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Are the Nationally Determined Contributions credible commitments?
Climate change is a global challenge that requires urgent and ambitious action from all countries. Many countries have submitted their Nationally Determined Contributions (NDCs) under the Paris Agreement, which outline their plans and targets for reducing greenhouse gas emissions and adapting to climate impacts. For example, the European Union has pledged to cut its emissions by at least 55% by 2030 and achieve climate neutrality by 2050. China plans to peak its emissions before 2030 and become carbon neutral by 2060. The United States has committed to a 50-52% reduction in emissions by 2030. However, these NDCs are not legally binding and depend on the political will and public support in each country. There is a risk that governments may backtrack on their commitments or face resistance from some sectors of society that are opposed to the low-carbon transition.
Why does credibility matter for the low-carbon transition?
Policy credibility is crucial because it affects private sector behavior and expectations. If firms and households do not trust that the government will stick to its NDCs, they will be less willing to invest in low-carbon technologies and delay their adaptation to a carbon-constrained world. This can make the transition more costly and difficult in the long run. A recent World Bank study on Türkiye’s net zero ambition highlights the importance of expectations regarding the government’s commitment to the low-carbon transition.
Lack of policy credibility will drive up the net costs of the transition
Policy credibility has a significant impact on the carbon tax required to achieve emission targets, private green investment, and GDP. When the policy path is not communicated in advance, the carbon tax required is about 10% higher on average. If the policy commitment is not deemed credible and expected to be reversed, the carbon tax must be around 24% higher. Lower policy credibility leads to even higher carbon tax requirements.
Private green finance follows a similar pattern. Under policy uncertainty, firms are reluctant to invest in green energy and technology. When the carbon tax increase is a surprise or the expected policy reversal doesn't happen, their green capital stock proves insufficient, leading to expensive production and higher market prices. The decline in GDP is also affected by policy credibility. Compared to the fully credible policy scenario, GDP declines almost twice as much in the surprise-reversal scenario. Note that under full commitment a carbon tax will expand GDP in the short run as it crowds in private investment.
This simple exercise shows that policy credibility drives the net economic costs of the low-carbon transition. A recent study at the Grantham Research Institute on Climate Change and the Environment confirms this view. The study assumes that expectations regarding the commitment to a policy depend on the net economic costs of that very policy. It shows that weak policy commitment can trap the economy in a vicious cycle of credibility loss, carbon-intensive investments, and increasing net costs of decarbonization, which may ultimately lead to a failure of the transition.
The importance of policy credibility is not a new concept in economics
Policy credibility has been widely studied in the context of monetary policy, where central banks need to anchor inflation expectations to achieve price stability and avoid costly fluctuations in output and employment. Most importantly, anchoring expectations reduces the need for large changes in interest rates. The same logic applies to climate policy, where governments need to anchor emission expectations around their NDCs. This helps to accelerate the low-carbon transition and minimize its economic and social costs. A key lesson from monetary policy is that institutional arrangements can enhance policy credibility and reduce uncertainty. Central banks can adopt inflation targeting regimes, independent governance structures, transparent communication strategies, and forward guidance mechanisms.
Innovative instruments are available
In climate policy, expectations are even more crucial for guiding long-term investment decisions and fostering innovation. Therefore, governments need to adopt institutional changes that can improve the credibility of their NDCs and signal their commitment to the low-carbon transition. This could involve legal measures such as giving constitutional status or statutory backing to the NDCs, or international treaties such as the carbon club proposed by Nordhaus (2015), where countries agree to impose tariffs on non-members who do not comply with a common carbon price. Another option is to use financial instruments such as sustainability-linked bonds, where the interest rate depends on the achievement of certain environmental targets. For example, Chile issued the world's first sovereign sustainability-linked bond in 2021.
In conclusion, strengthening government commitment to the low-carbon transition and enhancing policy credibility is critical to reduce uncertainty and encourage private sector participation.
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