Climate Change Mitigation: How Effective is Green Quantitative Easing?
This paper examines whether central banks - a monetary authority - can effectively contribute to mitigate global warming through green quantitative easing, i.e. through a shift of a monetary authorities’ privately-issued financial asset holdings towards the green sector of the economy. As a secondary question we further investigate the effectiveness of this policy in combination with fiscal policies - set by a fiscal authority -, more precisely, a carbon tax.
In our setup, green quantitative easing refers to a change in the portfolio allocation of a given outstanding stock of private sector securities (bonds) held by the monetary authority, towards bonds issued by the green sector.
To answer the question on the effectiveness of green quantitative easing, we develop a quantitative integrated assessment model with green and dirty capital.[1] In our global model, aggregate output is produced employing intermediate goods that are in turn produced in the dirty sector and in the clean (green) sector. Intermediate goods are produced using capital, labour and energy as inputs, with the dirty sector using carbon-based energy and the green sector using clean (renewable) energy. Markets do not take future climate damages into account and therefore rely too much on the dirty sector for the production of intermediate goods in the absence of policy interventions. Over time, this negative production externality leads to a reduction of total output as the global temperature increases.
Capital and labour are supplied to the intermediate firms by households, which allocate their savings between bonds issued by the two intermediate sectors (clean and dirty). The return on the capital used in the firms is stochastic and imperfectly correlated across sectors, which presents an income risk for the households seeking to optimise their consumption over time. This feature of the model is of central importance as the imperfect correlation of returns calibrated according to the data realistically implies that, in response to the portfolio allocation decision by the monetary authority, private households will not perfectly reallocate their portfolios towards dirty assets. Therefore, in our model, the portfolio reallocation decision by the monetary authority is not neutralized by private household reactions.
In this model setting, without policy intervention, the global temperature increases by 3.5 degree of Celsius above pre-industrial levels by 2100. This is in line with IPCC scenarios of climate change and well above the Paris agreement target to mitigate global warming.
Next we simulate three policy experiments. First, we model the effect of carbon pricing by a fiscal authority, which increases the price of dirty energy through a carbon tax. Second, we consider the contribution of green quantitative easing, where the monetary authority changes the composition of its private asset portfolio to only green bonds. Finally, we consider both policies in combination. Since our model is calibrated to the world, as global warming knows no borders, these simulated fiscal and monetary policies would require cooperation across countries that we abstract from.
The initial carbon tax is 50 USD per ton of carbon in 2021 (equivalent to 13.6 USD per ton of CO2).[2] We hold the implied tax rate of 6.6% constant along the transition and find that the global temperature increase could be reduced by 0.17 degrees of Celsius, compared to the baseline. This carbon tax is at the low end of many policy proposals to meet the Paris agreement, and chosen to facilitate the comparison with green quantitative easing. Green quantitative easing is modeled as a stylized scenario where the monetary authority’s private capital portfolio, which is initially split across both sectors in proportion to total capital in the economy, is reallocated to clean capital only. This additional supply of clean capital reduces its return and, since clean and dirty capital returns are imperfectly correlated, households will find it optimal to partially reallocate their savings to dirty capital. As a net effect, the capital stock employed for production in the clean sector will increase relative to the capital stock in the dirty sector, which triggers a relative increase of labour demand in the clean sector and a relative expansion of its output. The monetary authority can thus influence the relative production across the two sectors in the economy through the allocation of its asset portfolio.
Our green quantitative easing simulation is set up to investigate its maximum possible effect. We assume a complete and immediate switch to green bonds and no uncertainty about the classification of green and dirty bonds. The share of private assets held by the monetary authority (10 percent of GDP) is calibrated based on the privately-issued securities holdings of central banks of advanced economies, i.e. including asset-backed securities as well as commercial bonds. We also assume in our baseline scenario a very high elasticity of substitution between clean and dirty intermediate goods. Despite this calibration tailored to achieve the maximum possible effect, the impact of green quantitative easing is rather modest compared to the carbon tax. We find that the emission reduction through the carbon tax is about 4-times larger than the maximum reduction that could be achieved through this green quantitative easing policy. Put differently, achieving the same effect as the maximum reduction through green quantitative easing would require a carbon tax of about 11 USD per ton of carbon.
When combining both policies, we find that green quantitative easing complements fiscal policy, i.e. green quantitative easing on top of a carbon tax will reduce the increase of global temperature further. However, the whole is less than the sum of its parts: the marginal effect of the two policies in combination is lower than in isolation. Within the dirty sector, a carbontax increases the production costs of energy relative to the costs of capital and labour, which triggers a decline in dirty energy demand. In turn, green quantitative easing increases the costs of dirty capital, which partially leads to higher dirty energy demand. Thus, both policies partially counteract each other.
We conclude that green quantitative easing may be an effective complementary policy instrument, in particular if governments around the world fail to coordinate on introducing a sizeable carbon tax or equivalent carbon pricing through other fiscal policies.
However, considering the practical implications of real world governance problems concerning the implementation of green QE policies – which we sidestep in our analysis by assuming a perfect brown-green taxonomy - and the low relative effectiveness of the instrument which we document in our findings, a better suited policy option may be implementing “normal” quantitative easing policies and using the proceeds to finance subsidies of fiscal authorities of investments in clean technologies.
[1] An integrated assessment model unites a macroeconomic perspective with the possible damages of climate change, which are modelled as future output losses due to an increase in temperature that is caused by the build-up of carbon emissions in the atmosphere.
[2] Since there is no aggregate uncertainty in our model, an equivalent fiscal policy would be to set a carbon price through an emission trading scheme