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More Political Economy on Global Warming and a Proposition

Environnement & Ressources Naturelles 
Billet du 18 septembre 2015
Par Michel Aglietta, Etienne Espagne
We draw six political economy lessons from the actual dynamics of climate negotiations and their connection to the new macroeconomic normal emerging in the aftermath of the 2008 crisis. A specific proposal follows.

This article is part of a special series discussing the economic dimensions of environmental issues ahead of the - COP 21 Climate change Conference held in Paris on 30 November-11 December 2015. Read more about it here.

More political economy is needed on the climate agenda if we do not want the efforts towards the Paris Conference of Parties (COP21) and beyond to turn into new disillusions (Perrissin et al., 2014). This assessment is now widely shared among economists and policy makers who have experienced the aftermaths of the 2009 Copenhagen Summit.

But what does “more political economy” actually mean? Here, paths rapidly tend to diverge. For some, it seems to mean that there exists a “first-best climate policy option” which should be pursued and that the political economy context should be dealt with separately, as inevitable collateral damage. Advocates of a unique world carbon price with temporary compensations in order to deal with the transition process can be ranged in that category (Tirole and Gollier, 2015). The theoretical goal here dominates the political path. For others, more political economy means taking a “pragmatic” approach, so that every possible way to increase the penetration of low-carbon technologies and behaviors into the economy are worth taking, even at the cost of redundancies and inefficiencies. Advocates of sectoral industrial policies, or of multiple and partially redundant objectives (such as emission reductions and renewable energy objectives at the same time) will be ranged in that category where the political path dominates the theoretical goal.[1] We argue that this opposition is artificial at best and probably even counter-productive. The best climate policy instrument and the political environment have to be determined together, because the feedback loops are numerous between the two. In that sense, there is no abstract “first-best climate policy option,” as there are no “political constraints” to deal with.  There are political and economic paths to be defined towards low-carbon societies (Stern and Calderon, 2014). These preliminary observations lead us to draw six political economy lessons on global warming policies for the times to come.

Since the Kyoto Protocol and the subsequent Copenhagen failure, the climate negotiation agenda has put aside the question of carbon pricing in favor of a spontaneous commitment by member countries, illustrated by the so-called INDCs (Intended Nationally Determined Contributions). This way of dealing with climate strategies can be seen as a pis-aller which only validates the failure of first-best climate policy options. But it can also be seen as the basis for a new paradigm in climate policy, as the Cancùn Conference has called in 2010 this shifting point-of-view (Skea et al., 2013). This new paradigm basically reveals that the fight against global warming cannot be conducted at the expense of the endogenous development of developing countries. The first political economy lesson can thus be written: “do not hope for a (meaningful) carbon price, if it leads to less development for the developing world.”

The second political economy lesson stems from the aftermaths of the financial crisis. Public budgets are extremely tight in developed countries, and all the more so after inadequate public policy reactions. Central banks have forcefully intervened to counteract the deflation spectrum, but with very little effect at best on the ability of the financial system to create loans to the productive sectors. Investment levels in the Eurozone are still below their pre-crisis level, and the output gap is constantly revised downwards due to the degradation of the potential output (Aglietta, 2014). The recent rebound in Europe is mainly due to the two temporary exogenous shocks: the drop in oil prices and the fall of the euro. The conditions for a sustainable investment recovery are still not there. This will be our second political economy lesson, in this context: “substantial compensations at world scale in a western context of extremely tight budgetary constraints are a ‘no go.’”

All central banks are now trying to rebuild some leverage on the real economy. They have used very low interest rates and then developed quantitative tools based on the purchase of debt. But not all debt is equal, and not all credit is useful either.  Most of the existing quantitative easing tools were based on transfers of existing debt, through purchases on the secondary market, mostly of sovereign bonds. But only new investments, and thus new debt, can create profits, and thus growth. And if growth has to be sustainable, the creation of new debt has to be diverted towards sectors where the social benefit is maximum, which necessarily involves a quality issue (Espagne, 2015). The third political economy lesson follows: “any ambitious climate plan should make full use of the new macroeconomic normal, and even contribute to define the still blurry paradigms of next decades’ central banks missions.”

The key point is the evaluation of the social benefits of credit. Since markets are neither complete nor efficient, they are, among other things, subject to externalities. Some of them are just accepted as such without further debates, others are much more controversial or problematic, building a gap between the private return and the social return of investments. Once this gap is taken into account, or internalized, in the investment decision, there are no more quality issues for the central bank in its monetary policy decisions. In fact, the evaluation of this gap occurs outside, in the political arena, which is the only relevant place to decide on the definition of a “social return” or the “social value” of an externality.  Global warmingis surely the domain of the most extreme and global externalities. The willingness to pay for climate action defines per se a social cost of carbon emissions, or in reverse, a value for emission reductions (Teixeira, 2014). Fourth lesson: “an absence of immediate optimal carbon pricing does not mean there is no ambitious signal on new investments”.

Indeed, such a value can be properly and publicly defined. Once the government (or a public institution such as a public investment bank) makes such a value official, it necessarily gives birth to a new class of assets, which we can call the carbon certificates. These certificates, which can only be issued by competent certification agencies, guarantee that a certain amount of emission reductions has occurred in new investments. More concretely, all kinds of projects with a certain gap between their social and private return due to the carbon externality can now access financing thanks to this new type of asset. Many sectors of the economy are potentially concerned: energy efficiency in buildings, urban mobility, energy supply capacity, etc. All of them act as inputs or intermediate products for the whole economy, so that the productivity effect may be large. However, these sectors have very different properties, in terms of the size of the firms, the credit constraints of the agents, the technical difficulty to assess the emission reductions and the duration of the overall projects, and with it of the emission reduction. Whatever the quality of the certification agencies, there will thus be a risk that the certification does not capture the full value of the emission reductions or capture more than was actually reduced. This risk can be mitigated through financial mechanisms (Espagne et al., 2015). Fifth political economy lesson: “it is politically possible to be very ambitious with new investments first, the remaining stock of capital being temporarily spared.”

The financial sector is encouraged to participate in the process and to accept those certificates as repayment for their loans to low-carbon projects as soon as they can transform them on short notice at the public investment bank. Once on the public investment bank’s balance sheet, these certificates canbe transformed into long term obligations through pooling and securitization mechanisms, thus mitigating the risk of certification of the individual projects. Unless there is a systematic bias in the certification process, which can be easily identified, this risk can be entirely mitigated through the pooling mechanism. The most senior risks can be interesting for long term institutional investors, while the most risky securities may interest speculative funds. This way, a secondary market for this certification risk can emerge, on which the central bank can intervene in the context of its quantitative easing policy. This technique of secondary market asset purchase is already standard in non-conventional monetary policies. The State would have a strong incentive to pilot the implementation of a progressive carbon tax in order to generate the resources to reimburse the obligations at maturity (Aglietta and Espagne, 2015). Sixth and last political lesson: “involve and regulate the financial sector so that it actually serves its original purpose as a maturity transformer and a transition smoother”.

In fact, although this particular proposal is only one among many which are more or less closely related (Morel, 2014), these political economy lessons can serve in a much broader context. We can now go back to the general context of the COP21 and beyond agenda. A roadmap for the implementation of such transitional financing instruments is necessary. First, it is an issue for the Paris Conference only insofar as it puts back to the forefront the issue of carbon pricing. Again, this carbon pricing is not about a global carbon tax or an emission permits market. But it is also not about a self-regulation tool for industries. It is about a social value, and the agreement in Paris should let the door open for an arrangement on such a global long term signal, on which firms could rely to make their investment decisions. Such a signal is already called for by many firms (OLT, 2015). But the concrete implementation at a monetary zone level does only require the political will and some technical certification skills. This is a tool of maximum subsidiarity and minimum initial collaboration, which is precious for such a large scale problem. In a sentence, it gives long term visibility, has immediate credibility, while allowing for progressive price coherence.


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[1] The way the European climate and energy framework is implemented at both the horizons 2020 and 2030 could be a good example of this approach.
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