Climate Policy Transition Risk and the Macroeconomy

Authors

Kevin Novan

William B. Peterman

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2021-06 | June 1, 2022

Uncertainty surrounding if the U.S. will implement a federal climate policy introduces risk into the decision to invest in long-lived capital assets, particularly those designed to use, or to replace fossil fuel. We develop a dynamic, general equilibrium model to quantify the macroeconomic impacts of this climate policy transition risk. The model incorporates beliefs over the likelihood that the government adopts a climate policy causing the economy to dynamically transition to a lower carbon steady state. We find that climate policy transition risk decreases carbon emissions today by causing investment to become relatively cleaner and output to fall. This result counters the Green Paradox, which argues that climate policy risk raises emissions today by increasing incentives to extract fossil fuel, expanding its supply. Even allowing for the supply-side response, we find the demand-side response dominates, and the net effect of climate policy transition risk is still to reduce emissions today.

Article Citation

Novan, Kevin, Stephie Fried, and William B. Peterman. 2021. “Climate Policy Transition Risk and the Macroeconomy,” Federal Reserve Bank of San Francisco Working Paper 2021-06. Available at https://doi.org/10.24148/wp2021-06

About the Author
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Stephie Fried is a senior economist in the Economic Research Department of the Federal Reserve Bank of San Francisco. Learn more about Stephie Fried