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The Path to Climate Credibility
By Jean Pisani-Ferry

Green capitalism can work only if governments eventually keep their climate promises – and the current picture is one of massive credibility failure. Accelerating the green transition will require like-minded countries to form a “climate club” and impose import tariffs on trade partners not contributing to the collective effort.

On October 25, the electric-vehicle producer Tesla’s market capitalization reached $1 trillion – more than the combined value of the next ten global car manufacturers. Even after discounting for exuberance, this is a strong indicator of how the threat of climate change is triggering a transformation of capitalism. To be sure, polluters still abound, and greenwashing is pervasive. But it would be a mistake to dismiss the changeover underway.

Governments, however, are not on track to deliver on their promise in the 2015 Paris climate agreement to limit global warming to “well below” 2° Celsius relative to pre-industrial levels. According to the International Energy Agency, meeting the national pledges made so far within the framework of the Paris accord would lead to an increase in global temperature of 2.1°C. Moreover, actual policies fall short of even these insufficient pledges: under the IEA’s “stated policies scenario,” global warming would reach 2.6°C.

Add to this the fact that – as the Energy Transitions Commission has documented – most governments have committed to achieving net-zero emissions only by 2050 or 2060, and plan to postpone major mitigation efforts until after 2030, and the emerging picture is one of massive credibility failure.

The root of the problem is well known. The Paris agreement was based on the realistic judgment that governments could not agree on a precisely defined allocation of climate-change mitigation efforts. This conclusion had emerged from the collapse of the 1997 Kyoto Protocol (which involved such an allocation but left out emerging economies, including China) and the failure of the 2009 United Nations Climate Change Conference in Copenhagen (where an attempt to muster a global Kyoto-type agreement ended in dispute).

So, the world tried a different approach: experts would assess the climate efforts needed, governments would formulate pledges, and civil society would scrutinize them. No one expected the initial pledges to be sufficient. But the hope was that peer pressure, the weight of public opinion, and relentless warnings by the scientific community would gradually put policies on the right track.

Economists were skeptical. Christian Gollier and Jean Tirole of the Toulouse School of Economics warned early on that the strategy was “doomed to fail.” And William Nordhaus of Yale University showed that voluntary climate coalitions are vulnerable to free-riding and prone to instability.

The Paris agreement nonetheless achieved something that simple economic models could not reflect: the beginning of a change in business attitudes. Notably, the Paris accord encouraged investors and managers to ponder the risk of being left with stranded assets or an obsolete business model. Mark Carney, then-governor of the Bank of England, added that regulators would hold financial institutions accountable for hidden climate risks. Such considerations generated private-sector momentum toward decarbonization.

But green capitalism can prosper only if governments eventually keep their climate promises. Most investments in renewable energy, energy-efficient buildings, or zero-emission vehicles require carbon pricing, tight regulation, or both. Forward-looking investors may well bet on the eventual enactment of such measures, but only up to a point, and not without consequences.

An insufficiently credible decarbonization policy implies both higher overall costs (because it leads investors to hedge by combining brown and green investments) and recurrent imbalances between demand and supply. Balancing an accelerated transition away from fossil fuels is challenging in any scenario, but even more so if future policies are uncertain. The current rise in energy prices might therefore presage rougher times ahead.

The lack of climate-policy credibility partly reflects domestic political considerations, because governments simultaneously promise a green future and the continuation of the status quo. US President Joe Biden lacks a congressional majority in favor of penalizing fossil-fuel use, Chinese President Xi Jinping is afraid of jeopardizing his country’s energy-hungry economic growth, and French President Emmanuel Macron knows from experience that middle-class households are hostile to carbon taxation.

Such concerns are understandable. But if investors conclude that governments are not serious about achieving global climate goals, they will spend less on green initiatives, and the Paris agreement’s core mechanism will collapse.

One solution would be for governments to tie their own hands by giving the mandate to set the carbon price to an independent institution, in the same way that they previously delegated responsibility for controlling inflation to central banks. Alternatively, governments could commit to paying a penalty if they fail to adhere to a given future path for the price of carbon (for example, by issuing certificates whose value would depend on the difference between the announced and actual prices). The question, however, is whether institutional or financial engineering could solve a deeply political problem.

Moreover, governments will deliver on climate goals only if a critical mass of countries remains on track to do so. Even more than domestic politics, this is at the core of the current credibility deficit. Nordhaus has therefore proposed that a group of like-minded countries form a “climate club” and apply a tariff on imports from trade partners that are not contributing to the collective effort. Today, for example, this would mean punishing Brazil for President Jair Bolsonaro’s irresponsible climate policies.

The idea makes perfect economic sense, and the outgoing German government took it up in a softer form in a recent paper. The difficulty is that although a mechanism to offset the trade implications of differential carbon pricing should be compatible with World Trade Organization rules, an outright penalty would be in conflict with them.

The European Union’s decision to push ahead with its European Green Deal is a stepping-stone. Provided the EU sets aside sufficient resources to compensate vulnerable households, the program’s common character will help member states solve their own climate credibility problems. In time, the EU will probably form a climate club of sorts with selected trade partners and push for ambitious goals. The question is who the other members will be. As things stand, both the United States and China fall short of the ambition required for such an alliance. That makes this a narrow path to climate credibility. But it is the only one.

Jean Pisani-Ferry, a senior fellow at Brussels-based think tank Bruegel and a senior non-resident fellow at the Peterson Institute for International Economics, holds the Tommaso Padoa-Schioppa chair at the European University Institute.
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