Expecting the unexpected: Macroeconomic volatility and climate policy

Introduction: The global financial crisis, a deepening global recession, and continued turmoil in credit markets drive home the importance of developing a global climate architecture that can withstand major economic disruptions. A well-designed global climate regime and the attendant domestic policies in participating countries need to be resilient to large and unexpected changes in economic growth, technology, energy prices, demographic trends, and other factors that drive costs of abatement and emissions. Ideally, the climate regime would not exacerbate macroeconomic shocks, and would possibly buffer them instead, while withstanding defaults by individual members. Because climate policy must endure indefinitely in order to stabilize atmospheric concentrations of greenhouse gases (GHGs), all sorts of shocks will occur at some stage in the policy's existence. Anticipating such shocks may mean rejecting policies that might reduce emissions reliably in stable economic conditions but would be vulnerable to collapse—with consequent deterioration in environmental outcomes—in volatile conditions. Macroeconomic volatility is the practical manifestation of an issue that has received considerable attention in the theoretical literature on the design of environmental policies: uncertainty about the costs and benefits of reducing emissions. In particular, macroeconomic shocks can cause the cost of regulation to be much higher or lower than anticipated. Unexpectedly stringent and costly regulations may become political lightning rods. Recent world events, for example, highlight the fact that economic surprises can subject governments to enormous pressures to relax or repeal taxes or other policies perceived to impede economic growth.