## Box 1. Examples on how countries are incorporating climate risks into budgets and MTFFs

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---

### I. Introduction — context and framing
- Climate agenda requires significant upfront government action on mitigation and adaptation at a time of rising debt sustainability concerns.
- Relying largely on expenditure-based measures to achieve net zero emissions would put significant pressure on fiscal accounts in the absence of compensatory revenue measures (IMF October 2023 Fiscal Monitor).
- Fiscal rules aim to limit deficit bias by constraining fiscal discretion and increasing fiscal credibility, but must balance sustainability with flexibility to respond to shocks.
- Proposals for green fiscal rules typically seek to protect green public investments by excluding green spending from fiscal rule limits or introducing green escape clauses, benchmarks, or green investment funds.
- Key challenge: green rules risk undermining fiscal credibility and producing disruptive debt dynamics if green spending is large and financed mainly through public debt.

### II. Quantitative illustration: green rule simulations and key scenarios
- Simulation basis and assumptions:
  - Representative Emerging Market (EM) assumptions use IMF October 2023 Fiscal Monitor estimates.
  - Additional public investment of around 2 percent of GDP per year for mitigation (assuming public sector funds 20 percent of costs and private sector funds the remainder).
  - Adaptation costs estimated to average 1-2 percent of GDP per year for many developing countries (Aligishiev et al. 2022).
  - Simulations follow Escolano (2010) public debt dynamics methodology and use WEO extrapolation as baseline.
  - Debt anchor calibration uses IMF FAD toolkit; estimated safety buffers around 20 percent of GDP (normal volatility) and up to 30 percent of GDP (including tail risks), implying a debt anchor of around 40-50 percent of GDP.
  - Average EM government debt levels stood at 66 percent of GDP at the end of 2022.
  - Debt limit range for a typical EM: around 70-95 percent of GDP; the simulations use the lower end of the 70-95 range for prudence.
- Scenarios simulated (assume mostly spending-based policies to reach net zero by 2060 in EMs):
  - No fiscal rule: WEO extrapolation + additional 2 percent of GDP annual mitigation spending (blue line).
  - Green rule exempting mitigation spending: 3 percent of GDP deficit ceiling (excluding mitigation) + 2 percent of GDP annual mitigation spending (green line).
  - Green rule exempting mitigation and adaptation: 3 percent of GDP deficit ceiling (excluding mitigation and adaptation) + 4 percent of GDP annual green spending (mitigation + adaptation) (purple line).
  - Green rule preserving debt sustainability: 2.5 percent of GDP primary surplus (excluding green spending) calibrated to preserve debt sustainability with 2 percent of GDP annual green spending (yellow line).
  - Illustrative green MTFF allocation: higher green and lower non-green budget balances calibrated to preserve debt sustainability within a green MTFF that includes carbon pricing (red dashed line).
- Key quantitative simulation findings:
  - Under WEO extrapolation with additional 2 percent mitigation spending, the overall deficit deteriorates to almost 9 percent of GDP by 2050 and the debt ratio surges by more than 30 percentage points reaching almost 140 percent of GDP (blue line).
  - Under green rule with 3 percent non-green budget limit and 2 percent mitigation spending, public debt reaches more than 100 percent of GDP by 2050 (green line).
  - Adding 2 percent of GDP annual adaptation spending (total 4 percent green) with a 3 percent non-green deficit limit keeps the deficit at 7 percent of GDP and pushes debt to 125 percent of GDP by 2050 (purple line).
  - For a typical EM, the overall primary balance which stabilizes debt at the estimated debt anchor (50 percent of GDP) in the long run is a 0.5 percent of GDP primary surplus.
  - If mitigation spending of 2 percent of GDP is exempted under a green rule, a non-green primary yearly surplus around 2.5 percent of GDP would be required to ensure debt sustainability (yellow line).
  - In an illustrative green MTFF with carbon pricing and more balanced tool mix, the non-green primary balance required to keep debt sustainable is about 1 percent of GDP throughout the projection horizon (red dashed line).

### III. Interpretation and policy implications from simulations
- Simple green fiscal rules that exempt sizable green spending can produce either:
  - Unsustainable debt trajectories (if overall spending rises without compensatory measures), or
  - Overly tight non-green fiscal balances that significantly skew budget priorities (requiring large non-green surpluses).
- Numerical rules alone are unlikely to be credible given the large tradeoffs; a medium- and long-term fiscal strategy and broad public consensus are required to set priorities and financing.
- For low-income countries, achieving climate goals under constrained fiscal space will likely require significant donor support.
- The optimal mix of climate policy tools should consider:
  - Relative fiscal costs and returns of mitigation versus adaptation.
  - The potential for technological change (e.g., falling costs of solar and wind) to reduce green spending needs over time.
  - The role of carbon pricing to finance green investments and protect fiscal sustainability.

### IV. Operational and design challenges of green fiscal rules
- Classification and reclassification risks:
  - Green rules resemble golden rules (which exclude investment) and can incentivize reclassifying current expenditure as capital or classifying diverse spending as “green.”
  - Monitoring and enforcement become more difficult with greater rule complexity.
- Interaction with multiple rules:
  - Introducing floors or additional operational rules on green spending can undermine compliance with existing rules when multiple rules coexist.
- Uncertainty in sizing green needs:
  - Estimates of adaptation and mitigation costs are highly uncertain and heterogeneous (examples: 46 countries reporting adaptation estimates average 1.5 percent of GDP; Aligishiev et al. (2022) estimate annual adaptation costs at around 0.25 percent of world GDP per year with costs exceeding 1 percent of GDP for emerging markets and averaging 2.7 percent of GDP for small island states).
- Other modeling and empirical complexities not fully captured in simple simulations:
  - Externalities and general equilibrium effects of climate policies are not modeled; a general equilibrium approach would be needed to fully capture international spillovers.
  - Differing sizes of green fiscal multipliers could change debt dynamics: large green spending output multipliers could dampen adverse debt effects; some green investments may raise future revenues or reduce disaster-related losses.
  - Transition to renewables could reduce fiscal pressures from fossil fuel price surges and contribute to a more resilient fiscal path—this is not incorporated in the simulations.
- Practical design challenges highlighted elsewhere in the chapter:
  - Defining green spending is complex; most spending items can have a green component and definitions are heterogeneous (World Bank 2021).
  - Governments must decide whether to exempt only capital spending or also current spending; excluding interest associated with green financing could further worsen debt dynamics.
  - Historical experiences: Mexico’s exclusion of capital expenditures during the global financial crisis contributed to adverse public debt dynamics; Germany abandoned its golden rule in 2010; the UK suspended its golden rule when incompatible with debt rule adjustments.

### V. Alternative approach advocated: green MTFFs and broader green PFM
- Proposal: incorporate complex climate considerations into fiscal policy via green medium-term fiscal frameworks (MTFFs) and green public financial management (PFM).
- Advantages of green MTFFs:
  - Account for long-term effects of climate change and climate policies on fiscal accounts.
  - Help optimize the mix of green fiscal policy tools (spending, carbon pricing, subsidies, transfers) based on economic and fiscal impact.
  - Enable prioritization across spending items and focus green spending on high-impact areas for achieving climate objectives.
  - Facilitate financing strategies that can combine public investment with carbon pricing to preserve fiscal sustainability.
- Illustrative finding: a green MTFF combining carbon pricing and improved allocation can achieve debt sustainability with a less onerous non-green primary balance (about 1 percent of GDP) compared with strict green-rule exemptions that imply non-green surpluses around 2.5 percent of GDP.

### Evidence on fiscal multipliers for energy investment
- Batini et al. (2021) find that the point estimates of the multipliers are in the range 1.1-1.5 for renewable energy investment and between 0.5 and 0.6 for fossil fuel energy investment, depending on the horizon and econometric specification.
- Hasna (2021), using state-level data for the United States, find a contemporaneous multiplier of 1.1 and an upper bound of 4 in the second year of implementation.

### Use of carbon tax revenue
- Reference made to a more detailed discussion and country examples on how to use carbon tax revenue in: “Using Carbon Revenues”. Note 16. World Bank, Washington, DC. World Bank.

### III. A green medium-term fiscal framework — overview and rationale
- MTFFs can combine flexible rules with stronger institutions to promote sound public finances and help inform costs and benefits of climate policies and build consensus.
- Countries should develop “green” MTFFs that incorporate the economic and fiscal effects of climate change and of climate adaptation and mitigation policies to assess effects during the green transition.
- Developing green MTFFs requires significant reforms, including a medium-term perspective in budgeting, incorporating climate and aging in the budget process, and upgrading transparency and independent fiscal councils.

### Key components of green MTFFs
- Macroeconomic projections:
  - Economic costs of climate change (e.g., on potential growth).
  - Related fiscal costs.
  - Scenarios.
- Climate-related policies:
  - Choice of measures; impact on taxes (e.g., carbon taxes); impact on expenditures (investment; energy subsidies, safety nets); risks related to climate change; longer-term perspective.
- Risks and debt sustainability:
  - Mitigate risks (reduce needed buffers).
- Fiscal rules:
  - Target broad aggregates.
- Other green PFM practices:
  - Green PFM through other phases of the budget; climate-smart public investment.

### Incorporating macro-fiscal effects into projections
- MTFFs should quantify climate impacts on medium-term (potential) growth and implied fiscal costs.
- Projections should:
  - Include gradual effects of climate change and climate-related natural disasters, reflecting changes in frequency and magnitude over time.
  - Include discussion of fiscal risks posed by climate change.
  - Use longer-term projection analysis to identify risks beyond a 3-5 year horizon.
- Example model: IMF’s DIGNAD (Debt-Investment-Growth and Natural Disasters) enables users to:
  - evaluate debt sustainability risks following natural disasters amidst infrastructure rebuilding needs;
  - analyze effects of ex-ante policies (building adaptation infrastructure, increasing fiscal buffers, improving public investment efficiency);
  - study climate risk effects from natural disasters and how adaptation investments mitigate risks.
- Building capacity and improving knowledge of climate impact over time is required.

### Costing and assessing policy measures
- MTFFs should enhance costing of different policy measures and assess consistency with climate objectives.
- MTFFs could provide information on current and capital spending and revenues related to climate and how these affect debt dynamics.
- Economic and budgetary impact of climate policies should consider:
  - Policies for mitigation:
    - Different fiscal tools (green public investment, green subsidies, carbon pricing, feebates) have vastly different fiscal impacts.
    - Carbon pricing or revenue-neutral feebates can require fewer spending-side measures; medium- and long-term projections should incorporate chosen policies.
    - Projections for alternative scenarios relying on different fiscal policy mixes can inform optimal policy mix. Example tool: IMF’s Climate Policy Assessment Tool (CPAT).
  - Policies for adaptation:
    - Spending on adaptation should be weighed against counterfactual inaction (lower potential growth and larger climate-related shocks).
    - Adoption of significant adaptation measures increases resilience and can reduce future needs for fiscal buffers while implying short-term fiscal cost.
    - Knowing size of adaptation investment needs for different types is critical for designing affordable adaptation strategies.

### Risk-based debt sustainability analysis (DSA) including climate risks
- Debt sustainability analysis should include effects of climate change and natural disasters.
- IMF DSA tools (MAC-SRDSF and the LIC-DSF) provide stress tests for natural disasters (triggered for vulnerable countries), covering climate-related, geophysical, and hydrological shocks.
- MAC-DSA includes a module estimating consequences of adaptation and mitigation investments:
  - Produces 30-year debt and gross financing needs projections reflecting fiscal cost of adaptation investment and main debt drivers.
  - Includes a sub-module on mitigation costs capturing impact on debt sustainability of upfront investment needed for transition to a low carbon economy over a 30-year horizon.
- Longer-term fiscal projections and risk analysis are warranted but complex to estimate and communicate.

### Designing and calibrating fiscal rules within green MTFFs
- Enhanced MTFFs can help design and calibrate fiscal rules accounting for climate risks and policies.
- Fiscal rules should target broad aggregates to preserve debt sustainability, with specific considerations for climate vulnerability:
  - Incorporating climate considerations improves assessment of debt limits and fiscal buffers to calibrate debt anchors and operational rules.
    - Fiscal and debt projections should incorporate effects of climate change on variables like economic growth (including its mean and higher-order moments).
    - Adaptation policies can alter future growth paths and the amount of debt that can be sustained.
    - Fiscal anchor recalibration at regular intervals (e.g., every 5 years) is recommended to incorporate updated climate risk assessments.
  - Size of fiscal buffers will vary with magnitude of shocks and country-specific vulnerabilities and implementation of adaptation policies; fiscal impact of shocks should consider disaster insurance mechanisms.
  - Choice and calibration of fiscal rules depend on policy mix:
    - Example: combination of carbon taxes and higher adaptation spending can allow higher expenditure limits while preserving sustainable deficit and debt levels, compensated by higher tax revenues or dedicated grants.
    - Hump-shaped carbon revenue projections over time imply rules and limits may need revision over medium to long term.
    - Revenue mobilization more broadly should be considered as part of fiscal strategy to create space for green spending.
  - Adopt escape clauses to account for large natural disasters:
    - Rules should budget for smaller and frequent disasters, but large disasters may require temporary increases in spending or deficit via escape clauses, with specified strategies to return to rule limits over time.

### Complementary green PFM practices
- Green PFM integrates a climate-sensitive perspective into PFM practices, systems, and frameworks across the budget cycle and related entities (state-owned enterprises, subnational governments, fiscal transparency).
- Examples of green PFM practices:
  - Green or climate budget ‘tagging’ to classify budget items by climate/environmental impact and prioritize high-impact green spending.
  - Climate-smart public investment and IMF’s Climate-Public Investment Management Assessment (C-PIMA) covering planning, coordination, project appraisal, budgeting, portfolio management, and risk management.
  - Enhance transparency and performance measurement: performance budgeting frameworks, environmental impact assessments, ex-post evaluations, and Green Spending Reviews.
  - Independent oversight and assessment: fiscal councils, climate panels, and bodies (examples from Netherlands, Denmark, Finland, France, Ireland, Sweden, UK) to advise, monitor, and evaluate climate policies and green budgeting.
- Monitoring and evaluating green budgeting effects on decision-making strengthens green budgeting tools and progress toward green objectives.

### Country-level examples and analytical tools
- Denmark:
  - GreenREFORM Project: macroeconomic model producing annual projections up until 2100 for medium-to-long-term fiscal and economic analysis.
- United Kingdom (OBR):
  - 2021 Fiscal risks report: explored fiscal risks posed by climate change and net zero by 2050; acting early improves outcomes; carbon taxes and car taxes can in some scenarios improve public finances.
  - 2022 and 2023 Fiscal Risks and Sustainability reports analyzed the energy price crisis and transition costs.
  - 2023 OBR paper Next steps for climate change analysis: discusses future analytical avenues.
- New Zealand:
  - Combined Statement on the Long-term Fiscal Position and Long-term Insights Briefing includes fiscal impacts of climate change.
  - 2021 budget quantifies ETS impact and proceeds available by 2050.
  - Since 2023 Treasury publishes “Climate Economic and Fiscal Assessment”.
- France:
  - Adopted a “green budget” since 2022 focused on green budgeting tagging and presenting abatement costs of mitigation options.
- Senegal:
  - Adopted a 2024 green budget classifying expenditures by environmental impact and resilience-building capacity.
- Broader note: an increasing number of countries, including many developing countries, are undertaking green budget practices.

### Findings on fiscal implications and risks
- Fiscal costs of green policies can be very large, especially when achieving net zero is pursued mostly using spending-based instruments (investment and subsidies).
- Green fiscal rules that exclude “green” spending from fiscal limits would:
  - Undermine the objectives of fiscal rules and constrain governments’ ability to pursue other policy priorities.
  - Potentially lead to unsustainable debt dynamics.
- Calibrating a green fiscal rule consistent with the budget constraint and preserving debt sustainability would often require large cuts in the “non-green” fiscal balance beyond historical sustainment.
- Complex and dynamic policy choices cannot feasibly be fully reflected in a fiscal rule; defining green spending is challenging and risks creating complex and opaque rules.

### Policy and framework recommendations
- Strengthen MTFFs to better reflect climate change challenges and effects of green policies:
  - Incorporate climate considerations into macro projections by quantifying economic impacts (for instance on potential growth) and related fiscal costs.
  - Complement projections with debt sustainability analysis that includes effects of climate change and natural disasters.
  - Calibrate fiscal buffers and flexibility within MTFFs to respond to climate-related shocks.
- Supplement MTFFs with green PFM practices:
  - Climate budget tagging.
  - Climate-smart public investment.
- Adopt a mix of policies and tools to share the burden between public and private sectors, likely involving:
  - Carbon taxes.
  - Public and private investment.
  - Regulations on energy efficiency and climate adaptation.
- Emphasize broader policy analysis and public discussion to build wide public support for choices required to preserve debt sustainability while pursuing climate goals.

*Source: wpiea2024125-print-pdf - Box 1. Examples on how countries are incorporating climate risks into budgets and MTFFs*

### Box 1. Examples on how countries are incorporating climate risks into budgets and MTFFs ________________ 20

### Box 1. Examples on how countries are incorporating climate risks into budgets and MTFFs ________________ 20

### I. Introduction — context and framing
- Climate agenda requires significant upfront government action on mitigation and adaptation at a time of rising debt sustainability concerns.
- Relying largely on expenditure-based measures to achieve net zero emissions would put significant pressure on fiscal accounts in the absence of compensatory revenue measures (IMF October 2023 Fiscal Monitor).
- Fiscal rules aim to limit deficit bias by constraining fiscal discretion and increasing fiscal credibility, but must balance sustainability with flexibility to respond to shocks.
- Proposals for green fiscal rules typically seek to protect green public investments by excluding green spending from fiscal rule limits or introducing green escape clauses, benchmarks, or green investment funds.
- Key challenge: green rules risk undermining fiscal credibility and producing disruptive debt dynamics if green spending is large and financed mainly through public debt.

### II. Quantitative illustration: green rule simulations and key scenarios
- Simulation basis and assumptions:
  - Representative Emerging Market (EM) assumptions use IMF October 2023 Fiscal Monitor estimates.
  - Additional public investment of around 2 percent of GDP per year for mitigation (assuming public sector funds 20 percent of costs and private sector funds the remainder).
  - Adaptation costs estimated to average 1-2 percent of GDP per year for many developing countries (Aligishiev et al. 2022).
  - Simulations follow Escolano (2010) public debt dynamics methodology and use WEO extrapolation as baseline.
  - Debt anchor calibration uses IMF FAD toolkit; estimated safety buffers around 20 percent of GDP (normal volatility) and up to 30 percent of GDP (including tail risks), implying a debt anchor of around 40-50 percent of GDP.
  - Average EM government debt levels stood at 66 percent of GDP at the end of 2022.
  - Debt limit range for a typical EM: around 70-95 percent of GDP; the simulations use the lower end of the 70-95 range for prudence.
- Scenarios simulated (assume mostly spending-based policies to reach net zero by 2060 in EMs):
  - No fiscal rule: WEO extrapolation + additional 2 percent of GDP annual mitigation spending (blue line).
  - Green rule exempting mitigation spending: 3 percent of GDP deficit ceiling (excluding mitigation) + 2 percent of GDP annual mitigation spending (green line).
  - Green rule exempting mitigation and adaptation: 3 percent of GDP deficit ceiling (excluding mitigation and adaptation) + 4 percent of GDP annual green spending (mitigation + adaptation) (purple line).
  - Green rule preserving debt sustainability: 2.5 percent of GDP primary surplus (excluding green spending) calibrated to preserve debt sustainability with 2 percent of GDP annual green spending (yellow line).
  - Illustrative green MTFF allocation: higher green and lower non-green budget balances calibrated to preserve debt sustainability within a green MTFF that includes carbon pricing (red dashed line).
- Key quantitative simulation findings:
  - Under WEO extrapolation with additional 2 percent mitigation spending, the overall deficit deteriorates to almost 9 percent of GDP by 2050 and the debt ratio surges by more than 30 percentage points reaching almost 140 percent of GDP (blue line).
  - Under green rule with 3 percent non-green budget limit and 2 percent mitigation spending, public debt reaches more than 100 percent of GDP by 2050 (green line).
  - Adding 2 percent of GDP annual adaptation spending (total 4 percent green) with a 3 percent non-green deficit limit keeps the deficit at 7 percent of GDP and pushes debt to 125 percent of GDP by 2050 (purple line).
  - For a typical EM, the overall primary balance which stabilizes debt at the estimated debt anchor (50 percent of GDP) in the long run is a 0.5 percent of GDP primary surplus.
  - If mitigation spending of 2 percent of GDP is exempted under a green rule, a non-green primary yearly surplus around 2.5 percent of GDP would be required to ensure debt sustainability (yellow line).
  - In an illustrative green MTFF with carbon pricing and more balanced tool mix, the non-green primary balance required to keep debt sustainable is about 1 percent of GDP throughout the projection horizon (red dashed line).

### III. Interpretation and policy implications from simulations
- Simple green fiscal rules that exempt sizable green spending can produce either:
  - Unsustainable debt trajectories (if overall spending rises without compensatory measures), or
  - Overly tight non-green fiscal balances that significantly skew budget priorities (requiring large non-green surpluses).
- Numerical rules alone are unlikely to be credible given the large tradeoffs; a medium- and long-term fiscal strategy and broad public consensus are required to set priorities and financing.
- For low-income countries, achieving climate goals under constrained fiscal space will likely require significant donor support.
- The optimal mix of climate policy tools should consider:
  - Relative fiscal costs and returns of mitigation versus adaptation.
  - The potential for technological change (e.g., falling costs of solar and wind) to reduce green spending needs over time.
  - The role of carbon pricing to finance green investments and protect fiscal sustainability.

### IV. Operational and design challenges of green fiscal rules
- Classification and reclassification risks:
  - Green rules resemble golden rules (which exclude investment) and can incentivize reclassifying current expenditure as capital or classifying diverse spending as “green.”
  - Monitoring and enforcement become more difficult with greater rule complexity.
- Interaction with multiple rules:
  - Introducing floors or additional operational rules on green spending can undermine compliance with existing rules when multiple rules coexist.
- Uncertainty in sizing green needs:
  - Estimates of adaptation and mitigation costs are highly uncertain and heterogeneous (examples: 46 countries reporting adaptation estimates average 1.5 percent of GDP; Aligishiev et al. (2022) estimate annual adaptation costs at around 0.25 percent of world GDP per year with costs exceeding 1 percent of GDP for emerging markets and averaging 2.7 percent of GDP for small island states).
- Other modeling and empirical complexities not fully captured in simple simulations:
  - Externalities and general equilibrium effects of climate policies are not modeled; a general equilibrium approach would be needed to fully capture international spillovers.
  - Differing sizes of green fiscal multipliers could change debt dynamics: large green spending output multipliers could dampen adverse debt effects; some green investments may raise future revenues or reduce disaster-related losses.
  - Transition to renewables could reduce fiscal pressures from fossil fuel price surges and contribute to a more resilient fiscal path—this is not incorporated in the simulations.

### V. Alternative approach advocated: green MTFFs and broader green PFM
- Proposal: incorporate complex climate considerations into fiscal policy via green medium-term fiscal frameworks (MTFFs) and green public financial management (PFM).
- Advantages of green MTFFs:
  - Account for long-term effects of climate change and climate policies on fiscal accounts.
  - Help optimize the mix of green fiscal policy tools (spending, carbon pricing, subsidies, transfers) based on economic and fiscal impact.
  - Enable prioritization across spending items and focus green spending on high-impact areas for achieving climate objectives.
  - Facilitate financing strategies that can combine public investment with carbon pricing to preserve fiscal sustainability.
- Illustrative finding: a green MTFF combining carbon pricing and improved allocation can achieve debt sustainability with a less onerous non-green primary balance (about 1 percent of GDP) compared with strict green-rule exemptions that imply non-green surpluses around 2.5 percent of GDP.

*Source: wpiea2024125-print-pdf - Box 1. Examples on how countries are incorporating climate risks into budgets and MTFFs ________________ 20*

### introduction of similar types of rules. During the global financial crisis in Mexico, for instance, capital

### wpiea2024125-print-pdf - introduction of similar types of rules. During the global financial crisis in Mexico, for instance, capital

### Evidence on fiscal multipliers for energy investment
- Batini et al. (2021) find that the point estimates of the multipliers are in the range 1.1-1.5 for renewable energy investment and between 0.5 and 0.6 for fossil fuel energy investment, depending on the horizon and econometric specification.
- Hasna (2021), using state-level data for the United States, find a contemporaneous multiplier of 1.1 and an upper bound of 4 in the second year of implementation.

### Use of carbon tax revenue
- Reference made to a more detailed discussion and country examples on how to use carbon tax revenue in: “Using Carbon Revenues”. Note 16. World Bank, Washington, DC. World Bank.

### Historical experiences with investment/golden-rule style fiscal exemptions
- During the global financial crisis in Mexico, for instance, capital expenditures by the national oil and the state-owned electricity companies were excluded from the budget balance contributing to adverse public debt dynamics (Valencia 2015).
- Germany abandoned its golden rule in 2010, after more than 30 years, as it did not prove successful at impeding the buildup of debt (OECD 2008).
- In the UK, the objectives of the golden rule on public investment were incompatible with the fiscal adjustments imposed by the debt rule, and eventually led to the suspension of the rule (Basdevant et al. 2020).
- In some countries, capital expenditure sometimes includes social current expenditure (considered as a form of ‘human capital’) to allow for debt financing under this type of rules, reducing budget transparency.

### Practical design challenges for green fiscal rules
- Defining green spending:
  - A decision on what constitutes green spending will need to be taken; most spending items can have a green component (for example, water and sanitation).
  - Countries have very heterogenous definitions and procedures to define climate relevant activities across the public and private sectors (World Bank 2021), which can undermine transparency.
- Scope of spending covered:
  - Governments will need to decide whether only capital or also current spending should be exempted from the rule limit.
  - There could be a case for excluding current spending, such as green subsidies, as it may not matter whether climate mitigation spending takes the form of public investment or private investment through government subsidies.
- Treatment of interest associated with green financing:
  - If current spending is excluded, there could also be an argument in favor of excluding interest payments associated with financing the green budget, which would further worsen the debt dynamics in our simulations.

*Source: wpiea2024125-print-pdf - introduction of similar types of rules. During the global financial crisis in Mexico, for instance, capital*

### introduction of other measures, such as carbon taxes, could be considered in the design of green rules (see

### III. A green medium-term fiscal framework

### Overview and rationale
- Addressing climate change decisively requires integrating climate considerations into fiscal policy decision-making and planning rather than relying solely on numerical green rules.
- Medium-term fiscal frameworks (MTFFs) can combine flexible rules with stronger institutions to promote sound public finances and help inform costs and benefits of climate policies and build consensus.
- Countries should develop “green” MTFFs that incorporate the economic and fiscal effects of climate change and of climate adaptation and mitigation policies to assess effects during the green transition.
- Developing green MTFFs requires significant reforms, including a medium-term perspective in budgeting, incorporating climate and aging in the budget process, and upgrading transparency and independent fiscal councils.

### Key components of green MTFFs (as highlighted in Figure 4)
- Macroeconomic projections
  - Economic costs of climate change (e.g., on potential growth).
  - Related fiscal costs.
  - Scenarios.
- Climate-related policies
  - Choice of measures.
  - Impact on taxes (e.g., carbon taxes).
  - Impact on expenditures (investment; energy subsidies, safety nets).
  - Risks related to climate change.
  - Effects of climate-related policies (e.g., adaptation).
  - Longer-term perspective.
- Risks and debt sustainability
  - Mitigate risks (reduce needed buffers).
- Fiscal rules
  - Target broad aggregates.
- Other green PFM practices
  - Green PFM through other phases of the budget.
  - Climate-smart public investment.

### Incorporating macro-fiscal effects into projections
- MTFFs should quantify climate impacts on medium-term (potential) growth and implied fiscal costs.
- Projections should:
  - Include gradual effects of climate change and climate-related natural disasters, reflecting changes in frequency and magnitude over time.
  - Include discussion of fiscal risks posed by climate change.
  - Use longer-term projection analysis to identify risks beyond a 3-5 year horizon.
- Macro-fiscal forecasting models can account for economic, budgetary, and financial costs from climate change. Example model: IMF’s DIGNAD (Debt-Investment-Growth and Natural Disasters).
  - DIGNAD enables users to:
    - evaluate debt sustainability risks following natural disasters amidst infrastructure rebuilding needs;
    - analyze effects of ex-ante policies (building adaptation infrastructure, increasing fiscal buffers, improving public investment efficiency);
    - study climate risk effects from natural disasters and how adaptation investments mitigate risks.
- Building capacity and improving knowledge of climate impact over time is required.

### Costing and assessing policy measures
- MTFFs should enhance costing of different policy measures and assess consistency with climate objectives.
- MTFFs could provide information on current and capital spending and revenues related to climate and how these affect debt dynamics.
- Economic and budgetary impact of climate policies should consider:
  - Policies for mitigation:
    - Different fiscal tools (green public investment, green subsidies, carbon pricing, feebates) have vastly different fiscal impacts.
    - Carbon pricing or revenue-neutral feebates can require fewer spending-side measures; medium- and long-term projections should incorporate chosen policies.
    - Projections for alternative scenarios relying on different fiscal policy mixes can inform optimal policy mix. Example tool: IMF’s Climate Policy Assessment Tool (CPAT) helps estimate effects of climate mitigation policies on emissions and fiscal accounts.
  - Policies for adaptation:
    - Spending on adaptation should be weighed against counterfactual inaction (lower potential growth and larger climate-related shocks).
    - Adoption of significant adaptation measures increases resilience and can reduce future needs for fiscal buffers while implying short-term fiscal cost.
    - Knowing size of adaptation investment needs for different types (e.g., strengthening physical assets, coastal protection) is critical for designing affordable adaptation strategies.

### Risk-based debt sustainability analysis (DSA) including climate risks
- Debt sustainability analysis should include effects of climate change and natural disasters.
- IMF DSA tools (MAC-SRDSF and the LIC-DSF) provide stress tests for natural disasters (triggered for vulnerable countries), covering:
  - climate-related (droughts, wildfires), geophysical (earthquakes including tsunamis, volcanic activities), and hydrological (floods and landslides) shocks.
- MAC-DSA includes a module estimating consequences of adaptation and mitigation investments:
  - Produces 30-year debt and gross financing needs projections reflecting fiscal cost of adaptation investment and main debt drivers.
  - Includes a sub-module on mitigation costs capturing impact on debt sustainability of upfront investment needed for transition to a low carbon economy over a 30-year horizon.
- Longer-term fiscal projections and risk analysis are warranted but complex to estimate and communicate.

### Designing and calibrating fiscal rules within green MTFFs
- Enhanced MTFFs can help design and calibrate fiscal rules accounting for climate risks and policies.
- Fiscal rules should target broad aggregates to preserve debt sustainability, with specific considerations for climate vulnerability:
  - Incorporating climate considerations improves assessment of debt limits and fiscal buffers to calibrate debt anchors and operational rules.
    - Fiscal and debt projections should incorporate effects of climate change on variables like economic growth (including its mean and higher-order moments).
    - Adaptation policies can alter future growth paths and the amount of debt that can be sustained.
    - Fiscal anchor recalibration at regular intervals (e.g., every 5 years) is recommended to incorporate updated climate risk assessments.
  - Size of fiscal buffers will vary with magnitude of shocks and country-specific vulnerabilities and implementation of adaptation policies; fiscal impact of shocks should consider disaster insurance mechanisms.
  - Choice and calibration of fiscal rules depend on policy mix:
    - Example: combination of carbon taxes and higher adaptation spending can allow higher expenditure limits while preserving sustainable deficit and debt levels, compensated by higher tax revenues or dedicated grants.
    - Hump-shaped carbon revenue projections over time imply rules and limits may need revision over medium to long term.
    - Revenue mobilization more broadly should be considered as part of fiscal strategy to create space for green spending.
  - Adopt escape clauses to account for large natural disasters:
    - Rules should budget for smaller and frequent disasters, but large disasters may require temporary increases in spending or deficit via escape clauses, with specified strategies to return to rule limits over time.

### Complementary green PFM practices
- Green PFM integrates a climate-sensitive perspective into PFM practices, systems, and frameworks across the budget cycle and related entities (state-owned enterprises, subnational governments, fiscal transparency).
- Examples of green PFM practices to adopt alongside green MTFFs:
  - Green or climate budget ‘tagging’:
    - Classify budget items by climate/environmental impact to prioritize high-impact green spending (example: priority-based budgeting elevating climate as strategic priority).
  - Climate-smart public investment (public investment management, PIM):
    - IMF’s Climate-Public Investment Management Assessment (C-PIMA) focuses on climate-aware planning, coordination, project appraisal and selection, budgeting and portfolio management, and risk management.
  - Enhance transparency and performance measurement:
    - Develop performance budgeting frameworks to measure results and outcomes; environmental impact assessments and ex-post evaluations can accompany or follow budget measures.
    - Green Spending Reviews assess alignment of baseline expenditure with climate and environment policies and formulate options.
  - Independent oversight and assessment:
    - Independent bodies (e.g., fiscal councils, climate panels) can advise, monitor climate policies, assess coherence with environmental strategy, evaluate tools and methods in green budgeting, and perform/evaluate green spending reviews.
    - Examples of institutional roles: Netherlands’ PBL, Advisory Division of the Council of State, Bureau for Economic Policy Analysis (CPB), Denmark’s Council on Climate Change, Finland’s Climate Change Panel, France’s High Council for Climate, Ireland’s Climate Action Delivery Board, Sweden’s Climate Policy Council, UK’s Climate Change Commission.
- Monitoring and evaluating green budgeting effects on decision-making strengthens green budgeting tools and progress toward green objectives.

### Notable numeric and model references preserved from the source
- Projection horizons and intervals: 3-5 year horizon for near-term risk identification; 30-year projections for adaptation and mitigation investment modules; recalibration example every 5 years.
- Reported returns and ratios referenced:
  - Models of “optimal” level of adaptation point to high average returns of around 80-100 percent, above typical average returns (around 15-20 percent) of standard infrastructure investment in countries with large investment gaps.
  - Sectoral studies report climate adaptation returns (benefit-to-cost ratios) as high as 100-900 percent.
- Models and tools named: DIGNAD, CPAT, MAC-SRDSF, LIC-DSF, MAC-DSA, C-PIMA.

*IMF Working Papers — Green Fiscal Rules? Challenges and Policy Alternatives (section: III. A green medium-term fiscal framework).*

### Box 1. Examples on how countries are incorporating climate risks into budgets and MTFFs

### Box 1. Examples on how countries are incorporating climate risks into budgets and MTFFs

### Country-level examples and analytical tools
- Denmark
  - GreenREFORM Project: macroeconomic model to assess the economic and fiscal impacts of climate and environmental policies, and the climate and environmental impacts of economic policies.
  - Model produces annual projections up until 2100, enabling medium-to-long-term fiscal and economic analysis, including consistency with climate and environmental targets.
- United Kingdom (Office for Budget Responsibility, OBR)
  - 2021 Fiscal risks report: explored fiscal risks posed by climate change and the Government’s commitment to reduce the UK’s net carbon emissions to zero by 2050.
  - Findings: different scenarios in timing of measures adoption and type of policies lead to significantly different public debt outcomes.
  - Noted that the costs of getting to net zero could be significant, but under some scenarios which include carbon taxes and car taxes, public finances could even improve.
  - Acting early improves the outcome compared to a late-action scenario.
  - 2022 and 2023 Fiscal Risks and Sustainability reports: analyzed the impact of the energy price crisis, including its impact on demand for fossil fuels and the cost of transitioning to net zero.
  - 2023 OBR paper Next steps for climate change analysis: discusses future avenues for analytical analysis on climate change.
- New Zealand
  - Combined Statement on the Long-term Fiscal Position and Long-term Insights Briefing: includes discussion of fiscal impacts of climate change for both adaptation and mitigation; different scenarios at varying degrees of severity are considered and their fiscal impacts modeled.
  - 2021 New Zealand budget: quantifies the impact of its emissions trading scheme (ETS) and quantifies the scale of their proceeds that may be available by 2050.
  - Since 2023 the New Zealand Treasury began publishing a “Climate Economic and Fiscal Assessment”, complementing its regular Economic and Fiscal Updates.
- France
  - Adopted a “green budget” since 2022, primarily a green budgeting tagging exercise to change the composition toward more “green expenditure”.
  - Budget provides a presentation of abatement costs of different mitigation options to motivate policy choices across possible measures.
- Senegal
  - Adopted a 2024 green budget which classifies expenditures according to their environmental impact and their ability to support actions to build resilience to climate change.
- Broader note
  - An increasing number of countries, including many developing countries, are undertaking green budget practices.

### Findings on fiscal implications and risks
- Fiscal costs of green policies can be very large, especially when achieving the net zero emissions goal is pursued mostly using spending-based instruments (e.g., investment and subsidies).
- Green fiscal rules that exclude “green” spending from fiscal limits would:
  - Undermine the objectives of fiscal rules (constraining excessive deficits and signaling commitment to fiscal responsibility).
  - Ultimately constrain the ability of the government to pursue policy priorities, including on climate.
  - Potentially lead to unsustainable debt dynamics.
- Calibrating a green fiscal rule consistent with the budget constraint and preserving debt sustainability would often require large cuts in the “non-green” fiscal balance and above what countries have been able to sustain in the past.
- Complex and dynamic policy choices (mix of carbon taxes, public and private investment, regulations on energy efficiency and climate adaptation) cannot feasibly be fully reflected in a fiscal rule; designing such rules poses additional challenges (e.g., how to define green spending) and risks creating overly complex and opaque rules.

### Policy and framework recommendations
- Strengthen medium-term fiscal frameworks (MTFFs) to better reflect climate change challenges and the effects of green policies, including:
  - Incorporating climate considerations into macro projections by quantifying impacts in terms of economic costs (for instance on potential growth) and related fiscal costs.
  - Complementing projections with a debt sustainability analysis that includes the effects of climate change and natural disasters.
  - Calibrating fiscal buffers and flexibility within MTFFs to respond to climate-related shocks.
- Supplement MTFFs with green public financial management (PFM) practices, such as:
  - Climate budget tagging.
  - Specific attention to climate-smart public investment.
- Adopt a mix of policies and tools to share the burden of the climate transition between the public and private sector; likely to involve to some degree:
  - Carbon taxes.
  - Public and private investment.
  - Regulations on energy efficiency and climate adaptation.
- Emphasize broader policy analysis and public discussion to build wide public support for difficult policy choices required to preserve debt sustainability while pursuing climate goals.

*Source: Box 1. Examples on how countries are incorporating climate risks into budgets and MTFFs (from the supplied IMF working paper excerpt).*

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_Source: https://www.imf.org/-/media/files/publications/wp/2024/english/wpiea2024125-print-pdf.pdf_