The interaction of macroprudential regulation and climate policy – Bank Underground

Francesca DiLuiso, Barbara Anicchiarico and Marco Carli

While climate change is often viewed as a long-term concern, climate mitigation policies can have distinct short-term impacts, as they affect the transmission mechanisms of traditional macroeconomic shocks. In a new working paper, we show that cap-and-trade schemes lead to less volatility in GDP and fiscal variables, and reduce business cycle welfare costs, compared to more widely known carbon taxes. As we find that these welfare differences are primarily driven by distortions in financial markets, we argue that countercyclical macroprudential regulation, even without any green-biased component, improves the welfare performance of these policies. can effectively align and reduce their short-term costs.

Carbon Tax vs. Cap-and-Trade System: A Business Cycle Perspective

Carbon taxes and cap-and-trade schemes are the two main ways of pricing carbon, which together cover 23% of global emissions. While both work by imposing costs on the release of greenhouse gases, they generate different behavior in terms of emissions, emissions prices, and compliance costs in response to economic shocks. A cap-and-trade scheme – a policy where the regulator sets a limit for emissions and firms must keep allowances commensurate with that limit for each ton of greenhouse gas they produce – certainty about future emissions levels but environmental This implies uncertainty about compliance costs, as emissions allowance prices are volatile. Instead, a carbon tax limits uncertainty about compliance costs (the price is fixed for a unit of pollution), but allows emissions to shift cyclically with economic activity, thereby meeting pollution targets. Uncertainty arises regarding the success of completion. As a result, the respective macroeconomic effects of both policies remain a matter of debate.

We build a dynamic stochastic general equilibrium model with financial frictions and environmental aspects to explore the interactions between these policies and business cycle fluctuations. At the center of the model are intermediate polluting firms in a capital-intensive sector. These companies obtain capital by pooling their financial resources and taking loans from banks. However, they are also vulnerable to unexpected shocks that could drive them toward default. The negative effects of emissions resulting from their activity do not occur in the short term, but have detrimental effects on the productivity of the economy in the long run. For this reason, polluting companies are required to comply with environmental policies, which may include paying a carbon tax or purchasing emissions allowances under a cap-and-trade scheme. Business cycle fluctuations arise from a combination of different shocks and are exacerbated by the presence of ‘financial accelerator’ mechanisms, as explained by Cristiano et al (2014).

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We examine how the economy responds to different types of shocks under a fixed cap-and-trade scheme and a fixed-carbon tax. We have found that the cap-and-trade system keeps the economy much more stable. Under this policy, the price of emissions permits increases cyclically: to increase production, companies must buy more pollution allowances, the price of which increases due to increased demand, and the opposite is true during recessions. This means that producers bear higher costs to comply with environmental regulation during economic upturns, while they bear lower costs during recessions. As a result, a cap-and-trade plan helps smooth out the ups and downs of the business cycle.

For example, when an expansion results from a positive total factor productivity (TFP) shock that increases the efficiency of production inputs (Chart 1), firms adhering to the cap experience lower returns to output, to a lesser extent. Build wealth, invest more and borrow less. As companies borrow less due to higher compliance costs, the financial channel weakens, resulting in lower asset prices. It is interesting to see how these effects grow during the adjustment process, causing the spread (defined as the difference between the interest rate on companies’ loans and the rate on deposits) to be temporarily pushed above its pre-shock level. while the volume of debt shrinks and remains below its pre-shock level, the opposite of what we see under the tax. In response to contractional shocks, the same dynamics work in the opposite direction.

Chart 1: The economy’s response to a one-standard deviation TFP shock from the steady state

Note: Time on the horizontal axis is in quarters.

Under a carbon tax regime, instead, companies pay a constant fee for pollution, and the relative costs of compliance are slightly countercyclical. In the scenario in Chart 1, companies could take advantage of the economic boom to boost production beyond what is allowed under a limit. During recessions, instead, polluting producers face higher compliance costs and reduce their production under quantity restrictions.

Importantly, we also find that these policies differ in terms of the welfare costs of the business cycle. We traditionally measure these costs in terms of lost consumption due to uncertainty arising from economic shocks. We find that the welfare costs of the business cycle are significantly lower when a cap-and-trade scheme is implemented. We do not consider welfare benefits caused by environmental policies because policies implemented by a single country can hardly affect the global emissions stock, especially in the short run.

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Relevance of Financial Channel

The above results challenge the results of Fischer and Springbourne (2011) and Anichiarico and Dio (2015), who find that the welfare performance of cap-and-trade schemes is quantitatively similar to that of carbon taxes. However, these works do not consider the role played by financial markets. We argue that financial distortions are a key driver for the welfare gap between the two environmental policies. A cap-and-trade scheme, in fact, due to its countercyclical properties, strongly attenuates financial acceleration effects in business cycle fluctuations driven by the possibility of firms borrowing from banks and defaulting, thereby reducing shocks. Welfare costs are reduced.

Chart 2 shows the importance of the financial channel in explaining the welfare difference between the two policies: as firms’ risk of default increases, banks raise interest rates on loans. This forces producers to reduce their borrowings – the channel through which the financial accelerator effect occurs – and reduces leverage. As a result, the welfare costs of the business cycle accumulate under two alternative environmental policies: when the fiscal accelerator mechanism is weakened, welfare costs fall (more sharply under the tax scenario in which the fiscal effects are broader) and under the policy regimes. Narrows the welfare gap between. These findings indicate a strong interaction between financial markets and climate policies across the business cycle.

Chart 2: Welfare costs of the business cycle at different values ​​of risk and leverage

The role of a countercyclical macroprudential regulation

Because of the role played by financial markets, we should consider whether there are policy interventions that financial regulators can implement to reduce uncertainty around the functioning of carbon-pricing policies across the business cycle.

In Table A we report our estimates of welfare costs under different policy scenarios. The first row shows the results for the ‘benchmark’ case, in which the threshold is binding and the tax rate is fixed. The second row reports the results for the case in which emissions limits and taxes are flexible and respond to business cycle shocks to minimize welfare costs (‘optimal environmental policy’). Other lines report welfare costs when climate policies are implemented with specific types of macroprudential policies, (for example, see Leduc and Natal (2018)). These policies may take the form of interest rate subsidies to depositors (‘optimal subsidies’) or reserve requirements that limit the funds that banks can convert into loans. In the latter case banks are required to keep a portion of their funds in reserves, which is treated as ‘cash’ and earns a zero rate of return. This fraction can be pre-defined (‘static macroprudential policy’) or adjusted counter-cyclically in response to credit growth or changes in asset prices (rows five and six of Table A).

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Table A: Welfare costs of the business cycle under different scenarios (in % of consumption loss compared to an economy not subject to economic fluctuations)

cap and trade carbon tax
benchmark 0.6178 1.5231
optimal environmental policy 0.4528 1.1811
optimal subsidy 0.2506 0.4706
static macroprudential policy 0.1957 0.3863
Optimal macroprudential policy – ​​credit growth 0.1207 0.3231
Optimal macroprudential policy – ​​asset prices 0.1807 0.2310

We can see that when environmental policies are set optimally the welfare costs are lower but the welfare gap between them persists, because no policy adjustment can completely weaken the strength of the financial channel or the financial channel. Cannot address friction. Instead, countercyclical macroprudential policies have the potential to reduce the welfare costs and readjust the welfare performance of environmental policies. In particular, dynamic subsidies given to depositors protect households from consumption fluctuations, encouraging saving when credit declines and discouraging it when credit increases. Instead, reserve requirements of various types reduce firms’ ability to take risk and the amount of debt in the economy. Overall, countercyclical macroprudential policies may weaken cycles and reduce the cyclicality of carbon taxes, partially replicating the countercyclical effect observed with the cap-and-trade scheme.

macro-policy implications

Our results suggest that financial regulators can potentially support governments that are implementing climate policies by creating a more favorable welfare environment. Macroprudential policies, even without any green-bias component, can help align the performance of different carbon-pricing schemes by reducing the negative effects of financial frictions and promoting economic stability. This will make it easier for governments to adopt a wider range of climate policy instruments.


Francesca DiLuiso works in the Structural Economics Division of the Bank, Barbara Ancchiarico works at Roma Tre University and Marco Carli works at Tor Vergata University.

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