This chapter and report discusses how to achieve “better growth” that increases quality of life across key dimensions, including incomes, social stability, equality, and better health, while also achieving a “better climate”. By “better climate” we mean reducing the risk of dangerous climate change by cutting greenhouse gas emissions.
The economic framework presented in this chapter for “better growth” and a “better climate” recognises that economies are not “static” but are dynamic and constantly changing. As such the economic analysis and tools deployed must be appropriate for this context.
The framework has four main building blocks:
- The short-run opportunities to tackle market imperfections that hurt economic performance and increase climate risk;
- Investment, growth and structural change in different country contexts;
- Flexible approaches to managing transition, especially given political economy challenges, and distributional issues that need to be tackled; and
- The development and deployment of improved measurement and modelling tools that can improve economic decision-making and lead to better policy choices.
Tackling market imperfections and steering innovation
Economic principles inform us that there are opportunities to pursue strong economic growth today that are also good for climate because a range of market failures persist with immediate social, economic and environmental costs.
Greenhouse gases are a market failure as the emitter does not bear the costs of the damage and disruption from their activities. Some have suggested that greenhouse gases may be the largest market failure of all. 2 Beyond the long-run impact of greenhouse gases on the climate and thus the economy,emissions from burning of fossil fuels cause severe local air pollution today which damages the health and productivity of millions of people, particularly in urban areas in rapidly developing countries. Outdoor air pollution caused 3.7 million premature deaths in 2012, according to the World Health Organization (WHO). Emissions from transport, industry and power generation are a major source of this pollution. 3
Other market failures include imperfections in risk and capital markets, for example a failure to consider the full range of investment costs and benefits. Such market failures misprice risk; limit access to finance; and reduce investment in infrastructure. Another failure is in early stage research and development (R&D), where technical knowledge “spills over” to others. This prevents the innovator from capturing the rewards of their efforts and deters investment in innovation. Market failures around the provision of information and networks are also crucial. For example, poor awareness of the potential for long-term energy savings would result in under-investment in energy efficiency (see “Policies to tackle other market failures and political economy barriers”).
These combined market failures imply that policy reforms are possible today that can effectively and efficiently boost productivity and growth. Policy to reduce fiscal distortions from unpriced greenhouse gases will enhance resource efficiency and deliver multiple other benefits including reduced local air pollution. Policy to tackle market failures in capital markets will boost productive infrastructure investment. And policy to tackle the spillover problem can stimulate innovation, the benefits from which can often come through more quickly than expected. In economic terms, policy to tackle market failures can give rise to the possibility of a Pareto improvement, where at least one person is made better off with nobody worse off. 4
The cost-effectiveness and efficiency of such a strategy will be enhanced further if it is well-coordinated and complemented with policies to promote economic flexibility, including more responsive labour markets; a better educated workforce; and open and free trade. Strong and trusted institutions that align expectations on the direction of change and which reduce policy risk are also important.
But this framework goes far beyond an exercise in “comparative statics”, where the limitations of the existing economic system are stated and the policies that can correct market failures are described. This approach is about the dynamics of change: recognising that the transformation is likely to be non-marginal, and embracing this change through a broad suite of social and economic policies to steer the economy onto a low-carbon path. In other words, this is about combining the economics of market failures with the economics of change and transformation.
Investment, growth and structural change in different country contexts
Policies to foster low-carbon growth and realise the multiple benefits discussed throughout this report may require additional investment in the next 15 years, above what would be required without climate action (see “Policy risk and muddled expectations delay investment”). The appropriate way to consider these additional investment costs is the “dynamic net economic cost”.
The dynamic net economic cost includes the additional up-front investment, for example, the cost of upgrading and constructing new networks and new low-carbon energy infrastructure. These are monetary costs and must be financed (see “Policies to tackle other market failures and political economy barriers” and Chapter 6: Finance).
The additional investment may also impose a resource cost if it ties up additional inputs to produce the same amount of output, e.g. an off-shore wind farm may require more skilled labour and more physical resources than a fossil fuel plant to produce a megawatt of electricity. This would reduce total output as it uses up existing productive resources.
However, this resource cost does not reflect the final economic cost. For example, climate policies are likely to incentivise substitution away from more to less carbon-intensive goods, often with attractive fuel savings. The more substitution opportunities available in the short-term, and as innovation makes more substitutes available, the lower the economic cost.
But calculating the final dynamic net economic cost requires us to consider the full range of costs and benefits, including the returns to the up-front investments. These include a reduction in long-run climate risk but also short- and medium-run benefits such as health, congestion, security and innovation (see “Fiscal reform – carbon prices”). In fact, there is evidence that low-carbon investments may have greater scope for learning- and innovation-driven cost reductions than high-carbon alternatives, and also greater scope for spillover into other sectors.5
The full dynamic net economic cost must also reflect net economic benefits that will be forgone if action is delayed. Taking action later to derive the same economic returns will require a larger investment, and with high-carbon infrastructure, technologies and behaviours further locked-in, the dynamic costs will rise.
Therefore this is not a “free lunch” – some additional upfront investment is needed to pay for the attractive benefits and this may have an economic cost in terms of additional resources. But after considering the net benefits it is a “lunch worth paying for” – these investments have attractive economic returns and could quickly pay for themselves. Delay raises the dynamic net economic cost.
The precise policy framework required to drive investment for low-carbon growth will differ from country to country, depending on their individual contexts. For example, industrial policies have often been favoured in the past by countries, such as South Korea, trying to progress rapidly from middle- to high-income. When well-targeted, such policies have helped to foster investment in new and productive low-carbon industries. Another approach is tax reform to boost demand for environmental goods and services. Vietnam adjusted tax rates on polluting goods and services, such as fuels and chemicals, to reflect their environmental damage. This reform boosted investment and domestic demand for goods and services, but better recycling of the additional tax revenues could have reduced the costs of the reforms for particular groups. 6 China has incorporated growth and low-carbon objectives into its 5-year plans, with the 12th plan containing a range of measures to reduce emissions growth and promote investment in strategic high-tech, low-carbon industries. 7 The shape of its 13th plan (2016-2020) is likely to strengthen this transformation.
This chapter has many relevant lessons for least developed countries. However, their special circumstances demand additional analysis and focus. For example, a study prepared for the Commission examines the role that agriculture can play in addressing poverty reduction in Africa. It discusses how transformative adaptation in agriculture could present opportunities for “triple-win” outcomes with benefits for economic growth, poverty reduction and environmental sustainability. Crop intensification, minimum tillage, agroforestry coupled with designation and maintenance of protected forests, support for social protection and development of insurance markets, are examples of techniques and policies that can deliver these outcomes. Such adaptation also presents an opportunity to tackle long-standing barriers holding back productivity gains in agriculture, including restrictions on regional trade, under-investment in infrastructure and limited provision of social protection. 8
Managing the challenges of transition
In practice, governments have found it difficult to implement the most cost-effective and efficient policies for growth and reducing climate risk, such as legislating an explicit carbon price coupled with productive use of the resulting auction or tax revenues. This difficulty is partly a result of political economy pressures, including powerful vested interests in a fossil fuel-based economy, concerns around competitiveness, and concerns around any regressive impact of these policies on households. In a low-carbon transition, the specific costs, trade-offs and benefits that affect particular groups need to be carefully analysed. Dedicated, transparent measures are likely to be needed to reduce the costs and trade-offs for workers and firms. Managing change also requires strong institutions that can set clear and credible policies to guide expectations on the direction of change. Weaknesses in institutions and policy uncertainty raise the costs of change and slow the transition.
In cases where political and institutional realities are difficult to overcome, many countries have adopted pragmatic “second-best” approaches where the alternative may be no policy at all. Governments may need to take a step-by step approach, to discover the right combination of instruments and institutions to advance overall welfare. Where possible, governments could maintain flexibility in these policy frameworks, so that they can move towards more efficient and effective approaches over time – second best policy is only useful if it moves policy in the right direction. To ensure a continuing transition towards more optimal policy design, governments can legislate provisions to review the effectiveness and efficiency of policies.
Metrics and models for better policy
The appropriate metric for judging an economic policy intervention is its impact on overall welfare. If the policy creates a net welfare gain, it will still be important to consider the possible negative impacts on different groups, and whether some mechanism for redistributing the benefits of the policy is needed, e.g. assistance for some groups towards adjustment costs. Sometimes a policy may appear costly because not all its benefits are included in the balance of costs and benefits or are not easily identified. It is also of great importance to consider the counter-factual baseline with which a new policy is compared. In the case of low-carbon policies, the usual baseline assumption of “business as usual” growth may not hold due to the transformation that is coming anyway and the risks from future climate impacts. An appropriate counter-factual for comparison should reflect the economic costs of climate change and other impacts of continued growth in fossil fuel combustion, such as worsening air pollution.
Ministries of Finance need to tackle such shortcomings in their decision-making by adding several steps to routine policy evaluation. First, they could take an economy-wide view of costs and benefits. Second, they could recognise classes of costs and benefits not traditionally included in cost-benefit analysis, such as health costs from air pollution. Third, they could provide guidelines for how to incorporate these wider costs and benefits into planning and cost-benefit analysis tools. 9 Fourth, they could consider longer term returns rather than focus solely on up-front costs, as is standard practice when assessing investments in education or infrastructure. Governments can formalise this wider consideration of costs and benefits in economic policy-making through better use of metrics and models for monitoring and assessing the impacts of policy and change on quality of life, as discussed in “Better metrics and models for better macroeconomic management”.
Welfare must be approximated and gross domestic product (GDP) is often used. But GDP remains just one indicator among many attempting to measure changes in welfare. Supporting indicators are also necessary. For example, measuring the risk of overuse and damage to the natural world requires metrics beyond GDP. Governments and firms can incorporate such risks into decision-making by monitoring cumulative human impacts on various types of natural capital, including, water, ecosystems, species, minerals, the atmosphere and oceans. Monitoring would require governments and firms to include natural capital in national and corporate accounts (see “Better metrics and models for better macroeconomic management”). A failure to measure and manage natural capital is likely to result instead in its depreciation and possible destruction, with direct impacts on productivity, growth and output. 10 On the other hand, in recognising and measuring the value of natural capital, efficient environmental management can become a productive investment that is comparable with investments in physical or human capital. In this way there is a real opportunity to boost medium- to long-term growth through policies that increase the productivity of natural capital, including the atmosphere. Chapter 3: Land Use illustrates how this can happen in practice, through better management of degraded agricultural lands and by curbing deforestation.
To conclude, with economies constantly changing and transformation of the world economy likely over the coming decades, it makes sense to start to manage this change now. The framework for growth presented is a realistic one that can be implemented over the coming 15 years. The proposed approach would tackle the factors impeding economic growth today, while also accelerating a low-carbon transition. It will help to avoid the lock-in of long-lived high-carbon infrastructure, promote resource efficiency, reduce fiscal distortions, tackle pollution-related health issues, enhance energy security, drive low-carbon innovation, and increase the momentum for more effective and ambitious mitigation measures in the future.
The policy decisions taken in the next 15 years will be crucial for both long-term growth and the climate. There are huge opportunities for human welfare if change is managed well, and huge risks if managed badly. Sustained policy efforts will be needed beyond 2030 to ensure that these short- to medium-term reforms achieve the long term, internationally-agreed goal to reduce greenhouse gases to levels consistent with keeping global average temperature rise to below 2°C compared with pre-industrial levels.
The broad policy mix and institutions to enable change
Countries which anticipate and plan for change are likely to perform better. Various policy instruments will be needed to manage change. This does not mean more or unnecessary regulation, rather better policies and institutions for more efficient markets and for managing the type of change that countries will likely experience over the coming decades. The main types of policies and tools examined in this chapter are: fiscal policies such as carbon pricing and subsidies; policies to complement carbon pricing, such as standards; adjustment policies to ease the transition for households, workers and businesses; and models and metrics to manage change better.
Putting a price on greenhouse gas emissions is perhaps the most important policy, in particular to keep the costs of action low. Efforts should be focused on getting the design of such carbon pricing policies right, including applying the price across a wide base of different sectors, establishing a reasonable and robust price that rises over time, and using the revenues raised in productive ways, for example for fiscal reforms which make the broader tax system more efficient. But, carbon pricing is one among several instruments, to tackle a range of market failures, including in innovation, which should play an important role in the policy mix (see “Policies to tackle other market failures and political economy barriers”).
Additional policies to create a more flexible and responsive economy can also help to facilitate change more cost-effectively and efficiently. They will cover a broad range of areas including competition and product market policy, trade and investment policy, labour market policy, human capital and education policy, among others. These additional policies will increase the flexibility with which resources are deployed and support the conditions for growth. Campaigns against corruption, graft and fraud will ensure more responsive policy-making. More rigid economies, for example with inflexible labour and capital markets, will face higher costs of adjustment to structural changes, including those needed for a transition to a low-carbon economy.
A competitive product market is essential for a more responsive economy. This will lower entry barriers for new, more efficient and cleaner firms and products that can challenge incumbents. It will also allow inefficient firms to decline and exit. To encourage enterprise and boost productivity, product market regulation should be set in a way that does not hamper competition and is combined with a clear and effective antitrust framework to ensure a fair, level playing field among firms. 11 Openness to trade also makes economies more agile and adaptable, by making them less constrained by the limits of domestic markets. 12
Progressive labour market policies similarly enhance economic flexibility, providing firms with the ability to adapt to ever-changing market conditions, on the one hand, and workers with adequate employment rights, on the other (see “Managing and monitoring change and learning from experience”). Providing adjustment assistance for workers in declining industries will be an important task of transition policies. An affordable and flexible housing market facilitates labour mobility so that workers can move from regions with declining industries to expanding ones, aiding cost-effective economic transformation. Human capital and education policies ensure that workers have the right education and skills to benefit from structural change. Without training and re-skilling opportunities, some workers may find their existing skills are mismatched to those demanded in new growth industries. 13
Finally, any discussion of efficient and effective policies must take into account the nature of existing institutional frameworks and governance structures of individual countries. Effective and supportive institutions are crucial as they can help to shape expectations, strengthen policy co-ordination, and manage and resolve political economy challenges.
Political institutions that are trusted by citizens to execute policies in the public interest will perform better, as they better guide public expectations, and will be held accountable for their successes and failures. To take one example, governments in Scandinavia have long been expected to invest in long-run issues relating to childcare, education and the environment, and will be held electorally liable if they do not. By contrast, institutions which are not trusted, for example because they are subject to corruption and graft or because they fail to innovate and are not responsive to a changing economy and society, will not be trusted to deliver policies in the public interest. Opposition even to policy reforms in the public interest may arise on the assumption that the benefits will not reach citizens. This expectation itself reduces incentives for policymakers to implement reforms in their country’s long-run interest, especially when the costs to upsetting the beneficiaries of a corrupt system are high, and so the spiral continues.
Strong, trusted and responsive institutions can align expectations and reduce the costs of change by sending clear and credible policy signals across the economy on the direction of change. This will give the private sector the confidence to deliver the necessary efficiency gains, infrastructure, and innovation that will drive productivity of all forms of capital and growth. Box 1 describes institutional structures that can reinforce policy credibility. Clear policy signals lower the risk of premature stranding of infrastructure investments, while helping to accelerate and scale investments in more efficient products, new business models, new markets, new skills and jobs, and more productive ways of working and operating. Policies that send weak, absent or muddled signals slow or hinder change and increase costs.