Global | Climate Change and Potential GDP: Far from Neutral

Climate Change and Potential GDP: Far from Neutral, Tentatively Positive if Managed Well

 Under policy inaction, climate change is expected to operate as a negative supply-side shock to potential output. However, with effective adaptation and an orderly clean transition, it can become a long-run tailwind. Nevertheless, the balance between headwinds and tailwinds is highly uncertain and scenario-dependent.

Why climate change matters for potential GDP. Climate change affects potential GDP through all three production-function inputs: capital, labour, and Total Factor Productivity (TFP). Chronic changes in temperature, precipitation, and sea levels, together with more frequent extreme events, act as a negative supply-side shock by raising capital depreciation, reducing effective labour force, and lowering productivity. At the same time, climate policies, adaptation measures reshape investment, labour allocation, and innovation incentives (Table 1).

Headwinds dominate under inaction. There is a broad consensus that unmitigated climate change lowers potential output. Estimates for global GDP losses typically cluster around a few percent by mid-century, with much larger losses by 2100 (under high-emissions scenarios and very fat downside tail risks). Results vary widely depending on whether climate is modelled as a level or growth-rate shock and on the treatment of extreme events and tipping points.

Well-managed transitions can turn into tailwinds. Well-designed, early, and credible mitigation and adaptation strategies can partly offset, and in some scenarios slightly outweigh, climate damages in the long run. Integrated climate-growth strategies work through higher green investment, faster capital renewal, reduced exposure to fossil-fuel shocks, and innovation spillovers, namely crowding in private investment and fostering economy-wide productivity. However, the positive long-run gap relative to baseline would typically be smaller and more uncertain than the negative gap associated with unmanaged climate change (Figure 1).

Scenario dependence and asymmetries. Potential output paths diverge sharply across climate and transition scenarios. Faster transitions usually entail modest medium-term costs but deliver higher long-run output once avoided damages are accounted for. Regional impacts are highly asymmetric: low-income and climate-exposed economies face much larger losses, while some higher-latitude economies may see limited or temporary gains.

Policy framework implications. For central banks and policymakers, an important challenge is the incorporation of climate risks and transition scenarios into the estimation and forecasting of potential output. The literature provides methodological building blocks rather than a unified approach, reinforcing the case for scenario-based analysis instead of point estimates of climate-adjusted long-run GDP.

Overall, unmanaged climate change is likely to result in a large and widening negative gap in potential GDP relative to baseline, whereas early, ambitious, and well-managed mitigation and adaptation strategies may generate a more gradual positive uplift in the long run, with economy-wide spillovers through innovation and private capital investment. The specific quantification of both negative and positive effects is subject to considerable uncertainty.

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