Explainer: How climate change affects the federal budget

If climate change gets a mention, it’s usually in relation to relatively small expenditure items – for example, last year’s federal budget included a $1.6 billion package of emissions reduction initiatives and $210 million to establish a new climate intelligence centre.

Yet climate change has a much bigger impact on the budget both now and into the future. Here’s how.

Here and now: the health and rebuilding costs of more frequent and severe natural disasters

The most immediate human and financial challenge from climate change is the increasing frequency and severity of natural disasters.¹ Natural disasters impose substantial costs on the Australian economy – and these costs are growing rapidly.² The Federal Government has a role in funding support to those affected as well as cleaning up and rebuilding after natural disasters. Many of these immediate costs could also be reduced by more effective policy on adaption,³ and stronger emissions reduction policies would help to avoid larger costs down the track.

Under an agreement struck in 2018, the Federal Government covers hardship and distress payments to individuals affected by natural disasters and shares the costs of replacing essential infrastructure with the states and territories. These amounts vary with the scale of natural disasters, but for the Black Summer bushfires totalled $1.5 billion,⁴ and for the recent floods in Queensland and NSW are expected to exceed $1 billion.⁵ These costs are expected to keep rising, even in a scenario where emissions are constrained.⁶

A flow-on effect of more natural disasters is that more people are priced out of home and contents insurance.⁷ The Federal Government has tried to ameliorate this through a reinsurance pool for northern Australia,⁸ but as extreme weather becomes more common, more and more areas will have the same problem, increasing pressure on the Federal Government to be the insurer of last resort.

The health system is also feeling the effects of climate change. While no figures are available for directly-attributable costs, we can get some idea by looking at the Black Summer fires: about $2 billion in extra costs for the health system from premature deaths, emergency department attendance, and hospital admissions just from smoke exposure.⁹

Coming soon: declining revenue from fossil fuels and an infrastructure super-cycle

Australia’s fossil fuel industries have been an important source of income for governments.

Demand for fossil fuels contributes to the federal budget, through royalties on offshore oil and gas, the Resource Rent Tax, fuel excise, and import duty on imported fuels.¹⁰ In 2020-21, this revenue (excluding import duty) totalled $19.2 billion. Some of it flows back out again – for example, two-thirds of offshore oil and gas royalties go back to the states, and $7.6 billion was returned to diesel users as a fuel tax credit. Once we account for these flows, roughly $11.2 billion of revenue remained in 2020-21 – slightly less than what the Federal Government spent on higher education.¹¹ However, as the world increasingly commits to net zero, declining demand and therefore declining government revenues from these sources are inevitable.

Meanwhile, the unprecedented transformation of the Australian economy, particularly the energy sector, is likely to trigger an infrastructure super-cycle. We will need transmission lines, roads, railways, bridges and ports, and many more renewable electricity generators, batteries, and long-duration electricity storage such as pumped hydro. And it all needs to be built in less than 30 years if we are to meet our target of net-zero by 2050. Many of these costs will be spread across all of us as consumers, but where they relate to common-use infrastructure, they tend to be paid for by governments. As yet, the government has not published an assessment of the likely infrastructure costs of the transition to net zero. Now would be a good time.

The Federal Government will also need to maintain or increase its current spending on climate change mitigation and environmental protection, both to meet voter expectations and to meet policy goals. This means increased spending on energy innovation, emissions reduction programs, threatened species and biodiversity, and many other areas.

Ratcheting up: the many other ways climate can affect the federal budget

Beyond the direct impacts, there are a range of other ways that climate change will affect government finances – and many of these are ratcheting up over time.

First, uncertainty around climate change and its impacts adds to risk and operating complexity for Australian business. This will increasingly impact investment decisions and profitability, which flow through to the federal budget in the form of company tax receipts.

Australian firms are also likely to face increasing challenges accessing global capital markets as the push for disclosure of climate risks takes hold. The dominance of ‘high risk’¹² sectors in the Australian economy and our international ‘laggard’ status in terms of emission reductions commitments¹³ compound these challenges.

Some industries will be hit sooner and harder than others – including Australia’s agricultural production, coal and gas exports, and financial sectors – but no sector is immune. Together, Australia’s highest-risk sectors contribute more than a quarter of GDP.¹⁴ These sectors will need to adapt to a net-zero world – and those businesses that do this successfully will ultimately contribute to government revenues.

Government finances are also vulnerable on the spending side, with pressure on governments to ‘rescue’ struggling industries and ‘save’ jobs, whether or not they have a future. Seizing new business opportunities in areas such as clean hydrogen and green steel will probably require Australian governments to provide clear direction and heightened ambition for the transition to net zero.

Second, climate change will increasingly affect our health. More frequent, more intense, and longer-lasting natural disasters means more lives lost, more injuries, and other physical and mental health problems.¹⁵ This increases the cost of providing healthcare as well as reducing people’s participation and productivity at work. To take just one example, by 2061, NSW is expecting to lose up to 2.7 million days of work every year due to the higher frequency and intensity of heatwaves.¹⁶

Third, climate change could increase the cost of government debt. Climate vulnerability has already raised the average cost of debt in climate-vulnerable developing countries.¹⁷ A recent study estimated the effects of climate change on sovereign credit ratings for 108 countries, warning of the potential for climate-induced downgrades as early as 2030 for countries not pulling their weight on emissions reduction.¹⁸ Australia is among the countries expected to be hardest hit by downgrades, although our comparatively low level of government debt gives us some protection.¹⁹

Moving to account for climate risk

A head in the sand approach to the risks of climate change for public finances is no longer feasible.

The cumulative fiscal effects are large and growing. The German government estimates climate risks are roughly equivalent to the burden of an ageing population on the long-term budget position.²⁰ Closer to home, the NSW intergenerational report found that by 2060, the NSW economy would be more than $8 billion dollars a year smaller under a high warming scenario compared to a scenario where warming is limited to 1.5⁰C,²¹ with flow on effects for government revenues and spending.²²

Ignoring these costs means systematically underestimating structural budget challenges, further pushing costs to future generations. It also impedes the ability of government to effectively manage these risks and make trade-offs between different interventions. Indeed, businesses are investing in understanding their climate risks (in response to growing regulatory and investor demands) for exactly this reason.

There are several things that the Federal Government can and should do now to improve its understanding of the fiscal risks from climate change.

First, include some of the immediate downside risks of climate change in the Statement of Risks published in each budget. The statement highlights the sensitivity of budget projections to some external shocks such as movements in the terms of trade. Including estimates of the health and rebuilding costs from a severe natural disaster would highlight the budgetary consequences of these occurrences.

Second, adjust the medium-term fiscal projection models to factor in the effects of declining revenue from fossil fuels, higher cost of debt, and higher expenditure on health and natural disaster supports. The Parliamentary Budget Office would be well placed to undertake this work.

Third, model the longer-term impacts of climate change on the budget to inform the next Intergenerational Report in 2025. It makes no sense to carry out a projection exercise looking at budget challenges forty years into the future without factoring in the effects of climate change. The NSW Government has made progress in its latest intergenerational report and the Federal Government should follow suit.

Climate change ultimately challenges governments to reconsider their fiscal strategy. The many climate-related uncertainties make a strong case for preserving fiscal flexibility and firepower to cushion the direct impacts of climate change, including natural disasters.²³ But it also highlights the importance of investing in emissions reduction to avoid the worst effects,²⁴ and investing in areas such as education that improve economic flexibility.²⁵ To determine the best fiscal strategy for Australia, the Federal Government will need much better data on the fiscal effects of climate change.