WHAT happens to an economy when it is hot outside? Globally, record-breaking temperatures have been witnessed in the past few years. There is evidence that heatwaves dampen economic output, causing GDP losses and exacerbating global inequality. For instance, projections for the US economy show that rising temperatures could reduce economic growth by up to one-third over the next century.

Moreover, the assumption that economic damage from global warming is confined to the agriculture sector is no longer true, as climate change and environmental degradation pose significant risks to the macro economy and financial systems. For example, climate change will affect individual and household income, sectors of the economy, energy markets, inflation variability, financial markets, innovation, and rising public debt, among other things.

While rising global temperatures have a profound impact on economies all over the world, the phenomenon is still poorly understood due to the complexity of climate-related risks and their interactions with the real economy. Scientific studies are being conducted to estimate the impact of global warming on different sectors of the economy. However, there is consensus that macro-prudential measures are critical to mitigating climate-related risks, as without mitigation measures, physical risks from climate change-driven natural hazards — heatwaves, windstorms, floods, and droughts — are likely to increase significantly.

While the marginal effects of temperature rise are different in different regions, persistent increases in global temperature have serious implications for economic growth, productivity, and efficiency. However, the sensitivity of different economies to the impact of global warming depends on their reliance on different sectors of the economy, which can be susceptible to changing temperatures. Thus, climate change will be a critical factor in shaping responses to macroeconomic conditions in the near future.

Climate change can result in economic uncertainty.

Decarbonisation is no longer a matter of choice, as reducing carbon intensity in production processes and energy use is unavoidable to lower carbon emissions per unit of output produced and make production cleaner. Yet, the decarbonisation of economies for net-zero targets will affect both output and inflation, exerting changes in monetary policy and macroeconomic conditions in most countries. So, the key question for economy pundits, especially those from the developing world, is how to reduce carbon-intensive economic activity, without it having consequences for productivity, efficiency, and economic growth.

Climate change can potentially increase inflation and the debt-to-GDP ratio, resulting in economic uncertainty and tighter fiscal and monetary policies, which may lead to lower demand via lower spending and reduced economic activity. The transition to net zero would require the deployment of tools such as tax, subsidy, and regulation, resulting in increasing abatement costs. This can potentially generate relative price shocks, pushing up aggregate inflation, which is likely to necessitate changes in monetary policy, not to mention net-zero transition having an effect on inflation. Furthermore, the structural transformations required for the transition to net zero are expected to alter monetary policy channels.

Since climate change increases the frequency and severity of shocks, it may become very difficult for central banks to regularly read such shocks. In other words, identifying regular shocks — of an unknown nature — to the economy, will complicate the assessment of the monetary policy stance, which will often find itself confronting a trade-off between output and inflation stabilisation. Therefore, macroeconomic po­­licy responses must take into account the impact of ext­re­­me weather events, the decarbonisation of economies, and net-zero transition.

As the impact of climate change is regional and global, it may invoke structural adjustment processes that transcend national borders, thus necessitating assessment of macroeconomic implications and formulation of models that provide insight with regional and sectoral differentiation.

Existing analytical frameworks and macroeconomic modelling tools are inadequate and unsuitable for grappling with the dynamic nature of climate uncertainty and design-informed policy responses. Therefore, policymakers need to review and, where required, improve and align their toolkit to adapt to the new challenges.

Nevertheless, reducing uncertainty and creating an enabling environment to pacify reactions will be highly critical in the future as climate change will remain a major global risk for some time.

The writer has a PhD degree in economics from Durham University, UK. He is director of research programmes for the Social Protection Resource Centre, Islamabad.

Published in Dawn, July 1st, 2024