depends on a low foreign elasticity of energy supply, which means that forming a taxing coalition to ensure a low foreign elasticity of energy supply can act as a substitute for border adjustments on goods.

Abstract

Climate policies vary widely across countries, with some countries imposing stringent emissions policies and others doing very little. When climate policies vary across countries, energy- intensive industries have an incentive to relocate to places with few or no emissions restrictions, an effect known as leakage. Relocated industries would continue to pollute but would be operating in a less desirable location. We consider solutions to the leakage problem in a simple setting where one region of the world imposes a climate policy and the rest of the world is passive. We solve the model analytically and also calibrate and simulate the model. Our model and analysis imply: (1) optimal climate policies tax both the supply of fossil fuels and the demand for fossil fuels; (2) on the demand side, absent administrative costs, optimal policies would tax both the use of fossil fuels in domestic production and the domestic consumption of goods created with fossil fuels, but with the tax rate on production lower due to leakage; (3) taxing only production (on the demand side), however, would be substantially simpler, and almost as effective as taxing both production and consumption, because it would avoid the need for border adjustments on imports of goods; (4) the effectiveness of the latter strategy depends on a low foreign elasticity of energy supply, which means that forming a taxing coalition to ensure a low foreign elasticity of energy supply can act as a substitute for border adjustments on goods