Global Economic Impacts of Climate Shocks, Climate Policy and Changes in Climate Risk Assessment

Roshen Fernando, Weifeng Liu and Warwick J McKibbin

Abstract: This study assesses the global economic consequences of climate-related risk in three broad areas: (1) the macroeconomic impacts of physical climate risk due to chronic climate change associated with global temperature increases and climate-related extreme shocks; (2) the macroeconomic effects of climate policies designed to transition to net zero emissions by 2050 (transition risk); and (3) the potential macroeconomic consequences of changes in risk premia in financial markets associated with increasing concern over climate events.

We consider four widely used climate scenarios (Representative Concentration Pathways, or RCP), and identify the physical damage functions due to chronic climate risks. The chronic climate risks include sea-level rise, crop yield changes, heat-induced impacts on labor, and increased incidence of diseases. We also estimate the future incidence of climate-related extreme events, including droughts, floods, heat waves, cold waves, storms and wildfires, based on climate variable projections under the climate scenarios.

After translating physical climate shocks into economic shocks to labor force and sectoral productivity, we investigate the macroeconomic consequences under the climate scenarios using the G-Cubed model. The results demonstrate that physical climate risk is likely to cause large economic losses in all RCP scenarios, both through chronic climate change and extreme climate shocks.

We then explore the impact of country-specific economy-wide carbon taxes as a representative policy action to drive the global economy to achieve net-zero emissions by mid-century. Transition risks vary according to the ambition and the design of policies to reduce emissions. The results demonstrate that there can be potentially significant costs associated with policies to reduce emissions, and the costs differ across sectors and across countries.

We also address whether changes in climate risk perceptions can significantly impact the real economy through changes in risk premia in financial markets. We calculate shocks to financial risk premia based on relationships between historical climate shocks and changes in financial market risk premia. We apply these shocks to risk premia under the RCP scenarios and find that the cost of rising risk premia can be of a magnitude consistent with historical experience. The cost appears to be smaller than the economic costs of changes in physical climate risk and transition risk.

Keywords: Climate change, Extreme events, Climate shocks, Climate risk, Macroeconomics, DSGE, CGE, G-Cubed