The EIRIN Flow-of-funds Behavioural Model of Green Fiscal Policies and Green Sovereign Bonds
Introduction
Mature economies such as the European Union (EU) are still struggling to get out of the so-called “secular stagnation”. At the same time, climate change was recently identified as an additional source of risk for financial markets and for the real economy (see for instance Carney, 2015, ESRB Advisory Scientific Committee, 2016, Batten et al., 2016). Besides the well-known climate physical risks (Stocker et al., 2013), recently climate transition risks started to be investigated, in particular those related to carbon stranded assets, i.e., assets that are at risk of losing much of their value as a result of unburnable reserves of fossil fuels (McGlade and Ekins, 2015). The realization of carbon stranded assets is expected to increase price volatility of both carbon-intense and renewable energy assets, affecting negatively the former and positively the latter (Fischer, 2015, Lazarus and Tempest, 2014). The reason is that the introduction of market-based solutions to climate change (such as a global carbon tax) aimed at decarbonizing the economy could directly and immediately affect the revenues and thus the assets' value of companies in carbon-intense sectors, and as a consequence the value of the portfolios of investors exposed to them.
Risk transmission from climate change to the financial sector started to be analysed and appears to be substantial (Dietz et al., 2016), with potential systemic ramifications and cascade effects throughout the entire financial network (Battiston et al., 2017). However, capital is flowing in the low‑carbon economy at a much slower pace than needed to meet the 2°C target (Volz, 2017). While current investments in renewable energy reached USD 242 billion (bn) in 2016 (BNEF/UNEP, 2017), the International Energy Agency (IEA) has recently estimated that the retrofitting of the energy sector by 2035 would require investments worthy USD 53 trillion (trn).
Better disclosure of information on climate-related financial risk from the one hand (FSB TFCD, 2017), and the introduction of a stable green policy framework from the other hand (Stern, 2016) are recommended to provide investors the right signals and incentives to invest in a sustainable, inclusive and innovation-based growth. In this context, the role of green policies such as green fiscal and green monetary policies (see for instance Monnin and Barkawi, 2015, Mazzucato and Penna, 2015, Campiglio, 2016), and the introduction of new financial instruments, such as green sovereign bonds, gained attention among academics and practitioners. The political feasibility and the effectiveness of green public policies started to be addressed as well (Rozenberg et al., 2013, Rozenberg et al., 2017, Nemet et al., 2017). However, there is high uncertainty about their design, due to the lack of consolidated knowledge on their direct and indirect effects on the real economy and on financial markets. Moreover, their distributive effects and trade-offs, in terms of income inequality and wealth concentration across economic sectors and social groups, has not been properly addressed yet. Modelling methods based on general or partial equilibrium approaches, such as the Integrated Assessment Models (IAMs), are not able, by construction, to represent a complex system where the presence of cross-sector feedback loops and time delays at the macro-economic level, and heterogeneous short-term thinking agents at the micro-economic level, determines non-linearity and policy uncertainty (Mercure et al., 2016, Balint et al., 2017, Ackerman et al., 2009, Ackerman and Munitz, 2016, Scrieciu et al., 2013). Most important, IAMs don't include a credit and financial sector and omit modern money theory and banks' endogenous money creation (Wray, 2015, McLeay et al., 2014). This means that they are not able to display neither the dynamics of private debt (including the implications on risk creation and diffusion from the credit market to the real economy), nor the role of Central Banks on investors' expectations. Therefore, scholars started to recognize the need for bottom-up and out-of-equilibrium models rooted on complex system science to understand sources of systemic risk emerging from the interaction between climate change, the real economy, the credit and financial markets (Farmer et al., 2015, Battiston et al., 2016b). In particular, Rezai and Stagl (2016) called for the development of a new generation of models in ecological macroeconomics able to integrate the micro-foundations of the models with a meso and macroeconomic level of analysis to better understand the feedback loops between the ecosystem, the real economy and the financial sector.
With the aim to contribute to this stream of research, we introduce EIRIN, which is a Stock-Flow Consistent (SFC) model rooted on a neo-Schumpeterian, evolutionary economics approach. EIRIN features heterogeneous economic sectors and subsectors characterized by adaptive behaviours and expectations (households, firms), heterogeneous capital goods characterized by different resource intensity, a credit sector characterized by endogenous money creation, and a foreign sector. In addition, EIRIN connects these elements with policy agents, such as a government that decides on the fiscal policy and issues green financial products (i.e., green sovereign bonds), and a Central Bank in charge of setting the monetary policy. EIRIN includes some novel elements to the expanding field of the ecological macroeconomics and environmental economics literature (see Dafermos et al., 2017, Lamperti et al., 2015, Ponta et al., 2016, Bovari et al., 2017). First, it endogenizes green technology investments and displays their effects on the changes in green technology adoption and thus on the level of resource efficiency of the production process, on the structure of the real economy, on credit market performance and on income distribution. This solution is alternative to the conventional environmental economic models that adopt a cost-benefit approach through market-based pricing (Stern, 2006, Weitzman, 2009), and are well-known for underestimating the negative externalities of climate change, as displayed by the social cost of carbon, and the distributive effects (see Ackerman and Stanton, 2012, Pindyck, 2013).
Second, it analyses the effects of resource intensive production and consumption on the performance of the real economy (e.g., employment, capital accumulation), of the balance of payments and credit market.
Third, it simulates two different sets of green public policies – i.e. green sovereign bonds vis a vis green fiscal measures – through which the government covers the cost of the introduction of green subsidies. Green sovereign bonds are issued by the government and subsidize firms' green investments, thus they have a clear conditionality associated with their use. Green public policies influence firms' green/brown investment choices, macro-economic performance and credit conditions. In addition, the Central Bank influences investment and consumption's decisions of the economic agents by setting the nominal interest rate. These modelling solutions are important when we want to understand the channels of transmission of different sets of green public policies on the sectors and subsectors of the economy.
The name EIRIN, which in ancient Greek means “harmony, peace”, was chosen because we believe that the goals of economic development and sustainability are not mutually exclusive but could be instead mutually reinforcing under specific policy conditions.
Section snippets
Model Outline
EIRIN is a demand-driven model in the (post-) Keynesian tradition. EIRIN is SFC (Godley and Lavoie, 2007, Lavoie, 2014, Caverzasi and Godin, 2013, Caiani et al., 2015), and adopts a double-entry balance sheet accounting approach (Raberto et al., 2012, Bezemer, 2012) that contributes to increase the transparency and the consistency of results by tracking all the transactions within the economy, by recording all the changes in the stocks of assets and liabilities for each economic sector, and by
Model Scenarios and Results
We have performed a set of simulations implemented using the software Matlab, each running four different policy scenarios. Two scenarios are characterized by no government's intervention, i.e., no public support for green investments. We name them “Business as Usual” and “Coercive Green”. Then, we introduce two scenarios with government's intervention in the form of green fiscal policies and green sovereign bonds, and we name them respectively “Green Incentives/Taxes” and “Green
Conclusions
We have presented an initial version of the EIRIN model and the results of its application to the analysis of two sets of measures through which governments can support the low‑carbon transition, i.e., green fiscal measures or the issuance of green bonds. EIRIN has a peculiar structure that embodies some advantages of SD models, such as the deterministic nature that prevents the risk of over-complexity, and the stocks and flows structure that allows us to identify the causal feedback-loops. At
Acknowledgements
IM thanks Prof. Anthony Janetos of The Frederick S. Pardee Center for the Study of the Longer Range Future for the useful comments and revisions on an earlier version of the draft. IM thanks the IRCRES-CNR for the support to the research at its initial stages. MR thanks The Frederick S. Pardee Center for Global Studies and The Frederick S. Pardee Center for the Study of the Longer Range Future for the financial support during his visit in Boston (USA). IM thanks Stefano Battiston for the
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