The streams of analysis on the UN climate change talks in Glasgow last December read like the opening of the Charles Dickens’ novel, A Tale of Two Cities: “It was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair…”
There is some truth to both sides. There was deep regret that the goal of developed countries to mobilize US$ 100 billion per year by 2020 to support climate action in developing countries was not met. Under current pledges, the world is still off track with emissions set to rise by 15.9% above 2010 levels by 2030, which could lead to a temperature rise of about 2.7 degrees by 2100.
Despite the gloom, COP26 succeeded in keeping the goal alive to limit warming to 1.5 degrees with a request for countries to return with strengthened emissions reductions pledges for 2030 this year. The rulebook to implement the Paris Agreement was also agreed with outcomes regulating carbon markets and various pledges were made to stop public financing for fossil fuels and to halt deforestation.
Finance ministers can play a greater role to help make these COP26 outcomes a reality. Here we look at five key areas where these ministries can support the implementation of what was agreed at COP26 and help Latin American and the Caribbean countries to turn their pledges into concrete action.
1. Finance Ministries Must be Engaged in the Process of Strengthening Emission Reduction Pledges for 2030 by the End of This Year
Currently countries’ emission reduction pledges are insufficient to achieve the goal of limiting warming to 1.5 degrees. Recognizing this gap in ambition, countries are requested to return before the end of 2022 with strengthened pledges for 2030.
The engagement of finance ministries is critical since climate action is also about improving decision making and effective governance to build prosperity. Drawing on their key role in coordinating government policies, finance ministries can work with their counterparts to align development plans with climate goals. Finance ministries can also play a central role in both including climate investments in national budgets and avoiding funding for carbon intensive investments which undermine the Paris goals.
These ministries should take part in national dialogues to create a joint vision for a decarbonized future, which are essential to identify the winners and losers and how to support those adversely affected. Governments can then work with stakeholders to define a roadmap of actions including how to prioritize investments to create jobs, support decarbonization and build resilience.
At 10% of the global total, LAC’s emissions may appear modest, yet the region still has an important role to play to cut emissions. To date, eight LAC countries have announced or committed to carbon neutrality by around midcentury. However, assessments by Climate Action Tracker, currently do not rank the 2030 pledges of any LAC country (or any other country) as compatible with the 1.5-degree goal.
Among the outliers, Chile, Colombia, Costa Rica, and Uruguay are the only countries in the region to have developed a national decarbonization strategy aligned with net zero emissions by midcentury. As a result, there is ample space for finance ministries in the region to contribute to this goal.
2. Despite Scarce Financial Resources, Finance Ministries Can Play a Major Role in Promoting Financial Instruments for Climate Action
The final text noted with deep regret that the developed country goal to mobilize US$ 100 billion per year by 2020 to support climate action in developing countries was not met. While the goal might be achieved this year or next, LAC countries are still in a difficult position since most are middle-income or upper middle-income countries and are not usually first in line to receive these resources. Within the region, climate finance has also been concentrated with Brazil, Mexico and Colombia receiving close to half of the region’s funding, according to 2020 figures from Climate Funds Update.
Given these scarce resources, finance ministries can play an instrumental role in mobilizing financial instruments to support climate action. First, as counterparts of international financial institutions, they can seek support to design and implement climate strategies tied to development priorities. These ministries are also key players in developing innovative financing mechanisms. Various countries are already advancing this agenda: Colombia, Uruguay and Argentina have requested new finance instruments linked with environmental targets, such as debt-for-nature swaps.
Second, these ministries can lead on developing sustainable public investment systems required to unlock investment for sustainable infrastructure. This could involve establishing incentives and implementing regulatory reforms that lower barriers to public and private investment. The design of climate finance strategies can also be a gamechanger. Chile’s Financial Strategy for Climate Change helped facilitate the launch of the Americas’ first sovereign green bonds in Chile in 2019. The region’s green bonds market has grown rapidly from USS 13.6 billion in September 2019 to US$ 30.2 billion at the end of June 2021.
Third, finance ministries can establish effective budget classification and tagging systems, which have an essential role in identifying, quantifying, and evaluating spending on climate change. The benefits include enhanced transparency and accountability, the identification of fundings gaps and improved fiscal discipline by allowing more accurate tracking of spending.
With the IDB’s support, Costa Rica, Jamaica, and the Dominican Republic are developing budget classification or tagging systems for climate change that will be consistent with statistical standards currently in use such as the Government Finance Statistics Framework and the System of National Accounts. Understanding where resources are used is a first, but necessary, step to assess the quality of spending or achieve a more precise understanding of fiscal risks deriving from climate change.
3. Finance Ministries Can Support Countries to Ensure a Just Transition While Managing Fiscal Risks
COP26 saw the first-ever decision explicitly targeting fossil fuels, calling for a “phasedown of unabated coal” and “phase-out” of “inefficient” fossil fuel subsidies, while providing support for a just transition.
The transition away from fossil fuels poses significant fiscal and economic risks to those LAC countries dependent on revenues from fossil fuels. To keep the 1.5-degree goal alive, LAC’s oil production needs to fall to less than 4 million barrels per day by 2035 — 60 percent less than pre-pandemic levels. This drop in production could result in regional oil exporters losing around US$2.6 trillion in fiscal revenue by 2035 if strong climate action takes place.
Finance ministries need to better manage these fiscal challenges. Governments also need be wary of the risk of fossil fuel assets becoming stranded as the world decarbonizes, which would imply additional costs for public finances. Having been devalued or retired before the end of their expected useful life, stranded assets could also create political instability due to the loss of wealth among the owners of affected assets and workers.
To manage these risks, finance ministries can design fiscal strategies to anticipate the risks of lower fossil fuel revenues. They can also identify and manage the risks of stranded assets and design policies that address the distributional impacts on the economic sectors and affected workers. Lastly, finance ministries will also need to reform energy subsidies and establish measures that improve their social acceptance and support the most vulnerable.
Various energy-related announcements were also made at the COP. France, Germany, UK, U.S. and EU launched the International Just Energy Transition Partnership to support South Africa’s decarbonization efforts, which will mobilize an initial commitment of US$8.5 billion. Multiple LAC countries alongside the U.S. and the EU announced their support for the Global Methane Pledge to cut emissions by 30% by 2030. Additionally, the IDB Group announced during COP26 a plan of action to fully align its new operations with the Paris Agreement by January 2023.
4. Finance Ministries Can Help Countries Take Advantage of Market Mechanisms and Make Them More Effective
Although a carbon price is not a sufficient or necessary condition to decarbonize economies, it can help to advance this agenda. Price signals play a role in directing private sector investments and operations; however, the region still spends about 1 percent of GDP on fossil fuel subsidies. Correcting prices may require starting with energy subsidy reforms while managing social impacts and helping energy-intensive businesses to adapt.
After years of arduous negotiations, countries reached a deal on Article 6 of the Paris Agreement, which covers international cooperation including carbon markets. Regarding markets, Article 6.2 covers bilateral actions to reduce or remove emissions via internationally transferred mitigation outcomes (ITMOs) between two countries. For example, countries could link their emissions trading schemes or buy offsets towards achieving their emission reduction targets included in their Nationally Determined Contributions (NDC). Article 6.4 creates a new carbon market for trading emissions cuts, either by the public or private sector, via a new multilateral mechanism.
There is some optimism that this breakthrough might help to boost ambition and finance flows. The International Emissions Trading Association and the University of Maryland estimate that international carbon markets could stimulate up to US$ 1 trillion of new capital investment toward developing countries.
However, the implementation of the new rules regulating these markets will not happen overnight. The complex rules and systems envisaged to ensure environmental integrity (i.e., environmental, social, and governance standards and safeguards) will take time to implement, which could delay the functioning of carbon markets in the short-term.
Many uncertainties also remain in terms of the complexity, additionality, and environmental integrity. There is considerable complexity related to obtaining the data used to calculate a country’s NDC emissions (e.g., the types of emissions baselines used), as well as potential and real gaps in the quality of information requirements at both the NDC level and project level. These challenges are exacerbated as countries would need to allow some type of independent assessment, such as an additionally test. Countries are also constantly updating NDCs and emissions baselines, which complicates matters further.
Encouragingly, various countries from the region, including Costa Rica, Belize, Colombia, Paraguay, Peru and Trinidad and Tobago, are working through the San José Principles Coalition for High Ambition and Integrity in International Carbon Markets, to ensure these markets are more coherent.
There are also opportunities for finance ministries in those countries with existing carbon pricing regimes (either a carbon tax or emission trading system) to work with other countries to better integrate these regimes, which could lead to more trade in carbon credits and some convergence between carbon prices and offset prices. In the case of Argentina, Chile, Colombia, Mexico, and Uruguay, which have made progress on the development of carbon taxes, the prospect of increasing the tax rate from an average of around US$ 5 per ton of carbon dioxide equivalent in the region, would be a welcome step to boost the incentives to decarbonize. Finance ministries will also need to work closely with industry to broaden the tax base and introduce higher tax rates in an orderly and transparent fashion. In some cases, it will likely be necessary to introduce compensation or support mechanisms to affected sectors.
5. Finance Ministries Can Strengthen Adaptation Measures to Extreme Weather Events
COP26 agreed on a work program for operationalizing the Global Goal on Adaptation and addressing the lack of adaptation finance.
Finance ministries in the region are already contributing to the adaptation agenda. Colombia, Costa Rica, and El Salvador have incorporated extreme weather event risks in their medium-term fiscal programming. Yet, as one of the world’s most vulnerable regions to climate impacts, LAC countries face huge challenges.
Finance ministries can ramp up their work to better manage the fiscal impacts associated with extreme weather events. To adequately manage worsening climate impacts, finance ministries need to take various steps including the strengthening of public investment systems to ensure all new infrastructure be resilient to climate impacts. Effective disaster risk management also requires improving legal frameworks and better disaster management capacities across different sectors, and the establishment of guidelines and rules to internalize disaster risk assessments throughout the public investment project management cycle.
Finance ministries also need to have quality information to measure climate impacts on fiscal accounts, use financial instruments to mitigate natural disaster impacts, and develop a governance framework to manage fiscal risks. This would bring major benefits: every dollar invested in resilience can generate up to four dollars in benefits.
COP26 Outcomes Are a Call to Action for Finance Ministries
With very limited time to cut emissions by 50% by 2030 to keep the 1.5C goal alive, finance ministries can support countries to turn their climate pledges into policies and bankable and effective investment opportunities. There is no time to lose: recent estimates suggest that the economic damage of climate impacts could be six times higher by 2100 than previous estimates. Climate friendly policies can also lead to increased investment and co-benefits including greater social inclusion.
The increasing efforts of finance ministers to support climate action shows the potential of their transformative role. A new fund to boost green fiscal policies in the region, administered by the IDB in partnership with Germany’s Federal Ministry for Environment, Nature Conservation, and Nuclear Safety, will work with finance ministries to unlock this potential. Now is the time to act decisively. The costs of not doing so and the risk of being left behind are too great.