Macroeconomic effects of implementing climate change mitigation policies in Chile

An edited extract from World Bank’s report, ‘Green growth opportunities for the decarbonization goal for Chile’, which is based on the macroeconomic effects of implementing climate change mitigation policies in Chile 2020.

The study presents the results of model simulations showing the macroeconomic effects of the implementation of key climate change mitigation policies in Chile, aimed to reduce CO₂ eq emissions in accordance with Chilean latest NDC and a target of zero net CO₂ eq emissions by 2050. By using a multi-sector macroeconomic general equilibrium model, the study shows that the implementation of the proposed policy package could have an overall positive impact on the economy both in the short and long run, as measured by the effect on economic indicators such as GDP, and ensures decoupling of growth from fossil fuel use. Per the analysis, the expected level of GDP by 2050 could increase up to 4.4% when compared to the baseline scenario, which corresponds to a higher rate of growth of 0.13 p.p. Main contribution to GDP is expected from increased private consumption and investment, with an estimated 2.4% and 1.7% respectively. Since positive economic and financial implications could arise from the implementation of the proposed mitigation package, the unsolicited participation of the private sector could be expected and enhanced. Remaining questions and discussions from the study relate to limitations for the uptake of mitigation measures sooner than long term scenarios. Lack of enabling conditions and current restrictions to public-private sector engagement could prevent a smooth and spontaneous transition, including the risk of various market and government failures. Future analysis is needed on how to ensure financing of proposed mitigation measures, how to reduce political economy constrains and investment risks, and the evaluation of instruments needed for the implementation of the climate targets and related work plan.

The study evaluated the macroeconomic impact of implementing a mitigation package aligned with the achievement of the recent updated Chilean NDC and committed zero net CO₂eq emissions by 2050. The study assessed the impact on value added for the economy, the sectoral activity, the demand side of the economy, and the implications of delaying implementation and varying the costs of the mitigation package. The results for main macroeconomic indicators are positive, showing that the decoupling of economic activity and emissions is possible. The proposed mitigation package could yield a reduction in the use of fossil fuels and the corresponding emissions in main sectors for Chile.

The sensitivity analysis shows that a lag in the introduction of measures puts the achievement of net-zero emissions in 2050 at risk, highlighting the importance of acting now. The study also shows that overestimation of OPEX savings values could have a higher impact on emissions and GDP level than the underestimation of the necessary capital expenditures. It is important to also highlight assumptions and biases behind the modelling exercise. As input to the economic model, mitigation measures are simulated independently, losing the possible interactions and their effects. Results may change depending on the type of financing, budget closure and CAPEX – OPEX information. In addition, the baseline data for the model was built prior to the social unrest that began in October 2019, and more recently, the impacts of the COVID-19 pandemic. Therefore, the simulations in the study should be considered as a reference tool for understanding the impacts of climate mitigation policies on macroeconomic variables. The study acknowledges a degree of uncertainty on capital costs associated with each measure and would require periodic updates to be able to be used as a systematic tool in the selection of mitigation measures.

Introduction

The Chilean government has shown significant political will to implement climate change mitigation actions, which will enable the country to fulfil its commitments regarding reductions in greenhouse gas (GHG) emissions. These obligations are set in different initiatives, like the Financial Strategy on Climate Change and the revised Chilean Nationally Determined Contribution (NDC), which aims to reach a target of zero net emissions by 2050. The government has developed and updated a set of intervention measures which encourage emission reductions across the entire economy (Ministry of Environment, 2020). Implementing such policies requires a thorough economic analysis and understanding of their costs and consequences (Krogstrup & Oman, 2019). Since these policies are significant from the point of view of the economy, their full cost goes beyond the simple sum of the expenditures. Required policies usually involve fundamental changes in the structure of the economy, and therefore should be assessed strategically with tools that consider multiple interlinkages between various actors of the economy: government, consumers, firms in different sectors and trade with the rest of the world. Conducting such an assessment can shed light on the possible positive or negative macroeconomic consequences of these actions, while helping identify the winning and potentially losing sectors, and thus; helping ensure public support and enabling conditions for their implementation (IMF, 2019).

During the last decade, the Chilean government, universities and research centers have engaged in assessments of mitigation measures related to climate change (Palma et. al, 2020). The Mitigation Action Plans and Scenarios (MAPS) Chile project began in 2012, to study and deliver the best options the country had for mitigating GHG emissions. The output included the 2013-2030 GHG emissions baseline, mitigation measures and scenarios, together with an analysis of the macroeconomic effects associated with the different scenarios. A description of this process, the implications for the energy sector and the revised National Determined Contribution (NDC), are analyzed in Palma et. al (2019). The purpose of this report is to update the macroeconomic analysis of the new set of mitigation measures. The study aimed to assess the measures considered for the revised NDC and the carbon neutrality commitment along with the updated economic circumstances and projections that were in place by the newly revamped Chile NDC.

This study is based on similar work done for Mexico in 2016. Veysey et al. (2016) estimated that the mitigation costs for the country to implement measures to reduce emissions by 50% in 2050 with respect to 2000, could range from 2% to 4% of GDP in 2030, and from 7% to 15% of GDP in 2050. Similar studies by Tober et al. (2016), estimate that using carbon tax as a mitigation measure could have either negative and positive effects on GDP for Latin American countries, depending on the macroeconomic models used. Lefèvre et al (2018), suggest that Brazil could maintain oil production levels with a deeper decarbonization according to its NDC, and aligned with a 2°C emission pathway, with a small loss in GDP by 2030. The higher cost implications here in comparison with our results may be due to several factors, such as the evaluation of impacts in countries with different energy matrices (Mexico is an oil-producing country, for example) and different sets of mitigation measures, among others.

Chilean GHG emissions and mitigation measures

GHG emissions

Chile’s recently submitted NDC provides a set of mitigation actions that seek to reduce CO₂eq emissions from a wide range of economic activities. According to the 2016 GHG inventory from the country, the main CO2eq source sectors are Electricity and Transport, mostly due to the use of fossil fuels.

Chile has recently committed to the bold action of reaching carbon neutrality by 2050, with an ambitious NDC for 2030 as a step in the process to reduce 45% of net emissions, as stated in the recent revamped NDC. To achieve this neutrality, the ministries of Energy, Environment and Agriculture, have proposed several measures that aim to reduce CO₂eq emissions and to increase its capture. These measures are aggregated by category in the figure below, which illustrates their projected contribution. Sustainable Industry, the inclusion of Hydrogen into the energy matrix, Electromobility, Sustainable Building and the phase-out of coal-powered electric plants will play a major role, accounting for 93% of the projected CO₂eq reductions.

The figure shows the abatement costs curve, illustrating that some measures will imply savings, while in order to achieve neutrality it is needed to include measures that will have a high cost per ton of CO2eq reduced. From the previous five identified measures only coal phase-out is projected to have positive abatement costs.

Mitigation measures

The ministries of Energy, Environment and Agriculture have estimated that the net present value of the investment required to carry out these measures is around US$48.600 million. However, their estimates about the operational and maintenance expenditures represents savings of about US$80.100 million, giving a direct net gain of US$31.500 million. The details aggregated by category of measure are shown in the table below.

On the one hand, there are three categories that yield a negative net present value: Phase-out of coal-powered plants, Electromobility and Keeping Forestry Captures. On the other hand, Sustainable Building, Hydrogen and Sustainable Industry policies are projected to have a net present value of over US$9.000 million. Yet, the total CAPEX of the mitigation package adds up to an average 1.1% of the projected GDP and 5.3% of the projected Gross Fixed Capital Formation (GFCF), as summarized in the table below, which sheds light on the relevance of a macroeconomic evaluation of their effects and how it is going to be financed. Indeed, a hypothetical and extreme scenario in which there is no private investment, shows that this package implies an additional 31.3% of public investment. However, according to the Ministry of Energy, electromobility measures and others consider a significant amount of private investment that reduces the public share required to finance the measures. Thus, according to the Ministry of Energy estimates, public investment will need to account for around 26% of all CAPEX (in present value).

Despite this assessment of the measures, there is huge uncertainty around the effectiveness and opportunity of the measures. The package of measures has not considered ex-ante fiscal tools, or regulatory actions to enforce neutrality. However, a climate change bill targeting and mandating neutrality is currently under discussion in the National Congress.

The policies identified as the most cost-effective to reach carbon neutrality in 2050 will introduce changes in the energy, transport, industry and residential sectors mainly. These changes will have, among others, macroeconomic effects that we aim to analyse through this report.

Results

Reference simulation results – electricity sector

The study provides an analysis of the effects of the intervention package on selected sectors considered to be main emitters of carbon dioxide. Overall, the intervention package is successful in decoupling growth from fossil fuel use.

Most of the interventions in the policy package assume the electrification of selected industries, which results in increased demand for electricity at the expense of reductions in fossil fuel use. The electricity sector as a whole could, therefore, experience an increase in demand, which counterbalances some of the decarbonization efforts conducted in the electricity sector. Overall, fossil fuel electricity generation might experience a slight drop, whereas value added of electricity produced from renewable sources could increase by up to 12% in 2050.

Comments and future work

The study intended to update, re-calibrate, and develop a macroeconomic model for Chile to be used in the assessment of mitigation interventions proposed to comply with the recent updated Chilean NDC, and to achieve committed zero net CO₂eq emissions by 2050. Using the CAPEX and OPEX estimated and provided by the Ministries of Environment and Energy, the study assessed the impact on value added for the economy, the sectoral activity, the demand side of the economy, and the implications of delaying implementation and varying the costs of the mitigation package. Overall, Chile is a prime example of a country which can greatly benefit from a sustainable transition to a green economy. The results for main macroeconomic indicators are positive, showing that the decoupling of economic activity and emissions is possible.

Results show that under the proposed mitigation package, GDP growth could increase at a rate 0.13 p.p. higher than in the baseline scenario, resulting in an increase of 4.4% of the GDP level by 2050. This is due to increases in value added of investment, private consumption, public consumption, and a higher reduction of imports than exports. The proposed mitigation package could yield a reduction in the use of fossil fuels and the corresponding emissions in main sectors, with a remaining 4.5 Million tons of CO₂eq emissions left to achieve neutrality. Higher demand for electricity boosts value added of renewable sources and a moderate reduction in emissions in the generation sector. Sensitivity analysis shows that a delay in the introduction of measures puts the achievement of net-zero emissions in 2050 at risk, widening the gap by approximately 2.4 Million tons of CO₂eq, which is an increase by 50% relative to the gap estimated for the reference scenario. Furthermore, results show that overestimation of OPEX savings values has a higher impact on emissions and GDP level than the underestimation of the necessary capital expenditures.

Several caveats need to be considered when analyzing the results presented in this report. First, the baseline is built with the macroeconomic scenario before October 2019. Second, regarding the nature of the model, mitigations measures are simulated independently losing the possible interactions and their effects, and results may change depending on the type of financing, budget closure and CAPEX – OPEX information. Therefore, there are inconsistencies between National Accounts data and the approach used by experts to construct OPEX data, and apart from sensitivity analysis, the study does not vary parameters or assumptions that change CAPEX, OPEX, and baseline emissions.

The results presented in this report show the overall macroeconomic effect of the implementation of the intervention package. While this impact is positive, this analysis could be enhanced and implemented with more in-depth research on several, more narrowly defined issues. For example, the transformation to a carbon-neutral economy will generate winners and losers in the economy. The identification of losing actors and ensuring their support for the economical transformation is crucial. Export oriented industries, primarily mining of natural resources, stand out as possible losers. Furthermore, there is a high chance that the price of energy carriers could also increase, especially if a carbon tax is introduced to supplement the intervention package. This increase, together with transitions on the labor market, might induce understandable resistance from the general public. It is therefore crucial to fully understand the redistributive impacts of the proposed policies using, for example, microsimulation modelling based on household budget survey data. In order to ensure public support and clear benefits, research on various co-benefits of a green transformation should be conducted, for example highlighting the health benefits of reduced air pollution.

Moreover, the study has not analysed the way the measures of the mitigation package will be financed. Since positive economic and financial implications arise from implementing the mitigation package, the unsolicited participation of the private sector is expected. However, one question for further research that prompts is why these measures are not expected/or have been promoted to be carried out in the baseline scenario? There are several restrictions that may prevent such a smooth and spontaneous transition. There are market and government failures which may hinder a pure market provision of mitigation, as summarized by Krogstrup & Oman (2019). These failures can take the form of common pool and free-rider problems, time inconsistency (such as short-termed decision making), governance problems and interactions with regulation and accounting standards, incomplete and imperfect capital markets, collective action issues and capture by interest groups, and inability to commit. The study recommends to undertake a deep analysis of how each of these hurdles may affect the different measures in order to provide the appropriate mitigation policies. Lessons learned from this exercise are the macroeconomic impacts of sectoral proposed policies in Chile. Further questions should include how to determine the better tools and mix between public and private sector in the implementation of the policies. Complementary work to this first quantitative attempt must go beyond the political economy and management of the implementation of decarbonization plan to achieve the net-zero goal on 2050. For that, endeavor theory and data-driven evidence, like is presented in this work, must contribute to the development and implementation of better public policies to ensure Chile can deliver its ambitious climate change policy.