The adverse effects of climate change on the economy are likely large but difficult to predict, and therefore they increase fiscal risks, i.e., that fiscal outcomes differ substantially from projections. Assessing and managing fiscal risk from climate change can prevent an abrupt increase of public debt and improve governments' ability to raise new debt or refinance it.
What are the key policy instruments?
There are various strategies that governments can take to improve climate-related fiscal risk management.
- Identifying fiscal risks. Fiscal risks may arise from the moral and legal obligations of public corporations, local communities, and private-public partnerships, and there needs to be decentralized responsibilities to identify fiscal risks and produce a more comprehensive appraisal. Finance ministries can play a crucial role in coordinating the data collection and consolidate results.
- Quantifying fiscal risks: Once fiscal risks are identified, they need to be quantified. Quantification can occur either on the basis of historical trends, such as past public spending for natural disasters' reconstruction or on the basis of stochastic modeling.
- Identifying fiscal vulnerabilities: Good fiscal risk management requires identifying when the resources to cope with fiscal risks are likely insufficient. Identifying these fiscal vulnerabilities should be part of budget planning.
- Disclosing fiscal risks: Disclosing fiscal risks can improve management. It can also improve risk identification, by increasing public accountability and lead third parties to provide information voluntarily.
- Reducing fiscal risks: Investments in risk management capacity and physical risk reduction, e.g., improving water management against potential draughts, can reduce fiscal risks. As most countries have yet to fully internalize climate change into development planning and sector regulations, opportune adaptation measures can usually be found (especially for public infrastructure investments) to reduce fiscal risks. Beyond this, governments can also set liability caps to reduce the size of contingent liabilities, such as expenditures for natural disasters relief and recovery.
- Managing residual fiscal risk: The residual fiscal risk can be managed via a range of risk transfer and risk financing tools. Governments can implement some of these measures before the risk materializes (ex-ante measures). For instance, governments can establish dedicated reserve funds, or insure/reinsure against specific climate-related risks, or emit catastrophe bonds, i.e., bonds whose interest repayment is delayed, reduced, or forgiven in case a disaster occurs. There may be benefit in cross country collaboration, such as to collectively insure against risks from natural disasters. Ex-post financing measures also exist, such as budget reallocation, taxation, or borrowing from multilateral organizations or foreign countries.
What are the challenges and opportunities ahead?
Effectively managing climate-related fiscal risks presents various challenges:
- Uncertainty: Despite advances in physical and social sciences, knowledge about climate dynamics and their interactions with the economy is still evolving. It is difficult to predict how the climate will change, its effects on the economy, and the related fiscal risks. Also, uncertainty exists because governments’ climate-related liabilities are often grounded in moral considerations or incomplete agreements with third parties, such as insurance contracts that are ambiguous on parties' obligations under certain circumstances.
- Managing disclosure: While disclosure can improve fiscal risk management, it can also be harmful. For instance citizens may rely on government post-disaster recovery programs to restore property, eschewing insurance that would have covered damage to private assets. Disclosure needs to be carefully thought through.
- Balancing ex-ante and ex-post measures: residual risks can be reduced via ex-ante and ex-post measures. While many countries rely largely on ex-post financing, in many instances a mix between ex-ante and ex-post is preferable. The optimal combination depends on many factors, and is country-specific. For example, in countries where raising new revenues via taxation in the aftermath of a natural disaster is particularly difficult, ex-ante measures might be more warranted.
What are good practices and what can be learned from them?
As governments increasingly engage in climate-related fiscal risk management, good practice is emerging. Here are some examples:
- African region: more than 30 African countries are signatories to the treaty that establishes the African Risk Capacity (ARC). ARC pools risks between countries exposed to different weather risks, strengthening their management.
- Caribbean region: in 2007, countries in the Caribbean region established the Catastrophe Risk Insurance Facility, the first multi-country risk pool. The pool aims to reduce liquidity constraints that massive natural disasters, such as earthquakes and cyclones, impose on small developing economies. Since 2007, it has made disbursements for about US$130.5 million.
- Colombia: The country has estimated fiscal risks from natural disasters by considering its i) public property exposure; and ii) the exposure of private property of underprivileged groups, for which the government took responsibility. It has also improved its climate-related fiscal risk management capacity, for instance, by signing a Catastrophe Deferred Drawdown Option, i.e., a contingent line of credit that guarantees immediate liquidity upon the occurrence of a natural disaster.
- Ethiopia: The country has set up a contract, referred to as weather derivative, in which an international reinsurer covers against the precipitation level falling below the Ethiopia Drought Index (EDI).
- Mexico: The country has taken a number of ex-ante risk financing and transferring measures. For instance, in 2006 Mexico shifted part of its public sector catastrophe risk to capital markets and the reinsurance sector. It has also established a Fund for Natural Disasters (FONDEN), to which is allocated a share of the annual budget and covers natural disasters’ losses that Mexican states and federal agencies would not be able to cover independently.
- Philippines: the 2013 Fiscal Risk Statement of the Philippines’ government incorporated a debt sustainability analysis that included a natural disaster scenario analysis.
Peer exchange among Finance Ministries offers the opportunity to have a constructive debate on how to best assess and manage climate-fiscal risks.