How piecemeal carbon pricing affects cross-border lending

IN JUNE THE IMF made the latest of many calls from economists for a market-oriented policy to tackle climate change. “Carbon pricing...is the least-cost option to deliver deep emission cuts,” it argued in a paper written ahead of a meeting of the leaders of the G20 group of large economies. Carbon taxes, as this newspaper has long argued, can be a powerful way to force polluters to pay for the harm they do to the environment by burning fossil fuels.

With the political will for a global tax lacking, many places are going it alone. The World Bank reckons that 45 countries and 34 subnational jurisdictions have adopted some form of carbon pricing, ranging from taxes to emissions-trading systems. But these schemes cover only about a fifth of global greenhouse-gas emissions. New research shows that such piecemeal progress can have unintended consequences.

A recent paper by Luc Laeven and Alexander Popov of the European Central Bank, published by the Centre for Economic Policy Research (CEPR), analyses data on more than 2m loan tranches involving banks doing cross-border lending between 1988 and 2021, during which time many countries imposed carbon pricing. The authors find that carbon taxes at home led banks to reduce lending to coal, oil and gas companies domestically, but also had the perverse consequence of causing them to increase such lending abroad. The effect, they write, is “immediate” and “economically meaningful”. The shift was most pronounced for banks with big fossil-fuel-lending portfolios, and loans were most likely to be directed towards countries lacking a carbon tax.

This conclusion comes on the heels of a related CEPR paper which found that banks increase cross-border lending in response to stricter climate policies at home, with the effect more evident for banks with previous experience of international lending. Steven Ongena of the University of Zurich, one of its authors, argues that banks “use cross-border lending as a regulatory-arbitrage tool” by shifting dirty loans to countries with laxer climate policies.

The findings suggest that cracking down on carbon is a bit like squeezing a balloon. Press too hard all at once and it may pop, but squeeze only in one corner and the air will simply flow to where there is less pressure. Such effects also mirror concerns about leakages in industrial markets. The EU’s carbon-pricing scheme used to grant exemptions to heavy emitters, for fear that they would otherwise move production abroad. Now, as the EU looks to close those loopholes, it is considering a carbon border-adjustment mechanism to level the playing-field.

Yet domestic carbon pricing is still a policy worth pursuing, says Tara Laan of the International Institute for Sustainable Development, a think-tank. Messrs Laeven and Popov conclude that, even after accounting for their efforts to shift dirty lending overseas, carbon taxes do somewhat reduce net fossil-fuel lending by the banks studied, because they lower domestic lending by more. Uday Varadarajan of RMI, another think-tank, agrees, but points out that supplementing domestic carbon-pricing policies with measures to discourage leakage, say by urging greater transparency, could boost the impact of carbon-pricing schemes.

The best solution, of course, would be worldwide adoption. The IMF suggests that high-emitting countries start by embracing a modest carbon “floor”, in order to provide a stepping stone to a global price. As the evidence of perverse consequences arising from localised pricing schemes mounts, the main task for policymakers is to orchestrate a global squeeze. ■

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