When policy-makers set high targets but fail to commit to them, they create a cycle of credibility loss and increased transition risks. A new study by CMCC researchers shows how this negative feedback loop leads to policy backfiring, particularly when it comes to investment decisions made by companies based on their beliefs on future carbon prices.

As international pressure for governments to decarbonise mounts we have grown accustomed to ambitious mitigation announcements being made without a clear roadmap on how they will be achieved. The question is, how detrimental is this to decarbonisation plans and how does it influence the investment decisions and behaviour of companies?

A new paper, written by CMCC researchers, explores how the credibility of climate policy announcements, such as emissions targets, affects the transition to a green economy, highlighting the risks associated with policy-makers’ weak commitment to climate policy targets, which can negatively impact this transition.

“While ambitious climate targets are necessary for a successful transition, they can backfire if policy-makers partly default on them,” says co-author of the study Roberta Terranova. “It is essential for policy-makers to balance ambition with commitment to effectively drive the green transition.”

The paper reveals that the transition to a green economy is hindered not only by unambitious climate policies but also by failure to meet ambitious ones. In fact, when policy-makers set high targets but fail to commit to them, they create a cycle of credibility loss and increased transition risks.

The paper introduces several innovations including incorporating aspects of firms’ bounded rationality and diverse expectations in a transition model; quantitatively analysing how the lack of credibility in climate policies impacts the transition; and a study of the relationship between the ambition of climate policy targets and the commitment of policy-makers to these targets.

“Our work bridges two traditionally separate areas of research: transition modelling and the modelling of heterogeneous expectations using discrete choice modelling,” explains Terranova. “By combining these fields, we draw parallels between long-studied issues in monetary policy, such as policy credibility, and the challenges of the green transition.”

Considering the credibility of climate policies and the boundedly rational nature of firms is crucial and often overlooked, but these factors must be accounted for when setting climate policies if they are to be successful.

“Identifying optimal climate policies is essential, but it is equally important to ensure these policies are credible. This study realistically models firms’ responses to climate policies, considering their bounded rationality and diverse expectations. By incorporating these aspects, we can assess the significance of policy credibility in achieving effective climate action,” concludes Terranova.

Further information:

Emanuele Campiglio, Francesco Lamperti, Roberta Terranova, Believe me when I say green! Heterogeneous expectations and climate policy uncertainty, Journal of Economic Dynamics and Control, Volume 165, 2024, 104900, ISSN 0165-1889, https://doi.org/10.1016/j.jedc.2024.104900