Financing the green transition through public debt is possible
It’s like trying to square the circle on a budget: how can we both invest heavily in the green transition and keep debt under control to regain financial flexibility? Under certain conditions, both are possible at the same time. Find out how.
Mouez Fodha, University of Paris 1 Panthéon-Sorbonne; Léa Dispa, Aix-Marseille University (AMU); Marion Davin, University of Montpellier and Thomas Seegmuller, Aix-Marseille University (AMU)
Reducing greenhouse gas emissions, adapting to the effects of climate change, and investing in resilient infrastructure—all of this comes at a cost. The transition to a low-carbon economy is a major technological and financial challenge. To achieve the goal of carbon neutrality by 2050, for example, the European Union will need to mobilize investments estimated at around 2 to 3% of its GDP per year through 2030. Faced with these essential expenditures, a question arises: can we use public debt to finance the transition?
Some countries have already begun to explore this approach.
France is a pioneer in the issuance of green bonds—public debt securities specifically intended to finance environmental projects. In 2024, these bonds reached 61.9 billion euros. At the European level, European Central Bank President Christine Lagarde has advocated for the issuance of green bonds to mobilize large-scale financing for the green transition.
Given that fiscal flexibility is limited due to the breach of European deficit and debt thresholds, the idea of using government borrowing to finance green investments is naturally sparking intense debate.
Pollution vs. Productivity
In a recent study, economists propose a theoretical framework for understanding the sustainability of such a strategy. The aim is to examine under what conditions an economy can sustainably rely on borrowing to finance public spending on environmental initiatives without jeopardizing either its economic growth or its fiscal balance.
Their analysis is based on a model in which economic growth, pollution, and public debt evolve in tandem. Pollution is considered a cause of declining productivity. It acts as a factor in the degradation of the productive environment: air quality, worker health, equipment efficiency, and agricultural yields. The higher the level of pollution, the more it reduces companies’ ability to produce efficiently.
Mitigation costs and adaptation costs
To counter these effects, the government has two policy tools at its disposal: mitigation spending, which helps reduce pollution levels (for example, through investment in cleaner technologies or carbon capture), and adaptation spending, which limits the harmful effects of pollution on productivity (air conditioning, energy-efficient renovations, climate-resilient agriculture, and coastal protection measures).
These expenditures are financed through taxes on labor and capital, as well as through the issuance of public debt. Researchers are focusing on this interplay between taxation, debt, and the environmental effectiveness of public spending.
The originality of this analysis lies in the fact that it does not treat the level of debt as an exogenous constraint. Instead, it evolves endogenously in response to the financing needs of environmental policy and government tax revenues. This provides a better understanding of the complex interactions between fiscal policy, the environment, and long-term growth.
Debt can be sustainable
In the long term, the results point to several sustainable paths: public debt, though high, remains stable relative to productive capital; pollution is under control; and economic growth is sustained over the long term.
In such favorable circumstances, a virtuous cycle of debt can emerge: by funding effective environmental policies, the government improves the productivity of production factors, which stimulates investment and growth, thereby generating additional tax revenue.
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Sustainability remains fragile
First, productivity must not be overly vulnerable to pollution. If the harmful effects of pollution on the economy are too severe, even ambitious policies will not be enough to prevent a continued deterioration of economic, fiscal, and environmental conditions. The economy may then become trapped in a cycle of environmental degradation and economic stagnation.
Second, the initial levels of pollution and debt play a decisive role. Beyond a certain threshold, the economy can enter a tipping point where pollution grows faster than the ability to generate wealth, making sustainability impossible.
Finally, an appropriate tax system is essential. A sufficient tax rate on income from labor and capital is necessary to prevent a debt spiral. A lax fiscal policy undermines stability. Indeed, an excessively low tax burden jeopardizes the financing of adaptation and mitigation efforts, leading to an unsustainable accumulation of debt.
Crowding-out effect or windfall effect?
The model also shows that, under certain conditions, an increase in public debt can coincide with improved economic growth and well-being.
This is what the authors call a “windfall effect”: far from crowding out private investment, debt actually stimulates economic activity by financing effective public policies.
This finding contrasts with the traditional view that public debt hasa “crowding-out effect” on growth by diverting financial resources away from productive investment. Here, the social return on environmental spending justifies increased borrowing. https://www.youtube.com/embed/i-GSVaz-6tc?wmode=transparent&start=0, Citéco 2020.
Green debt is therefore sustainable if the expenditures it finances are sufficiently effective to offset their budgetary cost. This is a key point: not all debt is virtuous, even if it is labeled “green.” Sustainability depends not only on the level of debt, but also on the quality of the public investments made.
The study also shows that certain policies can improve consumer well-being along sustainable growth paths. This is the case with tax increases, which can reduce pollution without hindering growth, as long as productivity remains only moderately sensitive to pollution. Indeed, consumers benefit from lower pollution coupled with higher economic growth—and thus higher incomes.
Conditional debt
Public spending on adaptation measures, such as infrastructure to protect against floods or heat waves, is particularly recommended if it can significantly limit the impact of pollution on productivity. In such cases, it promotes both economic growth and debt sustainability.
On the other hand, mitigation efforts must be sufficiently effective to yield positive results. Otherwise, their costs may outweigh their long-term benefits. This would be the case, for example, with subsidies for the deployment of electric vehicles that are not accompanied by measures to decarbonize the energy mix.
Thus, this study confirms that debt can be a tool for ecological transition, provided it is used within a specific technological, fiscal, and environmental framework, alongside well-targeted policies and appropriate taxes. Under these conditions, debt can serve as a lever for economic and environmental sustainability.
Mouez Fodha, University Professor, Economist, University of Paris 1 Panthéon-Sorbonne; Léa Dispa, Science Outreach Officer, Aix-Marseille University (AMU); Marion Davin, Assistant Professor of Environmental Economics, University of Montpellier and Thomas Seegmuller, Macroeconomics, Environmental Economics, Demographic Economics, Aix-Marseille University (AMU)
This article is republished from The Conversation under a Creative Commons license. Readthe original article.