It’s a guest post by Daniela Gabor, Professor of Economics and Macrofinance at UWE Bristol, and Isabella Weber, Assistant Professor of Economics at the University of Massachusetts Amherst and author of How China Escaped Shock Therapy, arguing that ‘ a market-based approach to reducing carbon emissions can sow more instability than it is worth.
If COP26 wants to make any significant progress, the general wisdom is, it has to be around carbon prices. Big finances will like a global $ 50 per tonne carbon price to be determined at the meeting, which ends this week. Big business is finally on board, too. Corporate lobby groups recently argued that a global price on carbon will encourage energy producers, industries, consumers and financial markets to switch to low-carbon technologies and activities. Global coordination at COP26 should involve reluctant countries (especially the US, China and India) to ensure that everyone faces the disciplining hand of the market. COP26 is the last collective chance to confidence the power of price signals.
Those of us who have lived through the transition of centrally planned economies have another name for the mantra of ‘get prices right and the market will deliver’. We know this as shock therapy. In the 1990s, shock therapists told governments in Eastern Europe and the former Soviet Union that their economies needed rapid structural change.
State-owned companies had to make way for a large private sector. Shock therapy will subject them to market discipline by liberalizing the prices of previously state-controlled producer goods and by ending cheap credit, subsidies and tax concessions. In fact, shock therapists insisted that only a strong dose of fiscal and monetary austerity would finally eliminate the ‘soft budget constraint’, that peculiar socialist ordeal that kept dead state firms alive and tied up resources in the wrong sectors. The aim was to shrink heavy industries.
The real test for governments’ price increases, shock therapists warned, was not just to stay firm when real wages fell, but to stick to strict credit policies, even if bankruptcies in government sectors increased unemployment. It was a austerity test that even committed governments would fail when the market, rather predictably, delivered social and economic upheaval. But shock therapists have had a formidable institutional apparatus to condition unwilling governments: the IMF and the World Bank. Previously planned economies were dependent on the Bretton Woods institutions for crisis support, both solid believers in the power of price signals amplified by macro-austerity. Conservative economists in local central banks have been successfully used in their case.
Take a closer look at the rhetoric at COP26, and you can see the carbon shock therapists coming. The price narrative sounds strangely familiar: carbon price increases will allocate resources, real and financial, to the right sectors. Macro austerity may not be on the agenda, but it’s on the menu: after nearly two years of pandemic – related monetary and fiscal expansion, we’re back to calls to shrink the public purse.
The fiscal discipline fetishists are (still) in control, and they do not like the alternative to carbon shock therapy – massive green public investment among the Keynesian motto ‘anything we can actually do, we can afford’. As with the old shock therapists, their rejection is a political choice: state-led decarbonisation will require central banks and finance and industry ministries to work closely together again after nearly 40 years of separation. This will actively involve central banks redirected private capital flows from investment in dirty to low-carbon activities. This would mean developing public institutional capacity to move the private sector quickly to low-carbon activities, and to respond dynamically to obstacles and unintended consequences of higher carbon prices.
It’s a bit like how China escaped shock therapy: central planning institutions retained control over strategic aspects of the economic system, while new market dynamics were created in an experimental and gradual manner. China used market signals but did not allow them to dictate the pace and direction of transition.
Carbon shock therapy will not be applied everywhere. While global momentum seems to be about high-income countries, the historical polluters, the institutional apparatus of carbon shock therapy, are rapidly forming to target middle-income and poor countries. Again, the countries that are most vulnerable to climate events and least responsible for the climate crisis will be the laboratory. Saddled with high foreign debt in the wake of the pandemic and limited access to vaccines, they will have to turn to the IMF and the World Bank for financial support.
Where climate change meets business, markets and politics. Explore the FT’s coverage here.
Are you curious about the FT’s commitments for environmental sustainability? Find out more about our science-based targets here
The IMF was an early proponent of global carbon prices. His new Climate Change Dashboard approaches the transition in terms of lost tax revenue and prices of fossil fuel emissions at ‘socially efficient’ level that will increase both pollution and consumption tax revenue. However, it does not calculate the damage to local companies from higher carbon prices or the implications for employment and growth. The IMF is new Climate Strategy, published in July 2021, presents carbon pricing as the only viable strategy for transition. In 42 pages, it mentions carbon prices 23 times, green industrial policy once, and green public investment never. The turn to carbon shock therapy is spelled out in its plans to ‘green up’ conditional loans: IMF loans to countries in need will scale up experiments with (fuel and energy) subsidy cuts, carbon prices and building financial resilience.
The emphasis on carbon prices puts the central bank further as a key local ally, recreating the institutional policy of shock therapy. Like its predecessor, carbon shock therapy is inherently inflationary. Then countries were promised that free-floating exchange rates would strengthen price signals, but what they got earlier was higher inflation of weaker currencies, pushing central banks further into monetary sobriety. Now, even if central banks refuse to selectively increase the cost of bad credit (for high-carbon industries), monetary austerity may be necessary to fight inflation of carbon prices.
Carbon shock therapists may not support green public investment, but they have reassuring climate funding message. Countries can mobilize the trillions of dollars that global institutional investors like BlackRock would like to plunge into the low-carbon transition. These investors did not show up on a significant scale because climate investments in poor countries are too risky compared to returns. In addition to regulatory reforms, the key to unlocking private finances is fiscal derisking: countries are expected to find fiscal resources to guarantee returns for private investors, including official development aid.
The IMF’s new Sustainability and Sustainability Trust can also be used to reallocate the newly created Special Drawing Rights of high-income countries to global institutional investors, all in the name of discouraging green private investment. The only sector that will be protected from carbon shock therapy is private finances. Despite its devastating contribution to the climate crisis, through credit to polluters and greenwashing, is well known.
It is tempting to dismiss the growing calls for carbon prices as empty statements of entrenched interests that bet on the continued absence of political will. But poor and middle-income countries are expected to once again be forced to subject their economies to chaotic structural transformation. What they really need is carefully designed macro financial policy to adapt their productive structures.
As part of our coverage of COP26, we want to hear from you. Do you think carbon prices are the key to tackling climate change? Tell us via a short recording. We will share some of the most interesting and provocative answers in our newsletters or an upcoming story