Introduction

The study examines how climate policy interacts with distortionary fiscal policy, potentially leading to transition risk. By transition risk, the authors refer to the economic and financial disruptions along the transition to a low-carbon economy, including policy-induced changes in output and investment.

The authors develop an environmental dynamic stochastic general equilibrium (E-DSGE) model featuring financial frictions and pre-existing labour and capital taxes. The study simulates a carbon tax and an abatement subsidy under three scenarios for returning carbon tax revenue or financing the subsidy: via a lump-sum tax or transfer, adjusting the labour tax, or adjusting the capital tax.

The model also allows financial regulators to introduce green macroprudential policy. This is modelled as taxes or subsidies on banks’ assets, which can differ between green and brown assets, aiming to lower banks’ exposure to brown assets before climate policy is introduced.

Model

The E-DSGE framework features two production sectors: polluting (brown) and non-polluting (green). The household sector includes workers and bankers, where each banker manages a financial intermediary.

The model incorporates a frictional financial sector building on Gertler and Karadi (2011) and pre-existing distortionary taxes on labour and capital. The design enables the analysis of how policy choices and revenue recycling or financing strategies impact economic transitions.

Results

The gross fiscal flow is substantially larger for the carbon tax, representing about 0.21% of GDP, compared to the abatement subsidy, which is about 0.01% of GDP. Both policies are calibrated to achieve an identical 10% reduction in steady-state emissions.

For the carbon tax, achieving a 10% emissions reduction requires a tax of about $4.30 per ton of CO2. Recycling carbon tax revenues by cutting labour or capital taxes yields a higher increase in output and is less distortionary than using a lump-sum transfer, both in the steady state and during the transition.

For the abatement subsidy, a 10% reduction in emissions requires an abatement subsidy rate of 67%. The most efficient financing option is a lump-sum transfer. Output reductions during the transition path only emerge when the subsidy is financed by increasing distortionary taxes in the presence of financial frictions.

Financial frictions exacerbate the magnitude of transition effects for the carbon tax, with an impact comparable to the choice of revenue return. Conversely, under the abatement subsidy, detrimental transition effects like output declines occur solely because of financial frictions. Ex-ante green macroprudential policy mitigates transition risk under the carbon tax but has almost no effect under the abatement subsidy.

Conclusion

The research reveals novel trade-offs across climate policy instruments, financing choices, and financial regulation. Transition effects can differ sharply from long-run outcomes, highlighting that financial frictions impact carbon taxes and abatement subsidies differently.

The findings indicate that policymakers must focus on both short-run transition effects and long-run steady-state outcomes. Ignoring short-run implications of policy design, such as the choice of revenue return or subsidy financing, can lead to unanticipated and harmful effects, exacerbating financial instability.