Research

I present a dynamic politico-economic theory of fiscal policy focusing on public investment in policies aimed at mitigating emissions and environmental harm. This theory is embedded in an overlapping generation model, emphasizing an inherent intergenerational conflict within climate policy. While the bulk of the responsibility and costs of curbing climate change fall on present generations, the primary benefits will manifest for future generations. Addressing this mismatch, recent literature proposes financing environmental policy through debt instruments, specifically climate bonds.

In the model, governments finance both pollution abatement and other public goods through a combination of taxes and debt. Fiscal policy is determined through periodic elections. I analytically characterize the Markov Perfect Equilibrium of the dynamic game played out among successive generations of voters. Notably, current governments are unable to constrain future governments in terms of their future spending composition. Furthermore, they have no explicit interest in the utility of future generations. Consequently, merely increasing resource availability through debt does not guarantee heightened spending on environmental policy. Paradoxically, I show that access to debt, in the absence of other constraints, decreases funding for abatement, leading to future government impoverishment and exacerbating pollution in the long term.

Nonetheless, a well-designed framework for climate bonds can effectively curb pollution both in the short and long term. By mandating a proportion of debt proceeds for abatement purposes, climate bonds can stimulate abatement efforts and enhance the welfare of future generations. Intriguingly, the impact of this policy on abatement is non-monotonic concerning the allocated portion of debt. To validate my model, I calibrate it using macroeconomic data and key aspects of the DICE model, encompassing emissions and abatement technology. Remarkably, appropriately tailored climate bonds can potentially reduce emissions by over 20% and increase lifetime utility by 38% in consumption equivalent units in the long run.