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Price levels are always changing to reflect changes in the relative scarcity of inputs and other factors. However, when the overall cost of goods and services increases in a certain period, then the economy faces inflation. Two aspects of inflation need to be considered. First, for comparison at different points in time an adjustment should be made for any general increase in the price level, that is the comparisons should be made in real terms. The appropriate deflator is a matter of judgement, but it should be based on a basket of goods consumed by the relevant group of consumers in the country. Also, any such adjustments do not preclude the possibility of increases in “real prices”. It is quite possible that the costs and benefits attached to some impacts increase slower (or faster) than the general price level.
The second issue relates to the welfare cost of any inflation generated by the mitigation or adaptation activities. One of the main causes of inflation is when a country incurs a fiscal deficit (i.e., public expenditures exceed tax revenues) that is financed by printing money. Such an increase in inflation is effectively a tax on money holdings, on assets denominated in nominal terms, and on those with fixed money incomes.
The distributional consequences of the inflation tax are germane to the decision-making process. There is no simple way, however, to estimate this welfare cost; doing so requires sophisticated measurements of losses in the consumption level that affect distinct income groups. Moreover, for most mitigation and adaptation measures, the increase in inflation is likely to be quite small. Hence, in the majority of cases it is sufficient to report any increase in inflation that results from the climate change policy and use that information as a direct element in the decision-making process.
The capital costs of mitigation and adaptation programmes may be underestimated if the true scarcity of capital is not reflected in the costs incurred by the parties that implement the programme. This can arise if capital is “rationed”, that is the demand for investment projects exceeds the supply. In such a situation it is appropriate to apply a shadow price for capital,for the estimation of which the World Bank (1991) and others have made estimates. This adjustment is in addition to the adjustment for the marginal cost of public funds (Section 7.4.2.2). Moreover, when a shadow price for capital of greater than one is applied, it acts to ration capital when the discount rate applied is low.
The above discussion assumes that the capital allocated to the project is free to be used for any other project. What happens, however, if capital is not “fungible” in this sense, but is made available by a donor or third party for the specific purpose of implementing climate change programmes? In these circumstances the assessment of the programme from the national viewpoint differs from its assessment from the viewpoint of the third party. The national assessment could take the shadow price of capital as zero if it genuinely could not be used for any other purpose. If, however, there were a number of alternative projects to which the capital could be allocated, a comparison between them should be based on a shadow price of capital that reflects its scarcity relative to the investment opportunities available. The party providing the finance, on the other hand, will have its own set of alternative projects to which the capital could be allocated and it may apply its own shadow price. The important point is that the evaluation and ranking of projects from a domestic viewpoint may differ from their ranking from a donor perspective. When rankings differ, a compromise is usually reached, based on the relative bargaining strengths of the two parties.
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