Global warming is already at the dire halfway point to the 2°C limit set by the Paris Agreement. According to the Intergovernmental Panel on Climate Change (IPCC), to meet the 1.5°C target, global CO2 emissions need to be reduced by 45% from 2010 levels by 2030 and reach net-zero emissions by 2050. As low-carbon policies, technology, and market shifts become stronger, the adverse impacts from these changes could intensify for those not prepared to respond accordingly. Helping countries in Latin America and the Caribbean (LAC) prepare for these climate change transition risks and leverage the opportunities they present is a key part of our strategy at the Inter-American Development Bank (IDB).
The transition to low carbon takes different shapes
A low-carbon transformation entails substituting traditional fossil fuels with carbon-free sources, producing low-carbon electricity, undertaking massive electrification processes, and enhancing energy efficiency. But decarbonization goes beyond energy. It also encompasses greening transportation systems, improving waste management, halting deforestation, protecting and regenerating ecosystems, and developing more sustainable food systems.
All these changes are supported by new regulations, technologies and shifts in supply and demand. As low-carbon measures are integrated gradually by governments, and adopted by industries and consumers across all sectors, new challenges arise from switching from business-as-usual to more sustainable models. These risks, known as climate change transition risks, emerge from extensive policy, legal, technology, and market changes pushed by the transition to a low-carbon economy. But as risks arise from the new trends that decarbonization presents, so do opportunities.
As decarbonization processes advance, assets will start suffering from unanticipated or premature write-downs or devaluations, and become stranded assets. The Bank of England has pointed out that if worldwide government policies change in line with the Paris Agreement, two-thirds of the world’s known fossil fuel reserves could not be burned. This will lead to changes in the value of assets and investments, and impact direct and indirect fossil fuel-related activities globally, including LAC. The IDB has estimated that reducing the global demand for fossil fuels in the region in a way that is consistent with the Paris Agreement could result in 66% to 81% of oil and gas reserves to remain unexploited, with a cost by 2035 of over US$1.3 trillion and US$42 billion in oil and gas forgone royalties, respectively.
Emerging and low-income countries will pay a higher cost
The costs of a low-carbon transition will be higher for high fossil-fuel exporters and energy-intensive emerging economies. According to a recent IMF Blog, a budget-neutral policy package to achieve a 25 percent reduction in emissions by 2030 could slow economic growth in Europe, the United States, and China between 0.05 to 0.20 percentage points on average over eight years. This figure increases to 0.15 to 0.25 percentage points annually when expanding the assessment globally. These figures illustrate the urgent need to boost financing, technology, and knowledge transfer to developing countries to help them prepare for these processes.
Those who are not proactively planning an orderly transition will be more prone to facing challenges. In its 2022 Net-Zero Transition Report, Mckinsey noted that economic shifts could be substantially higher under a disorderly process, which would raise the risk of asset stranding and worker dislocations. For LAC, this creates pressure to define strategies that not only identify risks and opportunities, but more importantly, recognize the complex socio-economic contexts that challenge decarbonization efforts, including the heavy reliance on energy-intensive industries; fiscal situations that do not enable low-carbon technology investment; and the risks associated with social unrest resulting from non-inclusive development.
Regulations and policies will support these changes
Climate change policy actions will keep evolving and becoming more stringent. There is a misconception that only heavily polluting industries, such as oil and coal, will face these challenges. The truth is that this transformation would directly and indirectly affect all countries and almost all economic sectors. For instance, rigorous regulation of energy efficiency will impact building and construction, innovation for low hydrocarbon materials will challenge transportation infrastructure, and changes in land-use policies and water conservation will transform food production.
The risks and impacts of the transition depend on the nature and timing of the policy changes, the institutional capacity, and the government’s willingness to translate regulation into real action. For example, key issues are emerging in agriculture linked with deforestation. According to FAO, agricultural expansion drives almost 90 percent of global deforestation. Regions like the European Union (EU) are considering banning the import of deforestation-linked products, which places LAC exporters of agricultural products to the EU at risk. As a result, these countries must undergo a process of policy and regulatory strengthening on land-use planning, environmental requirements, and climate risk management. Moreover, sustainable production practices should be boosted to align with new market trends, and activities at risk should be identified to define proper plans to alleviate any adverse impacts.
Technological improvements and market sentiment are pressing for innovation
Other challenges will emerge from the substitution of existing products and services with innovative lower-emissions options. This includes the development and use of renewable energy, energy efficiency and battery storage, among others. Moreover, some activities are likely to become superseded or financially inviable as more affordable options become available, with direct social implications.
Changes in human behavior toward low-carbon emissions products and activities are taking place. Climate-friendly consumption is translating into more sustainable transportation, low-carbon manufacturing, and more efficient energy use. Moreover, consumers are gradually valuing certification standards (e.g., EDGE or LEED), which is also setting a precedent of consumer behavior pressuring industries to speed up the transition. This increased demand for low-emissions goods and services will lead to adjustments across value chains, such as cement, steel, and iron.
The IDB acknowledges these challenges and works closely with LAC to enhance preparedness
The IDB’s Institutional Strategy promotes an integrated approach to sustainability at all levels, including governance, strategy, and policy. For financed operations, the IDB’s Environmental and Social Policy Framework (ESPF) guides on GHG emissions estimates during project design and preparation. These assessments facilitate a better understanding of potential transition risk drivers and the project’s contribution to a country’s decarbonization efforts. Moreover, the Bank is developing a framework to ensure loans and projects are consistent with a country’s net-zero emissions and climate-resilient development goals, entailing the identification of climate change transition risks that could emerge from long-term decarbonization processes.
At the IDB, climate risk management is key to properly respond to this pressing reality. Risk management plays a crucial role in ensuring low-carbon challenges are timely assessed and monitored to help countries effectively undergo smooth and sustainable transition processes. Consequently, the IDB will keep strengthening the management of climate change risks recognizing LAC’s socio-economic context and constructing the right partnerships to drive the just transition the region needs.