Climate Change and Carbon Policy: A Story of Optimal Green Macroprudential and Capital Flow Management

The author analyzes the macro-financial implications of using carbon prices to achieve ambitious greenhouse gas (GHG) emission reduction targets. His empirical evidence shows a 0.6% output loss and a rise of 0.3% in inflation in response to a 1% shock on carbon policy. Furthermore, he also observes financial instability and allocation effects between the clean and highly polluted energy sectors. To have a better prediction of medium and long-term impact, using a medium-large macro-financial DSGE model with environmental aspects, he shows the recessionary effect of an ambitious carbon price implementation to achieve climate targets, a 40% reduction in GHG emission causes a 0.7% output loss while reaching a zero-emission economy in 30 years causes a 2.6% output loss. He documents an amplified effect of the banking sector during the transition path.

The study also uncovers the beneficial role of pre-announcements of carbon policies in mitigating inflation volatility by 0.2% at its peak, and the results suggest well-communicated carbon policies from authorities and investing to expand the green sector. His findings also stress the use of optimal green monetary and financial policies in mitigating the effects of transition risk and assisting the transition to a zero-emission world.

Utilizing a heterogeneous approach with macroprudential tools, the author finds that optimal macroprudential tools can mitigate the output loss by 0.1% and investment loss by 1%. Importantly, his work highlights the use of capital flow management in the green transition when a global cooperative solution is challenging.