the interplay of macroprudential regulation and climate policy – Bank Underground

Francesca Diluiso, Barbara Annicchiarico and Marco Carli

While climate change is often seen as a long-term concern, climate mitigation policies can have different short-term effects, since they affect the transmission mechanism of conventional macroeconomic shocks. In a new working paper, we show that cap-and-trade schemes lead to lower volatility in GDP and financial variables, and result in reduced welfare costs of the business cycle, when compared to the more widely known carbon taxes. As we find that these welfare differences are primarily driven by distortions in financial markets, we argue that countercyclical macroprudential regulation, even without any green-biased component, can effectively align the welfare performance of these policies and mitigate their short-run costs.

Carbon taxes versus cap-and-trade systems: a business cycle perspective

Carbon taxes and cap-and-trade schemes are the two main ways of pricing carbon, jointly covering 23% of global emissions. While both work by imposing a cost on the release of greenhouse gases, they produce different behaviours in terms of emissions, emission prices, and compliance costs in response to economic shocks. A cap-and-trade scheme – a policy where the regulator sets a limit to emissions and firms must hold allowances consistent with that limit for every ton of greenhouse gas they generate – implies certainty about future emission levels but uncertainty about environmental compliance costs, since emission allowance prices are volatile. A carbon tax, instead, limits the uncertainty about compliance costs (the price for unit of pollution is fixed) but allows emissions to move procyclically with economic activity, creating uncertainty about the success of meeting pollution targets. As a result, the respective macroeconomic effects of the two policies remain a point of debate.

We build a Dynamic Stochastic General Equilibrium model with financial frictions and environmental aspects to explore the interactions between these policies and business cycle fluctuations. At the heart of the model are intermediate polluting firms in a capital-intensive sector. These firms acquire capital by pooling their financial resources and taking loans from banks. However, they are also vulnerable to unexpected shocks that can lead them to default. The negative effects of emissions generated by their activity do not materialise in the short run but have a detrimental impact on the economy’s productivity in the long run. For this reason, polluting firms are required to adhere to environmental policies, which may include paying a carbon tax or purchasing emission allowances under a cap-and-trade scheme. Business cycle fluctuations are generated by a combination of different shocks and are amplified by the presence of a ‘financial accelerator’ mechanism, as explained by Christiano et al (2014).

We examine how the economy responds to various types of shocks under a fixed cap-and-trade scheme and a fixed-carbon tax. We find that a cap-and-trade system keeps the economy significantly more stable. Under this policy, the price of emission permits moves procyclically: to increase production, firms must purchase more pollution allowances, the price of which rises due to increased demand, and the opposite is true during a recession. This means that producers bear higher costs to comply with the environmental regulation during an economic upturn, while, during a recession, they incur lower costs. As a result, a cap-and-trade scheme helps to smooth out business cycle fluctuations.

For example, when an expansion is generated by a positive total factor productivity (TFP) shock which increases the efficiency of production inputs (Chart 1), firms abiding by the cap experience a reduced return on production, build up lower amounts of wealth, and invest and borrow less. Because firms borrow less due to higher compliance costs, the financial channel is weakened, resulting in lower asset prices. It is interesting to see how these effects pile up during the adjustment process, pushing the spread (defined as the difference between the interest rate on firms’ debt and the rate on deposits) temporarily above its pre-shock level, while the amount of credit shrinks and stays below its pre-shock level, contrary to what we observe under a tax. In response to contractionary shocks, the same dynamics operate in reverse.

Chart 1: Response of the economy to a one-standard deviation TFP shock from steady state

Note: Time on the horizontal axis is in quarters.

Under a carbon tax regime, instead, firms pay a constant fee to pollute, and the relative costs of compliance are slightly countercyclical. In the scenario of Chart 1, firms can take advantage of the economic upturn to boost production beyond what is allowed under a cap. During a recession, instead, polluting producers face higher compliance costs and reduce their production more than they would under a quantity restriction.

Importantly, we also find that these policies differ in terms of the welfare cost of the business cycle. We measure these costs conventionally in terms of lost consumption due to the uncertainty generated by economic shocks. We find that the welfare costs of the business cycle are significantly lower when a cap-and-trade scheme is in place. We do not consider welfare benefits due to environmental policies since policies implemented by a single country can barely affect the global emissions stock, in particular in the short run.

The relevance of the financial channel

The result above challenges those by Fischer and Springborn (2011) and Annicchiarico and Dio (2015), who find that the welfare performance of cap-and-trade schemes is quantitatively very similar to the one of carbon taxes. These works, however, do not consider the role played by financial markets. We argue that financial distortions are a key driver for the welfare gap between the two environmental policies. A cap-and-trade scheme, in fact, due to its countercyclical properties, strongly reduces the financial acceleration effects in business cycle fluctuations induced by the possibility for firms to borrow from banks and to default thus reducing the welfare costs of the shocks.

Chart 2 shows the importance of the financial channel in explaining the welfare difference between the two policies: as the risk of firms’ default rises, banks raise the interest rate charged on loans. This causes producers to reduce their borrowing – the channel through which financial accelerator effects materialise – and leverage to decrease. As a result, the welfare costs of the business cycle converge under the two alternative environmental policies: when the financial accelerator mechanism weakens, welfare costs fall (more intensively under the tax scenario in which financial effects are wider) and the welfare gap between policy regimes narrows. These findings indicate strong interactions between financial markets and climate policies throughout the business cycle.

Chart 2: Welfare costs of the business cycle over different values of risk and leverage

The role of a countercyclical macroprudential regulation

Due to the role played by financial markets, we should consider if there are policy interventions that financial regulators can implement to reduce the uncertainty surrounding the functioning of carbon-pricing policies throughout the business cycle.

In Table A we report our estimates of welfare costs under different policy scenarios. The first line shows the results for the ‘Benchmark’ case, in which the cap is binding and the tax rate is fixed. The second line reports the results for the case in which the emission cap and the tax are flexible and react to business cycle shocks to minimise welfare costs (‘Optimal environmental policy’). The other lines report the welfare costs when climate policies are implemented alongside specific types of macroprudential policies, (see for example, Leduc and Natal (2018)). These policies can take the form of interest rate subsidies to depositors (‘Optimal subsidy’) or reserve requirements which limit the funds that banks can convert into loans. In the latter case banks are required to hold a fraction of their funds in reserves, which are assumed to be in ‘cash’ and earn a zero rate of return. This fraction can be pre-defined (‘Static macroprudential policy’) or can adjust countercyclically in response to changes in credit growth or asset prices (lines five and six of Table A).

Table A: Welfare costs of the business cycle under different scenarios (in % of consumption lost compared to an economy not subject to economic fluctuations)

We can see that when environmental policies are set optimally the welfare costs are lower but the welfare gap between them persists, since no policy adjustment can fully weaken the strength of the financial channel or address financial frictions. Countercyclical macroprudential policies, instead, have the potential to both reduce the welfare costs and realign the welfare performance of the environmental policies. Specifically, a dynamic subsidy to depositors protects households from fluctuations in consumption, encouraging saving when credit declines and discouraging it when credit increases. Reserve requirements of different types, instead, reduce firms’ risk-taking and the amount of credit in the economy. Overall, countercyclical macroprudential policies can dampen cycles and can reduce the procyclicality of carbon taxes, partially replicating the countercyclical effect observed with a cap-and-trade scheme.

Broader-policy implications

Our results show that financial regulators can potentially support governments who are implementing climate policies by creating a more favourable welfare environment. Macroprudential policies, even without any green-biased component, can help align the performance of different carbon-pricing schemes by mitigating the negative impacts of financial frictions and promoting economic stability. This would make it easier for governments to adopt a broader range of climate policy instruments.

Francesca Diluiso works in the Bank’s Structural Economics Division, Barbara Annicchiarico works at Roma Tre University and Marco Carli works at the Tor Vergata University.

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