To address the recession and climate change, private investments are needed. But investment stalls when businesses wait for clarity on climate policy. A new RFF report shows that a carbon price can stimulate private investment by signaling future policy.
Federal and state policymakers confront two very significant challenges. The first is to develop and implement policies and programs to help the economy recover from the ravages of COVID. The pandemic has prompted a major economic slowdown, with job losses of 22 million at the outset of the crisis and an initial monthly GDP loss of 20 percent compared to pre-pandemic levels. Although the situation has improved, achieving a full recovery and returning to a path of growth will require government stimulus above and beyond what’s included in the recent American Rescue Plan.
The second challenge is to reduce greenhouse gas emissions from energy production. Science tells us that significant emissions reductions are needed to bring concentrations of greenhouse gases low enough to forestall the worst impacts of climate change. To that end, several states have adopted ambitious decarbonization goals, and President Joe Biden has committed to reduce US emissions to net zero by 2050.
Both overcoming the recession and achieving climate goals will require substantial investments by private industry.
Karen Palmer
Direct federal expenditures are likely to be an important part of federal economic policies, and stimulus spending can help steer the economy toward cleaner sources of energy and other ways of reducing emissions. Beyond direct expenditures, policies to encourage or require emissions reductions also can help stimulate the private investment needed for deep decarbonization. In fact, both overcoming the recession and achieving climate goals will require substantial investments by private industry.
The role of policy in stimulating private investment often is overlooked in policy analysis, because such analysis fails to consider the effects of uncertainty. Instead, climate policy analysis typically focuses on comparing policy and baseline scenarios—each of which is assumed to be implemented in a predictable and unchanging way—to assess policy outcomes and costs. Nonetheless, case comparisons generally find that implementing climate policy comes with costs, though the costs are not especially large.
In the real world, the failure of government to enact climate policy can stall private investment as businesses wait for clarity on future policy.
In a new RFF report, Brian Prest, Dallas Burtraw, and I present simple dynamic models to illustrate how addressing uncertainty about future policy can influence investment decisions; our examples focus on the electricity sector but have broader implications. We first use the model to illustrate how uncertainty about a future climate policy affects the expected return on investment for various courses of action that private companies can take. In many situations, waiting for policy uncertainty to resolve before making an investment is the most profitable course of action for firms. Consequently, when policy uncertainty persists, investment decisions may be delayed indefinitely.
Next, we demonstrate that the implementation of carbon-pricing policy, even with a modest price, can spur private investment by providing clarity on the expected profitability of various types of investments. Carbon pricing stimulates investment, because the movement from no policy to any policy provides information about both the time period when the policy is implemented and the possible trajectory of future policy. The way policies are adopted today affect expectations about future policy can be particularly important in stimulating investment—even across a range of carbon tax values.
In the real world, the failure of government to enact climate policy can stall private investment as businesses wait for clarity on future policy.
Karen Palmer
The perceived durability of a carbon price also is crucial for informing investor expectations. Policy durability in turn depends on policy design; for example, designing a policy that creates new industries whose success is tied directly to policy stringency can create policy durability. Emissions cap-and-trade policies can create a built-in constituency that favors more stringent future policy by enabling the banking of emissions allowances. And directing carbon revenues to households in the form of dividends also can create advocates for the enhanced stringency of related policies. In the paper, we present a version of our model that shows how a non-durable policy (i.e., a policy that’s politically unsustainable) can fail to shape expectations in a way that enhances investment. In short, policy durability can make waiting for policy certainty less attractive and less profitable.
Our results from this simple model are consistent with the findings of a separate empirical analysis by RFF University Fellows Gilbert Metcalf and James Stock. Their analysis looks at the growth rate of economic activity following the implementation of carbon taxes in many countries in Europe, outside the European Union Emissions Trading System. Economic growth rates across all countries before and after the adoption of carbon prices reveal no evidence of a negative impact on economic growth.
In addition, we consider four countries—Iceland, Ireland, Spain, and Estonia—that implemented a carbon tax during times of recession. In each of these cases, we find no evidence that the carbon tax negatively affected growth in either GDP or employment; in fact, our results suggest a potential positive impact on these two measures of economic well-being. Collectively, our results suggest that carbon prices are consistent with—and may accelerate—economic growth, especially during times of recession.
Our analysis draws heavily on the example of carbon-pricing policy; however, other types of climate policy may provide similar signals of policy intent that can shape investor expectations. Other research has shown that policies that address specific technology development failures or distributional concerns can pave the way for greater policy stringency and enable carbon pricing in the future. Ultimately, we believe that a carbon price is the most transparent policy signal (perhaps in combination with other technology policies) that can provide confidence about the future direction of climate policy—which could then accelerate investment in green technology and stimulate economic growth.
