Beyond externalities - a new framework for climate policies

Building on previous discussions and research facilitated by the Forum New Economy, this paper lays out the economic rationale behind approaching climate policy beyond a focus on externalities and discusses the synthesis of strategic investment support, positive incentives, and carbon pricing to design effective policy mixes. Traditional climate economics have assumed that the climate crisis can be solved by using an environmental pollution framework, to which the classic policy response is a form of carbon tax. However, addressing the climate crisis differs fundamentally from a pollution problem and requires the transformation of several major economic sectors so that carbon emissions collapse.

Key to such a systemic transformation is sustainable energy production, and the electrification of other key sectors. This changes the policy handbook: to accelerate investment spending in clean energy technologies, we need policies that address the cost of capital and the return on capital, while also reducing financial risks. Alongside this, to induce changes in consumption, it is essential to target the price elasticity of demand by creating near-perfect low-carbon alternatives, including by accelerating innovation and low-carbon infrastructure.

What does this mean for the practical design of climate policy mixes? In reality, finance is not neutral, and to support strategic investment in green energy technologies, financial de-risking policies and policies addressing revenue risks play a vital role. To help decarbonise consumption patterns and promote electrification and low-carbon alternatives in the rest of the economy, deploying Targeted Positive Incentives, i.e., policies that make sustainable choices cheaper, easier, and more attractive, is essential, especially in cases that involve high upfront capital expenditure. Carbon prices play a critical role as a signal in favour of sustainable substitutes and can also serve as a revenue-raising tool during transition periods. However, a broader understanding of the economics of price elasticity suggests that sequencing carbon prices with other policies can significantly enhance their effectiveness.

One of the key complementary factors that can either support or hinder the implementation of climate and energy policy is Political Economy, i.e., the ideas and public perceptions, interests, and power dynamics that influence policymaking. What are the main challenges in current narratives around climate policy and cleantech – such as the widespread perception of it as a burden for consumers and businesses? And what strategies would help make the political economy of climate policy more conducive to ambitious and socially accepted transformation?