Is Climate Change a Fiscal or Monetary Policy Challenge?

Lekha Chakraborty | November 10, 2021

Lekha Chakraborty
(Professor, NIPFP, and Member of Governing Board, International Institute of Public Finance, Munich)

Climate change is about risks and uncertainty. How well the monetary policy stance can incorporate such risks and uncertainties is questioned by many economists. There is a broad consensus among economists that fiscal policy is capable of dealing with the climate crisis but monetary policy is not, due to the latter’s lack of tools. It is widely acknowledged that public finance commitments are essential to lowering carbon emissions. Public finance interventions—through taxation to reduce carbon prints or through public expenditure to support green energy and technology—have proven to be effective in reducing emissions. However, such empirical evidence is absent in the case of monetary policy.

India was the first to integrate a climate change criterion in its inter-governmental fiscal transfers. The macroeconomic policy channel of these “ecological fiscal transfers” works through the prioritization of public expenditure on climate change commitments by subnational governments, to make a “just transition” towards a sustainable climate-resilient economy.

Within the environmental federalism framework, the “principle of subsidiarity” demands that the responsibility for providing a particular service should be assigned to the level of government closest to the people. This tax transfer also compensates for the cost burdens faced by subnational governments, due to foregone revenue and opportunity costs associated with establishing protected areas in their path towards economic growth. However, ecological fiscal transfers are only one among many fiscal policy tools to meet climate change commitments.

On the monetary policy front, climate-focused stress tests conducted by central banks are an upcoming policy tool to address the issue. Such green stress tests assess how the banking system is exposed to climate risks and uncertainties. Such a test was first conducted by the Bank of England. Christine Lagarde of the European Central Bank (ECB) is very supportive of greening monetary policy and the ECB will conduct such tests of the risk exposure of top banks in the European Commission in 2022. However, the US Federal Reserve has not yet begun such tests. Fed Chair Jay Powell explained that the Fed has asked lenders to articulate their risk exposure and how they can mitigate such risks. The Reserve Bank of India has published a chapter on greening monetary policy; however, there is no further communication regarding toolkits. The response to the question of whether the RBI is open to conducting such green stress tests on the top banks is awaited.

Recently, Professor Lars Peter Hansen, an economist at the University of Chicago (and winner of 2013 Nobel Prize for economics), mentioned that there can be “reputation risks” if central banks go beyond their mandates. Raghuram Rajan, another Professor at the University of Chicago and the former Central Bank Governor of India, said that central banks should turn their focus to the financial stability of green investments instead of asking whether to buy only green bonds (versus brown bonds), which is primarily a “fiscal” decision in his view. The broad consensus is that central banks should focus on price stability and financial stability. However, this can be refuted by the concern that climate change is a crucial determinant of financial stability and it is crucial to integrate such climate-related risks and uncertainties in financing investment decisions.

In Brazil and Portugal, ecological fiscal transfers are conditional grants in nature, which incentivizes decentralized environmental conservation efforts, while in India, thclimate change criterion is incorporated in formula-based unconditional tax transfers. The point to be noted here is that the Twelfth and Thirteenth Finance Commissions of India designed specific purpose grants of Rs 1000 crores and Rs 5000 crores, respectively, for the conservation of the forestry sector. In addition to these intergovernmental fiscal transfers, the CAMPA (Compensatory Afforestation Management and Planning Authority) funds are also there, with the objective to enhance forest cover to maximize carbon sequestration. However, these conditional grants and CAMPA funds were not significant enough to make a “just transition” towards a sustainable climate-resilient economy. The District Mineral Fund, which is earmarked from mining royalties and intended to redress spatial inequalities in the districts from which it is extracted, has also not been an effective policy tool towards “just transition.”

Against this backdrop, the Fourteenth Finance Commission was the first to integrate climate change criteria in intergovernmental fiscal transfers. The Fifteenth Finance Commission has retained the criterion.

In addition to these fiscal transfers, the long-term Public Financial Management (PFM) tool, like climate-responsive budgeting at national and subnational levels, is crucial to address climate change commitments. This PFM tool links national climate action plans to budgetary commitments. The roadmap and the analytical matrices to prepare climate-responsive budgeting can also eliminate the “fragmented approach” by line ministries towards adaptation and mitigation in India. However, differential tax rates can lead to a “race to the bottom” to attract mobile capital and create “pollution havens” through trading lower environmental quality for more mobile capital.

In general, economists are apprehensive about the efficacy of central banks in dichotomizing green bonds and brown bonds in their asset portfolio and moving towards a low-carbon-emission enterprise. This skepticism is mainly because of the political economy perspectives in such decisions and whether central banks are equipped with knowledge and toolkits to engage in such a mandate.

Economists and policymakers underestimate the information asymmetries and knowledge gaps of a central bank in tackling climate change commitments. The financing of green investment and technology might lead to a de-carbonization process in future. But the question is how effective are the available expertise and toolkits of central banks to engage in such goals. Policy prioritization and political will are the prime determinants towards climate change commitments.


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