Six opportunities to promote resilience and decarbonization through fiscal policy

All countries in the region have signed the Paris Agreement, which aims to increase countries’ resilience and adaptive capacity, as well as stabilize global warming below 2°C and as close to 1.5°C as possible.

This objective implies two major challenges for finance ministries. First, they need to help drive large-scale and unprecedented changes in the energy, construction, industry, transportation, agriculture, and other sectors. Second, they need to respond to the fiscal and institutional challenges generated by the physical impacts of climate change and the transition to decarbonized economies.

Fiscal policy is a powerful tool for tackling these challenges. Spending, taxation, public investment, debt management and financing policies can contribute to transform the behavior of different economic actors. These policies can also provide greater resilience to the economy and address the distributional impacts of the transition, safeguarding the sustainability of public finances and avoiding the emergence of stranded assets.

Opportunities for Advancing the Climate Dimension of Fiscal Policy

The study addresses six areas of responsibility of finance ministries relevant to climate action:

1. the fiscal impacts of the transition to decarbonized economies,
2. fiscal risks associated with weather events,
3. policies and expenditure management related to climate change,
4. green procurement policy and management,
5. climate change and public investment management, and
6. carbon pricing, subsidy policy and the tax agenda.

The following is a summary of the main opportunities found in this new publication.

Opportunity #1: Fiscal Impact of the Energy Transition

The transition to low-carbon economies poses risks to fiscal sustainability, but also presents opportunities in new areas of growth and development. The global energy transition, driven by technological change and international commitments to comply with the Paris Agreement, generates uncertainty about future fossil fuel demand, prices, and associated government revenues.

It is therefore important to promote a well-planned transition that will result in a more robust growth path and sustainable development, thus contributing to fiscal sustainability. In this regard, ministries of finance face the challenge of strengthening their capacities for early identification and management of transition risks.

Among the priority actions that could be considered by the ministries are:

1. develop long-term strategies, with the ministry of the environment and other sectors,   that incorporate fiscal policy instruments in their design and implementation;
2. identify, quantify, and manage the impacts of the transition at the macro fiscal level and on public finances, including the risk of stranded assets;
3. review fossil fuel subsidy policies in areas where reforms are needed to rationalize and/or phase out fossil fuel subsidies; and
4. support the identification of sectors and communities that will face difficulties due to the energy transition and changes in subsidy policies.

Opportunity #2: Disaster Risk Management

The increase in the frequency and intensity of disasters caused by climate change is a major challenge for the region, given that we are one of the region’s most vulnerable to the negative effects of climate change.

The magnitude, frequency and duration of natural disasters have multiple impacts on public finances. For example, it is estimated worldwide that the occurrence of at least one event per year is associated with an increase in that year’s fiscal deficit of 0.8% of GDP for lower-middle-income countries and 0.9% of GDP for the low-income group. Faced with this challenge, finance ministries would benefit from:

1. develop and implement methodologies to identify and quantify the main fiscal risks derived from climate events;
2. incorporate fiscal risks into short- and medium-term fiscal planning; and
3. develop financial disaster management strategies and methodological frameworks for their evaluation.

Opportunity #3: Public Spending Coordinated with Climate Action

Proper management of public finances requires rules, mechanisms, processes, and controls to ensure that spending decisions avoid added fiscal costs and contribute to an orderly, fair, and inclusive transition to a carbon neutral economy.

However, green public financial management (PFM) practices are still incipient in most countries in the region. The lack of data on climate-related public spending significantly limits the ability to evaluate it and prevents an accurate understanding of the associated fiscal risks. To solve this problem, it is important to promote green PFM and improve the effectiveness and efficiency of spending through different actions:

1. conduct a diagnosis and a strategic plan to integrate climate change goals into PFM;
2. consistently and periodically identify public climate expenditure and monitor its execution;
3. develop information to feed back into the budget formulation process with assessments of climate-related spending;
4. produce green financial statements that allow the standardization of comparable information with other countries, thus facilitating audits; and
5. implement mechanisms for transparency, monitoring and oversight of climate-related public spending and countries’ international commitments.

Opportunity #4: Green Procurement

Public procurement accounts for about 20 percent of total government spending in the region, so the contribution of green procurement policies and management to commitments under the Paris Agreement is potentially high.

However, there are still challenges to their adoption, such as lack of institutional capacity, knowledge gaps, lack of clear environmental criteria and conflicts with other priorities. Fortunately, progress has been made in the region and countries are in a position to develop diagnoses, tools, and institutional capacities to promote green procurement.

With the application of methodologies and tools already available such as the sustainability module of the Methodology for the Assessment of Public Procurement Systems (MAPS), ministries of finance would be in a better position to:

1. develop a green procurement strategy;
2. strengthen the legal and policy framework for incorporating the climate dimension into procurement procedures;
3. develop market studies to understand the potential supply of sustainable or green products;
4. introduce environmental standards in the technical specifications, procurement selection and award criteria, as well as in the performance clauses of contracts and deliverables; and
5. design training plans.

Opportunity #5: Public Investment in the Face of Climate Change

To address the climate crisis, it is necessary to spend between 2% and 8% of GDP on the provision of infrastructure services. Given the magnitude of the resources required, there are three possible courses of action: redirecting existing resources towards new resilient and low-carbon investment priorities; improving the quality of investments; and achieving greater mobilization of public and private resources.

Some of the actions that the ministries in charge of public investment policy and management (usually the ministries of finance or planning) could take are:

1. elaborate robust diagnostics to find areas for integration of climate change into public investment management;
2. improve resource allocation using tools such as investment taxonomies, adoption of better systems for prioritization and selection of climate impact projects, and improvements in the integration of climate and transition risk management into investment management;
3. increase the quality of projects through the adoption of social carbon pricing in cost-benefit methodologies, application of greenhouse gas emissions estimation methodologies, and the development of energy efficiency standards at the sectoral and national levels.
4. expand access to finance by developing climate finance strategies, building resilient and low-carbon project portfolios, and developing sustainable/green finance instruments.

Opportunity #6: Pricing System and Tax Incentives

The price system can hinder or contribute to countries’ greenhouse gas emission reduction strategies. One example is fossil fuel subsidies, which in the region represent 1.1% of GDP.

However, beyond energy subsidies, and despite ample arguments in favor of other carbon pricing schemes, their use remains slow due to various technical difficulties such as their potential negative distributional impact.

At the same level of relevance, the study underlines that the empirical evidence shows that, although the carbon pricing mechanisms used around the world have allowed marginal emission reductions, they have not had an impact on investment in the transition to zero net emissions.

This is because there are other institutional and market failures that are as important, if not more so, as the absence of carbon pricing, which highlights the importance of government interventions that cover a broad spectrum of policies. In this regard, countries wishing to move forward with the establishment of carbon pricing mechanisms should consider the following aspects:

1. impact on competitiveness,
2. the use of revenues generated to support the achievement of climate goals,
3. identification and management of distributional and efficiency impacts, and
4. the establishment of an adequate communication strategy aimed at helping the implementation of the selected reforms.

In summary, the new publication succinctly describes the importance of each of these areas of green fiscal policy, reviews the empirical evidence supporting their use, and proposes a set of actions that, with the corresponding support of policy and public management instruments, can serve as a basis for finance ministries to move towards a green fiscal policy.

Learn more about the IDB’s work on fiscal policy and climate change.

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Results-based green budgeting for effective management of climate change-related public expenditures

How governments can make public financial management green

Six lessons on the implementation of climate spending budget classifiers