Climate Change and Macroeconomic Policy
1Prof. Dr. Miranda S. Goeltom
Senior Deputy Governor of Bank Indonesia
Abstract
This paper describes briefly the complexity of problems as well as efforts to mitigate the negative impacts of climate change on the economy from the perspective of macroeconomic policies in emerging countries. The paper argues that the issue of climate change emerges due to imbalances in the structure of global economic development. These imbalances might bring about the risk on global economic growth, higher inflation pressure and financial market vulnerability. Various studies show that the global economy may face a downturn due to increasing pressure stemming from global climate change. A key aspect of the risks posed by
climate change is the damage associated with severe weather events, whose frequency and
severity is likely to increase. Against this unfavorable backdrop, several policy implications could be explored from both global and Indonesian perspectives. In this regards, there is a fundamental thought need to be considered; emphasizing that the policies should be integrated in different sectors and not be instituted to sacrifice the achievement of long-term social welfare.
All countries need to agree that climate change and development goals can and should be pursued jointly; they are not mutually exclusive. International frameworks should recognize the right of nations to increase their living standards, and the common but differentiated responsibilities of developed and developing countries in mitigating the effects of climate change. For this, countries need to pursue effective mitigation at the lowest cost. In this regard, not only unequivocal political leadership of developed countries, but also strong commitment from all countries to prove engagement on climate change, is amongst the fundamental pillars to promote global welfare.
I. IN TRO D U CTIO N
The climate change phenomenon has caught the attention of people all around the world recently. Advancements in research and broader knowledge concerning climate change has unquestionably demonstrated the existence, and to some extent the effects, of global warming in recent times, possibly attributable to the activities of humans with indifference and disregard for the environment, manifested among others in the extensive burning of fossil fuels as well as the widespread misuse of agricultural land. Global warming will be responsible for grave consequences in the near future affecting all aspects of our lives and costing untold amounts of money.
1 Presented at the Bank Indonesia International Seminar on “Macroeconomic Impact of Climate Change:
From a micro perspective, there are an abundance of factors affecting the earth’s climate. The primary influence on our climate certainly stems from the sun’s energy. In addition, a build up of greenhouse and aerosol gases in the atmosphere as well as the specific characteristics of the earth’s surface, which controls how much of the sun’s energy is retained or reflected back into the atmosphere, can also affect the earth’s climate. The concentration of greenhouse gases in the atmosphere, such as carbondioxide (CO2), methane (CH4) and nitrogen oxide (N2O) has increased significantly since the beginning of industrial revolution. With increasing greenhouse emissions, the impact of global warming becomes alarming, both in terms of environmental destruction as well as economic consequences.
Various observations conducted by scientists have shown that air and sea temperatures have risen, the ice caps are melting more and more, and the sea level is rising. An IPCC (2007) report said that from the twelve hottest years recorded since 1850, eleven occurred from 1995-2006. Furthermore, in the past 100 years
(1906-2005) the average global temperature has risen by as much as 0.740
C. To compound matters further, the average global sea level rose 17 cm during the 20th Century,
principally due to the melting of mountain ice and snow as well as the polar ice caps.2
The costs involved in mitigating climate change rely on a plethora of factors, including how fast the global economy is growing in the long term and how fast technological breakthroughs can produce lower greenhouse gas emissions that can be applied to the global economy. A recent report stated that “climate change might cost the global economy $9.6 trillion (USD) by 2100. A rise of just 2 to 3 degrees Celsius in the average world temperature could devastate food crops and shave 3% off global economic output.” (Stern, 2006).
The problems do not stop here. Deteriorating environmental conditions have been exacerbated by the concomitant rise of emerging and developing economies, that have driven up demand for energy for cooling and economic activities, most of which is still sourced from fossil fuels. Against this inauspicious backdrop, carbon emissions produced in the drive to support the global economy have continued to aggravate the
global climate. There are two basic complications. Firstly, new, innovative
technologies that are expected to produce lower greenhouse emissions still face constraints to their mass adoption due to the exorbitant prices involved for such
technology. Consequently, such technologies are less competitive. Second, strong
1
demand for fossil fuels has pushed up the price of world crude oil and gas. As an illustration, in mid 2008, the global price of crude oil was USD 140/barrel, whereas just six months previously the price was around USD 70-80/barrel.
The high price of fossil fuels and the need to curtail its use have encouraged developed countries to institute economic policy to promote alternative energy, so-called biofuels. The other macroeconomic consequences of this policy are very significant. Biofuel, which is derived from vegetable products such as beans and vegetable oils has raised food prices. Put another way, competition has emerged between the food requirement and meeting the alternative energy needs stipulated by government policy. With food supply not expanding to meet additional demand, food prices continue to spiral. This will become a serious issues for the global economy, in particular developing countries, where inflation caused by rising food prices will have direct adverse impacts on people with low, fixed incomes. With most of their income allocated for food, any hike in food prices would detrimentally affect their already difficult lives. Sporadically, cases of malnutrition have been found in families due to their inability to fulfill their nutritional needs.
So far it is clear that climate change not only destroys the environment, but also the economy. This paper will describe briefly the complexity of problems as well as efforts to mitigate the negative impacts of climate change on the economy from the perspective of macroeconomic policies in emerging countries. Following this introduction, the subsequent two chapters will explain the relationship between economic development imbalances and climate change as well as the macroeconomic impacts of climate change. Prior to the conclusion, several economic policy implications from both global and indonesian perspectives will be elaborated.
II. ECO N O M IC D EVELO PM EN T IM BALAN CES AN D CLIM ATE CH AN GE
The issue of climate change corresponds closely to the strategy and structure of global economic development, which creates imbalances in several aspects of the global economy. Such imbalances include: (i) imbalances in the growth of the physical economy and development of the green economy; (ii) imbalances in the pace of global economic development; and (iii) imbalances in the
development strategies of various economic sectors. Inefficacious strategy and the sub-Gross W orld Product, 1950-2007
Chart 1. Gross World Product 1950-2007
Total Energy Consumption by Region
20.000 60.000 100.000 140.000
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 Quadrillion btu
optimal structure of global economic development in maintaining a balance between such aspects continue to accumulate and compound the climate change problems experienced recently.
The overarching influence of the prevailing attitude to prioritize physical economic growth rather than maintain a balance with the global green economy is clear from recent economic developments. This has been reflected in the global economy during the last decade before the expansionary trend (Chart 1). The year 2004 was noted as the highlight of an expanding world economy, which grew by more than 5%. However, CO2 emissions from the combustion of fuel are also mushrooming. This pattern seems inescapable in a world where industrialization continues to play a key role in global economic growth. Therefore, it is safe to assume that the current world development structure disregards environmental sustainability.
However, one should take a look at another facet of economic development. Increasing economic activity has driven demand for resources as production inputs, as well as fossil fuels, for example oil, to ignite the growth engine. Along with geopolitical factors in oil-producing and trading countries, the complex interaction between supply and demand for fossil fuels has pushed up the price of crude oil to historical highs, approaching US$ 150 in recent months. According to the Energy Information Agency, world oil consumption is projected to
grow by almost 900,000 barrels per day (bbl/d) and by an additional 1.4 million bbl/d in 2009 (Chart 2). Increased oil consumption will clearly release more CO2 emissions into the atmosphere. Burning fossil fuels like coal, oil and gas for heat, power and transportation produces CO2. Scientists concur that CO2 emissions are a key contributor to global warming.
The catalyst of such strong global economic growth is inseparable from the robust economic development in developed countries compared to developing countries, and based on several studies it contributes significantly to climate change. This relates to imbalances in global economic growth between developed and developing countries. The IMF (2007) has documented the contributions made by developed countries to the reserves of CO2 (accumulated emissions since 1750). The results indicate that annual emissions from developed countries as of 2004 account for about 75-80% (Chart 3). Latest indications show that several large emerging economies,
Chart 2. Total Energy Consumption by Region
which are experiencing strong growth, have also contributed to the increase in emissions. The IMF study also details emissions per capita, which are about four times as high in OECD countries compared to elsewhere; although relative to GDP, developing countries recorded higher numbers.
Chart 3. Greenhouse Gas Emission by Region
Source: WEO Oct 2007, IMF Source: WEO Oct 2007, IMF
Rapid development in the global economy has generally always been supported more by the industrial sector compared to other economic sectors, such as agriculture and mining. The study results show that the industrial sector is a major contributor to CO2 emissions compared to other economic sectors. Using standard economic sector classifications, emissions from electricity generation in the USA contributed the most to total gas emissions in 2006 (Chart 4). The transportation sector and industrial sector were second and third respectively. However, after being distributed among sectors, the industrial sector accounts for the largest proportion of US gas emissions (Chart 5). A similar story was repeated in Australia and Japan. Based on the 2007 report of Department of Climate Change in Australia, the largest single source of direct emissions was the utilities sector (electricity, gas and water), responsible for 35.5 % of Australia’s total emissions while in Japan, the industrial sector consistently led greenhouse gas emissions among other economic sectors.
Chart 4. Emission Allocated to Economic Sector in US Chart 5. Emission with Electricity Distributed to Economic Sector in US
0
Jun-87 Jun-90 Jun-93 Jun-96 Jun-99 Jun-02 Jun-05 Jun-08 USD/barel
The impact of imbalances in strategy support among economic sectors on climate change has the potential to continue, particularly in light of current global economic problems; namely rising energy prices (Chart 6). This primarily relates to several global strategies to reduce dependence on oil. Dependence on oil has many inherent risks that could exacerbate climate change.
In response to unpredictable future movements in oil prices, many governments have rolled out policies and programs to minimize socio-economic impacts by reducing consumption and dependence on oil. The most notable endeavors taken to reduce dependence on oil (and other kinds of fossil fuels) are through the promotion and use of alternative energy.
Some important alternative fuels (or biofuels) include biodiesel, bio alcohol (ethanol), vegetable oil, non-oil natural gas, and other biomass sources. To increase biofuel production, countries are beginning to grow sugar crops (sugar cane, sugar beet and sweet sorghum) or starch (corn) and use fermentation techniques to produce ethanol; and to grow plants that produce oils, such as oil palm, soybean, or jathropa, to be directly used as fuels or to be chemically processed to produce biofuels. The major driving force behind the development of biofuel production and use stems from the desire to achieve independence from petroleum, to moderate the global oil price, and
to produce environmentally friendly fuel3
.
However, the promotion of biofuels has come under the spotlight due to the significant side effects the production of these alternative fuels is starting to have. The use of food plants to produce biofuels has brought about a significant agricultural shift in resources away from food production to biofuels. Initially, stronger demand for agricultural products to produce biofuels raised food commodity prices and intensified global inflationary pressures (Chart 7). Subsequently, however, the trend of rising food commodity prices aggravated the problems associated with climate change.
3The world initiators in biofuel development and use are United States, Brazil, France, Sweden and
Germany. U.S. Energy Independence and Security Act 0f 2007 that requires the American fuel producers to use at least 36 billion gallons of biofuels in 2022. The European Union in its biofuels directive has set the goal that for 2010 each member state should achieve at least 5.75 % biofuel usage of all used traffic fuel and by 2020, the figure should be increased to 10 %.
Chart 6. Oil Price (Monthly Average)
Causes of Tropical Deforestation 2000-2005
White Rice 5% thailand CPO Corn(rhs) Soybeans (rhs)
Source: Bloomberg
Yet, another effect of sky-high agricultural commodities that requires closer attention is land conversion into arable land in order to maximize profits from the soaring prices of agricultural commodities. A new round of competition between land for fuel and land for food has brought immense environmental impacts on the increase of critical land area. Recent developments include rising demand for palm oil in Europe, which has consequently led to the razing of huge tracts of Southeast Asian
rainforest and the overuse of chemical fertilizer4
. The conversion of tropical forest into arable land has occurred rapidly around the world. This is a result of economic incentives offered by higher international commodity prices. Deforestation is the unwelcome result of several key causes. During the period of 2000-2005, tropical deforestation was attributable to small-holder agriculture (still pose as largest cost), large-scale agriculture, logging and cattle pasture (Chart 8). Economic incentives for the production of food crops have also played an important role in deforestation. Land conversion occurs as a deliberate economic activity to facilitate agricultural expansion for crop production.
4As reported by the International H erald Tribune,
Chart 7. World Commodity Price
Chart 8. Causes of Tropical Deforestation 2000-2005
The time has now come to rethink our priorities. Deforestation (mainly in tropical areas) accounts for up to one-third of total carbon dioxide emissions. It is a clear-cut contradiction to the nature of developing and using of biofuels due to the subsequent rise in crop prices but with a very limited effect on reducing greenhouse emissions and nearly no impact on moderating conventional fuel prices.
III. M ACRO ECO N O M IC IM PACTS O F CLIM ATE CH AN GE
Current global economic performance provides an early warning of climate change impact. Sluggish economic growth, spiraling inflation and uncertainty in financial markets are inseparable from the impact of global climate change; directly and indirectly. The impact of record-high oil prices and the ongoing impact on escalating food commodity prices amidst a range of natural disasters in different parts of the world have undermined the global economy.
Various studies show that the global economy may face a downturn due to increasing pressure stemming from global climate change. This mainly relates to corrections by economic players because of the impact of increasing GHG emissions. The IMF (2008) has indicated that GHG emissions will continue to surge following the impact of GDP per capita growth and the burgeoning world population, despite greater energy intensity actually reducing GHG emissions slightly (Chart 9). However, different adjustments made following the impacts of climate change could lead to differing results, across sectors, countries and regions.
Chart 9. Carbon Dioxide Energy-Related Emission
Source: WEO April 208, IMF
patterns and air pressure. Such conditions will directly influence agriculture, plantations and forestry as well as tourism. Under such circumstances that climate change precipitates natural disasters, productivity will also decline. The effect will be compounded further if intangible issues, such as health and nutritional quality suffer due to the calamity. The contribution of climate change from the supply side could be bigger, if concomitantly, there is population migration to avoid the risks of climate change. Migration could also have significant impacts on overall economic productivity.
On the other hand, climate change may trigger demand shocks (IMF, 2008). Energy consumption is increasing to meet the requirement for air conditioning. At the same time, stronger demand for alternative commodities could also intensify to mitigate the rise in energy commodity prices. This demand shock is also possible if governments respond by increasing spending to minimize the impact of climate change. However, in the mid term, with a lack of budgetary resources, government stimuli in the economy, in particular stimulating economic productivity, will decrease due to budgetary constraints.
In general, climate change will dent global economic growth due to this dominant supply shock. The IMF literature survey (2008), demonstrates that global economic growth will decline in the mid-long term. Three references regarding the impacts of climate change (Mendelson and others, 2002; Nordhaus and Boyer, 2000; Tol, 2002) and the Stern Review (2007), have assessed that GDP will decline by between 0 and 3% for
every 3o
C of global warming (from 1990-2000 levels) (Chart 10). IMF (2008) has acknowledged that the decline in global
economic growth could surpass existing estimations. This is possible if the evaluation includes intangible conditions such as health (due to poor water quality), the spread of disease and air pollution.
Nordhaus and Boyer (2000) show that the impact of climate change is likely to vary across countries, depending on their vulnerability to climate change and ability to adapt to its effects. Declining economic growth in countries with temperate climates will be of relatively less magnitude than that experienced in warmer climate. The differing initial climates in each region will determine the magnitude of the impact of
0
Weight of Food Component within CPI (%)
climate change on economic productivity and growth. Based on region, several studies foresee that developing countries will be influenced first and, cumulatively, will suffer the most compared to developed countries. Africa, South and Southeast Asia (especially India), Latin America and OECD Europe are predicted to face more pressures than other countries (Chart 11). In addition, climate change could also deteriorate the poverty level. In line with the findings on inter-regional impacts, Cline (2007) and Yohe and others (2007) predict that Africa and Asia are particularly vulnerable in terms of the physical impacts of climate change. In these regions, almost 1 billion people may experience water shortages by 2080, more than 9 million could fall victim to coastal floods, and many more could face hunger.
Chart 11. Impact of Warming by Region and Sector
Source: WEO April 208, IMF
The strong impact of supply shocks followed by increasing demand will intensify global inflationary pressures. Inflationary pressures in the medium term are dominantly influenced by declines in the supply of goods and services with a decline in aggregate productivity (IMF, 2008). Food prices will skyrocket if there is a harvest failure due to climate change or natural disaster. Inflation will rise if demand for energy and alternative commodities as well as food commodities strengthens. Pressures will intensify further if the services sector, such as the health sector, raises its service fees due to increased demand.
Recent performance has indicated that food price inflation is a much more significant issue in emerging markets compared to developed markets. This corresponds to the greater weight of food within the
Chart 12. W eight of Food Component within CPI
2
consumer price basket in emerging countries (Chart 12). Subsequently, higher inflation attributable to soaring commodity prices will raise inflation expectations and trigger inflationary pressures on other products (second-round effects). The second-round effect of commodity price hikes has been the rise in core inflation, particularly in developing countries since mid 2007 (Chart 13). Increasing core inflation has comprehensively intensified global inflationary pressures since mid 2007 (Chart 14).
Chart 13. Global Core Inflation Chart 14. Global Headline Inflation
2003 2004 2005 2006 2007 2008
1.0
Index, 2005 = 100 Inflation (% yoy)
Source: Bloomberg Source: Bloomberg
In the case of Indonesia, the impact of commodity price shocks on inflation will be transmitted through both energy and food commodity prices. The spike in the oil price inevitably induced higher inflation through unsubsidized domestic fuel prices. Our preliminary estimations show that oil price elasticity to CPI inflation is around 0.04. This elasticity is an accumulation of the first and second-round effect of oil price shocks. The impact of the soaring oil price on inflation is more severe when the
government cuts its fuel subsidy, as occurred in 2005 (125%) and May 2008 (28.7%)5
. Meanwhile the spike in global
commodity prices will generate higher inflation both through volatility and core inflation (Chart 15). The effect of food prices on core inflation does not only correspond to food and beverages, but will also be transmitted as second-round effects to other commodities. In general, the response of core inflation to global commodity shocks is triggered by
5Inflation in 2005 soared to 17.1% from 6.4% in 2004, while in inflation in 2008 is predicted to reach
around 12%.
Chart 15. Indonesia Core Inflation
increasing inflation expectations as a result of the rising oil price, which play a dominant role in Indonesia’s case.
The slowing down economic growth and inflation pressure potentially deteriorates the fiscal performance. Fiscal deficit could arise due to the weakening of conventional tax base and/or the rise of the expenditure on some item to mitigate as well as to adapt of the risk of climate change. IMF (2007) argued the higher fiscal deficit correspond to the climate change plausibly emerge from the effort to mitigate carbon emission, including higher energy prices and increased investment, as well as the measures to lessen the impact of the climate change both direct and indirect to the poor. Some countries apply this policy by multiply the subsidy and hence enhance the fiscal deficit. For the case of Indonesia, the Government implemented the Compensating Program, by providing direct cash support and food assistance programs to the 40 percent lower income group.
The prospect of an economic slowdown and increasing inflation risk will subsequently increase global uncertainties. Such global uncertainties will, in turn, leave financial market performance quite vulnerable. With increased liquidity and financial market innovations, the changing risks associated with climate change will easily be transmitted to global financial markets, which will eventually place pressure on the goods market. IMF (2008) has shown that risk premia and the global cost of capital may rise as output and inflation uncertainty increase owing to greater intensity and frequency of extreme weather events and increased weather variability.
IV. PO LICY IM PLICATIO N S AN D RESPO N SES
The huge cost of climate change imposed on the global economy has at least
three facets that must be addressed. First, environmental destruction is hazardous to the
sustainability of our lives in general, and the economy in particular. Therefore, we need to reach a set of solutions to forestall any actions that can directly damage the
environment. Second, it is imperative to discourage any activities in all sectors of the
economy that contribute in any way to the destruction of the environment as well as encourage more activities that will be instrumental in reducing the negative effects on
the environment and restore nature’s balance. Third, rising energy and food prices
inevitably contribute to higher global inflation, by raising the cost of production inputs, which consequently hamper global economic growth.
be integrated in different sectors and not be instituted to sacrifice the achievement of long-term social welfare.
In the fiscal sector, for instance, even though the impact of fiscal operations is expected to mitigate the adverse effects of climate change, these policies have to be supported by a firm strategy to promote fiscal sustainability. Meanwhile, in other sectors, such as banking and monetary, the spirit to support the environment has to remain in line with steps to support a solid and robust economy. Most importantly is that there should be consensus among all nations that climate change is a global issue, so that it must be overcome through global management.
4.1. Global policy perspectives
From a global perspective, there are at least two existing issues to be resolved as a priority; how to minimize the effects of soaring international commodity prices and how to mitigate the impacts on particular groups; as well as how to promote environmentally friendly economic policies at both the macroeconomic and microeconomic levels. Therefore, climate change requires global understanding and cooperation. Adaptation and mitigation to climate change should become a critical aspect to shield the poor from its adverse impacts. The financial costs for a developing country to roll out adaptation and mitigation programs for climate change could be extremely expensive; something developing countries are not in a position to afford.
Collective international action may be seen as key to support these efforts across countries. But how far can they go? To answer this question, we may consider two salient global actions to mitigate climate change, namely the Kyoto Protocol and Bali Action Plan. According to the Kyoto Protocol, which was adopted in December 1997 and ratified in February 2005, developed countries must reduce their carbon dioxide and other greenhouse gas emissions (referred to collectively in this paper as CO2 emissions) by specified amounts by target dates. One hundred and thirty-seven (137) developing countries have ratified the protocol, including Brazil, China and India, but have no obligation beyond monitoring and reporting emissions. The United States has not ratified the treaty. Among various experts, scientists, and critics, there is debate about the usefulness of the protocol, and there have been cost-benefit studies performed on its usefulness.
After the 2007 United Nations Climate Change Conference on the island of Bali
in Indonesia in December, 2007, the participating nations adopted the BaliRoadmap
Convention and emphasizing the urgency to address climate change as indicated in the
Fourth Assessment Report of the Intergovernmental Panel on Climate Change6.
It seems that there is still a winding road ahead. According to OECD Environmental Outlook to 2030 (2008), there are several obstacles preventing international policy and actions to mitigation climate change as follows: (i) Fears of adverse impacts on industrial competitiveness. Resistance from affected sectors often challenges the political feasibility of introducing environmental boundaries such as emission standards, targets and green taxes. Many countries face the same hesitation to move toward a low-carbon economy due to the infant technologies of cleaner fuel; (ii) Uncertainty surrounding who should take action and who should bear the costs of action; and (iii) Under pricing of natural resource use and pollution. It is difficult, practically, to accurately calculate the full costs of environmental, health, and productivity damage caused by economic activities. The concept of compensating polluting activities into prices will be distorted by the fact that in most countries the use of scarce natural resources remains under-priced or even subsidized. From the three obstacles mentioned, the central issue is the cost calculation and fair burden sharing for every country in adaptation and climate change mitigation. How large is the cost estimation and how the burden sharing should be implemented remains a hotly debated topic.
4.2. Indonesian Perspectives
Indonesia is blessed with a forest area that accounts for 25% of all forests in East Asia and the Pacific. Indonesia also represents one of the mega-biodiverse countries in
the world.7
Therefore, by taking appropriate actions, Indonesia has the potential to contribute significantly to the region in terms of reducing greenhouse gases (GHG) that many blame for causing climate change. The consequences of ignoring this issue may induce a high economic cost in restoring imbalances in the environment caused by irresponsible choices of procedures in investment projects.
4.2.1. Policy in Banking and Financial Sector
In the banking sector, Bank Indonesia (BI) aims its policy towards supporting the protection of the environment by encouraging banks to invest in businesses that serve
6
The Fourth Assessment Report (AR4) of the United Nations Intergovernmental Panel on Climate Change (IPCC) placed specific importance on assessing the integration of adaptation and mitigation in the field of climate change as well as on the cross cutting theme of sustainable development.
7
to protect the environment.8
BI has the capacity to encourage banks to finance projects aimed at safeguarding the environment such as finding alternatives to fossil fuel energy, recycling waste, reforestation/afforestation, and the preservation of nature. BI has already stipulated in its banking regulations that projects with impacts on the environment should be well designed and supported by environmental effects analyses.
Bank Indonesia Regulation No. 7/2/PBI/2005 dated January 20th
, 2005 and Circular
Letter No. 7/3/DPNP dated January 31st
, 2005 on Asset Quality Rating of Commercial Banks, prescribe that when assessing business prospects, banks are required to evaluate the measures taken by the debtors to conserve the environment. In this case, banks have to pay more attention to the results of the Analysis of Environmental Study (or AMDAL) from the project. It can be seen here an opportunity to amend this regulation further in order to place more emphasis on complying with international standards. Concisely speaking, BI will begin the transition from resource-based to environment-based development.
Moreover, under the framework of risk-based supervision, BI urges banks to be aware of their operational risks, especially related to lending activities to finance projects that have direct or indirect effects on the environment. Banks are required to maintain manageable risk in order to achieve a sound assessment from the supervisors. By ignoring environmental issues, a bank can run environmental risks that link to its operational risk, which in turn can raise overall risk. This should discourage banks from financing projects without sound analysis on the environmental effects and without steps to prevent environmental degradation. In this case, opportunities also exist for private insurance companies in their relationships with ensuring the best practices for banking. The insurance sector has the potential to become an economic agent that sends signals on the price of environmental risks, especially for projects financed by bank lending.
Furthermore, within the financial stability framework, BI considers the surveillance of bank lending for projects that could potentially damage the environment as important. By end of 2007 lending to the Mining and Manufacturing sectors accounted for 23% of total bank lending. This is less than lending to the “Others” sector (29%), which includes loans for consumption, and partly credit for automobiles and motorcycles. It is important to monitor outstanding bank lending that
8 On a lighter note, BI as a public entity has contributed directly in environmental protection activities
could be environmentally destructive, which will enable the authority to oversee the environmental risk contributed by the banking sector. This way BI can observe the banking sector’s overall operational risk related to the environment and help the domestic banking sector comply with international standards governing environmental protection.
From another perspective, one may consider also how financial markes can foster adaptation to climate change. Some arguments state that the financial markets’ capacity to realllocatae costs and risks will help reduce the social costs of adaptation. Two types of financial instruments which are commonly used to respond climate change are ‘weather derivatives’ and Catastrophe bonds. In Asia, not many countries have developed these instruments. Indonesia itself has not been using hedging instruments against weather and catastrophic risks. For a further policy option, traditionally, Indonesia has been adopting a self-hedging policy by strengthening financial system and building financing structure mechanisms to protect domestic economy from the price risks.
4.2.2. M onetary Policy
High inflation due to rising food and oil prices has caused dilemmatic condition for economic growth in Indonesia. On one side, efforts to overcome inflation in the short term can curb economic growth. However, on the other side, economic growth is required to increase the population’s income to guarantee purchasing power. This
condition is in accordance with the existence of Philips Curve in Indonesia that shows
a more inelastic trade-off between economic growth and inflation in the post crisis period (Solikin, 2004). This empirical fact indicates that for demand stimuli not to generate excessive inflationary pressures, demand management policy must be complemented by the mitigation of capacity constraints on the supply side, such as through legal, institutional and infrastructure improvements.
Meanwhile, the increasing independence of central banks (since 1999) and the growing adoption of price stability objectives, often based on inflation targeting, have helped to improve the response of monetary policy, and price-setting behavior more generally, to oil price shocks. In particular, inflation targeting, has helped to anchor inflation expectations among economic agents, preventing temporary inflationary shocks from becoming embedded into a more generalized and enduring increase in the inflation rate.
rates to respond to headline inflation in order to reshape inflation expectations. Furthermore, monetary policy must be vigilant towards any second-round inflationary effects that show up in core inflation (China and Korea). For emerging economies with currencies closely linked to the US dollar, movement towards a more flexible exchange rate regime could also provide greater scope for effective and stable monetary policy action (as China).
4.2.3. Fiscal policy
On the fiscal front, economic and institutional development is perhaps the best means of improving climate-related adaptive capacity. Thus, to be effective in fostering adaptation, development strategies nee to take climate change vulnerabilities into account. In this regard, the Government should be affirmed that fiscal spending should be aimed to guide long term goals, especially alleviating supply bottlenecks— particularly related to infrastructure—that have contributed to inflation pressures. In addition, efforts to reduce the level of protectionism as well as subsidies aimed at stimulating biofuels production and increasing energy conservation not only would help to moderate the growth in energy demand, but also would remove distortions and allow for greater overall efficiency. Another important thing which is also needed is fiscal self-insurance against climate change, whereby government budgets must include room for adaptation expenditures, and social safety nets must be strengthened.
For the case of Indonesia, the social impact of recent oil price shock was estimated by considering the impact of decreased domestic fuel price subsidy (around 30 percent) on household income. It is expected that the decrease in domestic fuel price subsidy will increase poverty level. To contain this impact, on the other front the Government implement the Compensating Program, by providing direct cash support to the 40 percent lower income group. It relies on the fact that recent domestic fuel price subsidy was mostly (70 percent) enjoyed by only 40 percent of a higher income group. Thus, compensating program is expected to shift the benefit subsidy from the higher income group to the lower income group, thus improve income distribution.
4.2.4. Policy in the Real Sector
Meanwhile, considering inflation in the past few years has stemmed from the demand side, the treatment of this problem has to focus on improvements in goods and services world supply. Any trade restrictions that could induce a more limited world food supply amidst persistent strong demand should be short term in nature and applicable only for good reason.
government has set aside budget to support the development of biofuel production and subsidize loans for biofuel development. However, as with other countries, Indonesia also faces the challenge of supplying raw materials for biofuels. For instance, sugar production in 2006 only reached 2.3 million tons, which was still far below domestic consumption of 4 million tons. It would be naïve to convert this production to cover domestic energy needs. Therefore, the government has poured efforts into identifying other commodities that could be used for biofuel production. The government has supported these efforts by issuing a Presidential Decree (Inpres I/2006) involving various ministries and local governments to encourage various institutions to be involved in developing material for biofuels without sacrificing consumption needs. Also, as one of the biggest palm oil producers, Indonesia supports palm oil production by expanding the utilization of palm plantation.
V. CO N CLU D IN G REM ARKS
Climate change has precipitated macroeconomic challenges in numerous countries, especially countries vulnerable to the impacts of climatic change. Thus, sharing integrated economic policies is expected to help mitigate the negative effects. In relation to mitigation steps in order to reduce the spread of climate change and gas emissions, there are several things that can be done in the banking, monetary, fiscal and real sectors. Related to the exploding biofuel industry and the trade of this commodity, it is necessary to have adequate safeguards to avoid any detrimental environmental effects. Besides those steps, some have opined that carbon pricing is also an effective option in creating incentives to mitigate gas emissions. To this end, policies to reduce or even totally remove fossil fuel subsidies, if possible, are crucial to promote efforts to reduce carbon emissions. For that, appropriate energy pricing must be brought to the forefront of global attention. Climate change can help the world focus on this matter.
Reference
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International Monetary and Fund (2008), “Climate Change and the Global Economy”, in World Economic Outlook, (October), pp. 133-189
____________________________ (2007), “Climate Change; Economic Impact and Policy Responses”, in World Economic Outlook (April), pp. 53-68
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