## _022208

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### Executive Summary — Overview
- Reviews fiscal implications of climate change and potential role of the Fund.
- Key overarching points:
  - Fiscal implications are immediate as well as lasting, and liable to affect—in differing forms and degree—all Fund members.
  - Climate change is a global externality problem, calling for some degree of international fiscal cooperation.
  - Features that complicate policy: intertemporal mismatch between (early) costs and (later) benefits; pervasive uncertainties and irreversibilities (including risk of catastrophe); sharp asymmetries in effects across countries.
  - Climate change both impacts public finances and calls for deploying fiscal instruments to mitigate and adapt.

### Executive Summary — Scientific projections and impacts
- IPCC (2007) BAU projection:
  - Global mean temperature will increase over the next century by 2.8 o C, with a 3 percent chance of rising 6 o C or more.
  - For a 3 o C rise, benchmark estimates for loss of global GDP range from zero to 3 percent.
- Physical consequences: changed precipitation, sea level rise (amplified by storm surges), more intense/frequent extreme weather, increased vector-borne diseases, potential catastrophic events (e.g., reversal of the Gulf Stream, melting of the Greenland ice sheet).
- Potential economic consequences: productivity changes in climate-sensitive sectors, coastal damage, stresses on health and water systems, altered trade and investment, financial market disruption, increased vulnerability to sudden shocks, altered migration patterns—affecting external stability.

### Executive Summary — Fiscal policy roles
- Mitigation: fiscal instruments (taxes, cap-and-trade, hybrids) to price emissions; level and future path of carbon prices critical.
- Adaptation: additional public spending may be needed to provide public goods and facilitate private adjustment.
- Implications for the Fund: reinforce current Fund advice (raise/broaden energy taxes; identify/prepare for fiscal risks); many design issues lie within Fund expertise; implications for Fund fiscal work appear modest and can be accommodated within the prospective budget envelope.

### Introduction — Key messages
- Hotter and lower-lying countries—often already most vulnerable—are most at risk; some temperate countries may benefit from moderate warming.
- Most likely aggregate damage expected later this century, but near-term severe events illustrate immediate challenges.
- Core actions must be anticipatory; policy responses require long lead times.
- Fiscal implications can be immediate and powerful: direct effects on tax bases and spending programs; case for purposive use of fiscal instruments for mitigation and adaptation.

### Economics of climate change — core features
- Externality: emitters do not internalize aggregate damage; international coordination required.
- Counterfactual mitigation: slowing and then (starting in 2020–40) cutting global emissions (by 60–80 percent).
- Asymmetries:
  - High-income economies generated about 80 percent of past fossil fuel-based emissions.
  - Within a decade, most emissions will come from outside the OECD.
- Stock nature and timing: global temperature depends on cumulative stock; emissions take decades to have full effect and decay; intertemporal mismatch between early costs and late benefits; discount rate choice critical.
- Uncertainty and catastrophe risk: relationships among emissions, interventions, market responses, and damage are very unsure; extremely costly events possible though probabilities likely low and unknown.
- Interactions with other market failures: innovation externalities, revenue and tax-system interactions, deforestation (~20 percent of GHG emissions) hindered by weak property rights and governance.
- Exhaustibility of fossil fuels: extraction timing affects mitigation outcomes.

### Impact effects on public finances
- Direct fiscal impacts:
  - Slow-moving productivity changes and higher risk of intense shocks can reduce revenues and increase spending.
  - Examples: reduced agricultural productivity, impacts on tourism/fishing rights, increased vector-borne diseases, population movements.
  - Fiscal impacts most adverse where wider vulnerabilities greatest.
- Fiscal instruments:
  - Mitigation instruments often generate public funds (carbon pricing); adaptation instruments often use public funds.
  - Given distortionary costs of raising revenue, there is marginal preference for revenue-raising over revenue-using measures.
- Uncertainty/irreversibility:
  - Low-probability, high-impact events can dominate policy assessments; uncertainty may justify aggressive responses (Weitzman, 2007).
  - Irreversibility supports both precautionary action and waiting for better information; assessments differ.

### Fiscal instruments for mitigation — principles and design
- Pigovian pricing:
  - Charge a price for emitting CO2 equal to present value of social damage.
  - Efficiency requires same carbon price for all emissions wherever they arise.
  - Future path and credibility of carbon price are critical; optimal path implies steady increase in real carbon price; discount rate is key determinant.
- Supply-side/exhaustibility:
  - A carbon tax rising at the market interest rate would not affect extraction timing; incidence may fall on resource owners if long-run supply is inelastic.
  - High fossil fuel prices do not substitute for explicit carbon pricing.
- Revenue use and “double dividend”:
  - Receipts usable to reduce other distorting taxes, increase public spending, or reduce debt.
  - “Double dividend” not guaranteed because energy price rises can reinforce labor tax distortions.
  - Historical example: Germany shifted around 3 percent of total tax revenue this way in 1996–99.
  - Best use of revenue varies by country; developing countries may strengthen revenue mobilization; developed countries have used “green tax swaps” to reduce social contributions.
- Exhaustibility and rate path:
  - Some argue fossil fuels are extracted too rapidly, implying a carbon price rising at less than the market interest rate could be appropriate to shift emissions into the future.
  - Property-rights insecurity can reduce oil production but increase deforestation.
  - Aiming for too rapid an increase in carbon price risks increasing current emissions.

### Instrument choice — taxes, cap-and-trade, hybrids
- Implementation options:
  - Carbon tax: specific rate on emissions or on fossil fuels.
  - Cap-and-trade: fixed total emission rights issued and tradable; permit price equals carbon price.
  - Hybrids: e.g., cap-and-trade with a maximum price.
- Equivalence and uncertainty:
  - Tax and cap-and-trade can be equivalent if permits are auctioned and abatement costs known.
  - Free permit allocation foregoes revenue relative to carbon taxation.
  - Under abatement cost uncertainty, carbon taxation likely preferable to pure cap-and-trade.
  - Taxes provide price certainty; cap-and-trade provides emissions (quantity) certainty.
- Cross-country revenue allocation:
  - Under carbon tax, revenue typically remains where levied (destination basis) but could be origin-based or used for global public goods.
  - Under international cap-and-trade, countries with cheap abatement sell rights to those with costly abatement; transfers depend on rights allocation.

### Rates, revenue and model evidence
- Indicative carbon price magnitudes (estimates vary widely):
  - Many studies: starting carbon price often US$15–US$60 per ton of carbon (/tC) — equivalent to around US$2–US$8 per barrel of oil, or 5–20 cents per gallon of gasoline.
  - Meta-study modal value: around US$20/tC; median: US$48/tC (distribution strongly right-skewed) (Tol, 2007).
  - Stern Review (2007) estimate: US$312/tC.
  - Nordhaus (2007) suggests starting carbon price around US$17/tC.
  - For comparison: current EU-ETS forward price (for delivery in late 2008) is around € 83/tC.
- Importance of future path: real increases over time more important than initial level.
- Models referenced: IGSM and MiniCAM; WEO uses G-cubed (McKibbin and Wilcoxen, 1998).
  - Results reported for stabilization objectives: 450 ppm, 550 ppm, 650 ppm; focus on 550 ppm.
  - In IGSM, carbon price rises from about US$75/tC to US$380/tC (nearly US$50 per barrel of oil) by 2060. [text ends]

### Fiscal instruments and revenue potential (model outputs and country examples)
- Potential revenue from appropriate carbon pricing: around 1–2 percent of global GDP until mid-century.
- Revenue increases throughout the century (except under more aggressive MiniCAM scenarios).
- MiniCAM baseline emissions: reaching US$135/tC by 2060.
- Stern (2007) example: strong mitigation reducing marginal damage to US$105/tC.
- United States example:
  - A tax of US$55/tC would raise around US$80 billion a year.
  - Equivalent to 30 percent of the corporate income tax, or enough to rebate the first US$560 of payroll taxes to all workers.
- MiniCAM regional implications: a 2 point increase in tax ratios in Africa, FSU/East Europe and India by 2060 highlighted.
- Selected MiniCAM regional revenues in percent of GDP (Table 1, MiniCAM output):
  - Africa: 450 alternative 2020 = 2.5; 2060 = 1.3.
  - China: 450 alternative 2020 = 2.5; 2060 = 0.6.
  - India: 450 alternative 2020 = 2.6; 2060 = 0.1.
  - United States: 450 alternative 2020 = 0.9; 2060 = 0.5.
  - West Europe: 450 alternative 2020 = 0.7; 2060 = 0.2.
- Note: Table 1 sourced to IMF staff calculations using MiniCAM output.

### Cross-country flows under international cap-and-trade
- Flows depend on allocation (relative to BAU emissions vs. per capita).
- Under allocation relative to BAU: flows much less than 1 percent of GDP (except under 450 ppm alternative).
- Under equal per capita allocation: Africa and India have inflows around 1 percent of GDP in 2020, rising steadily thereafter in Africa.
- Allocation rules produce markedly different regional effects (e.g., FSU sells under BAU allocation but buys under per capita).
- G-Cubed (Table 2) example (annual emission rights proportional measures, percent of GDP):
  - Proportional to initial emissions:
    - United States: 2020 = 0.02; 2030 = 0.11; 2040 = 0.22.
    - China: 2020 = 0.32; 2030 = 2.16; 2040 = 5.95.
    - Less developed countries: 2020 = -0.11; 2030 = -0.59; 2040 = -1.44.
  - Proportional to population share:
    - United States: 2020 = -0.02; 2030 = -0.32; 2040 = -0.32.
    - China: 2020 = 0.33; 2030 = 1.96; 2040 = 5.46.
    - Less developed countries: 2020 = 0.71; 2030 = 1.08; 2040 = 0.77.
- Caution: model differences (BAU projections, regional coverage) yield divergent conclusions (e.g., China modest buyer/seller in MiniCAM vs. large seller in G-Cubed).

### Domestic equity, compensation, and policy design
- Carbon pricing likely regressive in both developed and developing countries (direct fuel use and indirect commodity price effects).
- Distributional impact depends on pass-through and consumption patterns (gasoline vs. kerosene).
- Compensation examples:
  - United States: carbon price ~US$50/tC raises electricity and gas prices ~12 percent and gasoline ~8 percent; reconfiguring the earned income tax credit and social security payments can largely offset regressivity (Metcalf, 2007).
  - United Kingdom: targeted benefits (e.g., winter supplement to pensioners) can protect vulnerable groups.
- Poorly targeted measures (e.g., reduced indirect tax rates on energy-intensive products) compromise climate objectives.
- Developing-country priorities:
  - Eliminate remaining fuel subsidies (explicit and implicit); examples: 17 percent of GDP in Azerbaijan and 10 percent in Yemen (subsidy prevalence noted).
  - Complementary measures: Ghana example—elimination of school fees for primary and secondary education with fuel price increases to protect the poor.
  - Beware unintended effects: higher kerosene prices inducing substitution to burning wood with health and deforestation consequences.

### Earmarking, auctioning, and fiscal governance
- Earmarking mitigation revenue generally undesirable but may overcome political resistance; tight earmarking can overly constrain public finances.
- No clear economic rationale for linking mitigation revenue directly to adaptation spending (CDM proceeds to an Adaptation Fund questioned).
- Cap-and-trade fiscal implications:
  - Full fiscal benefits require selling rights rather than allocating free (grandfathering).
  - Grandfathering foregoes sizable public finance benefits:
    - EU-ETS foregone benefit estimated in order of €40 billion annually.
    - Recent U.S. proposals foregone benefit estimated at US$130–US$370 billion (in 2015).
  - Grandfathering may be defensible for sunk investments made before emissions charges were foreseeable; where unavoidable, record value of grandfathered rights as a tax expenditure.
- European Commission example: proposes full auctioning of EU-ETS permits for power companies from the start of 2013, and for all others by 2020 (text notes this proposal).

### International coordination, trade measures, and instrument choice
- Fully coordinated approach: uniform carbon price with cross-country transfers to address fairness; national fiscal incentives impede cooperation.
- Importer/exporter incentives: importers may use carbon taxes/tariffs to extract rent from exporters; exporters may manipulate supply—risk of carbon taxes too high globally (Strand, 2007).
- Noncooperation currently results in too little mitigation given projected BAU damage.
- Leakage and efficiency:
  - Emissions concentrated among relatively few countries (25 account for about 80 percent); broad agreement likely needed for efficient mitigation.
  - Mitigation costs vary markedly across countries, supporting gains from trade and case for “broad-but-shallow” over “narrow-but-deep” agreements.
- Measures to encourage cooperation:
  - Adopt minimum (not harmonized) carbon tax rates.
  - Selective border tax adjustments (BTA): remit carbon price content of exports and impose corresponding charges on imports—preserves domestic mitigation while addressing competitiveness but risks WTO inconsistency and practical implementation challenges.
- Administrative and currency issues:
  - Multi-country carbon tax must be specified in a basket of currencies since it is a specific charge; cap-and-trade market price maps automatically into national currencies.
  - Compliance assurance differs by instrument: taxes require confidence others are not offsetting via subsidies; trading requires governance confidence in permit schemes and use of quota rents.

### Current measures, policy coherence, and first steps
- Systematic carbon pricing is rare; no country has a carbon tax uniform across uses and sectors.
  - Closest examples: Denmark, Norway, Sweden, and the Climate Change Levy in the United Kingdom (each with significant exemptions).
  - EU-ETS covers about 45 percent of GHG emissions.
- Many fiscal instruments affect emissions indirectly (fuel excises, tax treatment of company cars, extraction fiscal arrangements).
- Effective carbon pricing requires greater coherence in energy tax policies and fewer exemptions.
- First policy step in many countries: increase fossil fuel taxes and equalize them across types; many systems favor diesel and leave international aviation and shipping largely uncharged.
- Auctioning vs. grandfathering: auctioning captures fiscal benefits; grandfathering has distributional and incentive costs and should be transparently recorded if used.

### Box 1 — Carbon Credits and the Clean Development Mechanism
- Role/mechanism:
  - Carbon credits allow those subject to emissions restrictions to purchase emissions reductions from those not restricted.
  - CDM supports emissions-reducing projects in lower income countries; creditable against Kyoto commitments.
  - CDM cumulative trades in primary markets: about US$8 billion.
  - CDM primary means of encouraging mitigation in developing countries; criticized as overly-bureaucratic; efforts to strengthen programmatic support noted.
- Fundamental difficulties with credit schemes:
  - Identifying the baseline for measuring reductions.
  - Ensuring reductions are not undone by increases elsewhere.
- Mitigation through reduced deforestation:
  - Deforestation accounts for about 20 percent of emissions.
  - Lack of progress reflects conceptual challenges and forestry governance problems.
  - World Bank’s Forest Carbon Partnership Facility may help via capacity building and piloting incentive schemes.
- Innovation and fiscal incentives:
  - Proper carbon pricing anchors efficient innovation.
  - Risks of low carbon pricing combined with strong public support for innovation: wastes resources by substituting expensive R&D for inexpensive mitigation.
  - Fiscal instruments can address R&D market failures; targeted public research spending may be preferable to additional tax incentives.
- Cost-effectiveness of fiscal instruments for renewables:
  - Instruments: capital grants, low interest loans, feed-in tariffs, tax credits.
  - OECD (2004) finds cost of displacing emissions by these means higher than most estimates of marginal damage.
  - Learning-by-doing could alter assessments; monitoring and tax expenditure analysis important.
- Adaptation fiscal context:
  - Much adaptation via private adjustment; more intense events may trigger financial innovations (weather derivatives, catastrophe bonds).
  - Public goods and adaptation: information, transport, water, health, sea defenses may require public spending; full “climate-proofing” not generally optimal.
  - Donor support: signatories to UNFCCC committed to help vulnerable developing countries; delivered financing around US$26 million (UNDP, 2007), though committed amounts larger.
  - Uncertainties/irreversibilities require balancing precautionary adaptation spending against risk of unnecessary expenditures.

### Gradualism, flexibility, and private adaptation (Section II.B)
- Gradualism/flexibility in incurring sunk costs for adaptation is a project design issue (e.g., coastal zones).
- Public investments with heavy sunk costs increase option value of waiting.
- Barriers to private adaptation:
  - Imperfect information, credit market imperfections, unavailable/unaffordable insurance, Samaritan’s dilemma, private agents discounting too heavily.
- Fiscal instruments and targeted policy responses:
  - Taxing use of flood-prone land or zoning regulations may be more practicable than taxes where administration is weak.
  - Tax breaks/subsidies for insurance reduce revenues but do not resolve Samaritan’s dilemma.
- Insurance and financial innovation:
  - Insurance reduces welfare losses and implicit fiscal risks but may introduce moral hazard.
  - Mandatory insurance is one response; market insurance often unavailable in developing countries.
  - Examples of innovation:
    - Caribbean Catastrophe Risk Insurance Facility (CCRIF), launched 2007, offers premia about 40 percent below market rates; limitations: verification and limited pooling for correlated shocks.
    - Sovereign catastrophe bonds: principal forgiven if disaster strikes; tap global capital markets.
  - Open question whether further innovations could handle longer-term climate risk and deep uncertainty (Heal and Kristrom, 2002).
- Fiscal self-insurance:
  - Enhanced self-insurance difficult in many low-income countries; but fiscal risks should be assessed and recognized.
  - Precautionary public saving can convey benefits when disaster strikes and via improved ratings and reduced risk premia otherwise.
  - Achievable self-insurance may be limited; first step is to recognize fiscal risks.

### Assessing fiscal costs of adaptation — emerging estimates and caveats
- Evidence on aggregate/adaptation fiscal costs scant, especially for lower income countries.
- Examples:
  - Coastal protection for a rise ~0.2–0.3 meters over the century: less than one percent of GDP for the 15 most-affected countries by 2080 (Nicholls and Tol, 2006).
  - Small Pacific islands: Micronesia 5–13.5 percent of GDP; Palau 3.9–9.1 percent (sea level protection costs).
- Emerging aggregate adaptation cost estimates for developing countries (very rough; public/private not distinguished):
  - World Bank (2006): climate-proofing existing investments in developing countries at US$10–US$40 billion per annum; excluding outliers (as high as US$100 billion), range equals around 10–40 percent of net ODA. Climate-proofing ODA and exposed concessionally-financed investments estimated at US$4–US$8 billion annually.
  - UNDP (2007): annual cost of climate-proofing development investment, by 2015, around US$44 billion per annum, plus US$2 billion to strengthen disaster response, and a further annual US$40 billion for strengthening social safety nets.
  - UNFCCC (2007): annual investment cost for agriculture, health, water and coastal protection of around US$40 billion per annum by 2030—perhaps half might fall on the public sector; additional infrastructure needs estimated US$8–US$130 billion annually.
- Caveats:
  - Estimates rudimentary, often adjust current activities for climate-proofing.
  - May overstate costs if full climate-proofing not optimal; may understate costs if additional projects or variability impacts omitted.
- Need far better country-specific assessment; strong case for increased assistance to developing countries to avoid jeopardizing Millennium Development Goals.
- Even with expanded resources, adaptation competes with other uses; “win-win” opportunities where resilience spending also warranted for development.

### Implications for the Fund — roles and activities
- Climate change raises fiscal risks and design issues of potential macroeconomic significance; within Fund expertise.
- Similarity to aging challenges but with greater uncertainty and risk of extreme outcomes.
- Fund need not acquire scientific/sector skills where others (World Bank, UNDP, UNEP, IEA) have expertise; can draw on others.
- Possible Fund activities:
  - Technical assistance: design/implement fiscal mitigation instruments; monitor climate-related expenditures; assess/manage fiscal risks from extreme weather (FAD support to Area Departments).
  - Bilateral surveillance: discuss fiscal/macro implications in Article IV consultations where macroeconomic significance and external stability affected.
  - Multilateral surveillance: discuss international cooperation in fiscal measures addressing emissions spillovers; Fund role depends on institutional climate-policy developments.
  - Policy Development and Research: inform public debate on fiscal/macro consequences of alternative fiscal responses.
  - Lending: Exogenous Shocks Facility provides support to countries hit by extreme weather events.
- Overall assessment: potential implications for Fund’s fiscal work appear quite modest; areas in Fund domain can be accommodated within existing resource envelope.

### Box 2 — The Science of Climate Change (selected points)
- GHG sources and shares:
  - CO2 accounts for about 75 percent of GHG emissions.
  - Burning fossil fuels (petroleums, coal and natural gas) contributes 55 percent; deforestation 20 percent.
  - Methane contributes 15 percent; nitrous oxides account for most of remaining 10 percent.
  - Some man-made aerosols reduce warming but decay quickly and are localized.
- GHG concentration trends:
  - CO2e rose from about 280 ppm in 1750 to around 430 ppm now.
  - Rising by more than 2 ppm per annum; under BAU could increase to around 750 ppm by 2100.
- Temperature response:
  - By IPCC (2007), global average temperature increased by about 0.75 degrees Celsius (°C) since 1960.
  - Under BAU, end-of-century rise might be between 2.2 and 6.4 °C above pre-industrial levels (5–95 percent confidence; IPCC (2007)).
  - Strong mitigation might limit rise to 1–3 °C.

### Appendix — Selected glossary entries (selected)
- BAU Business as Usual: The outcome under current policies.
- BTA Border Tax Adjustment: Remitting tax on exports, charging tax on imports.
- Carbon price: price charged—for example as a tax or permit price—for emitting CO2, payable in addition to resource price.
- CDM Clean Development Mechanism: Kyoto provision allowing Annex B countries to credit financing of emissions-reducing projects in non-Annex B countries.
- CO2e CO2 equivalent.
- EU-ETS European Union Emission Trading Scheme.
- Geoengineering Deliberate climate modification (e.g., aerosols to reflect solar radiation).
- GHG Greenhouse Gas.
- IAM Integrated Assessment Model.
- IPCC Intergovernmental Panel on Climate Change.
- Kyoto protocol: Protocol to UNFCCC committing industrialized (“Annex B”) countries to differentiated GHG reductions relative to 1990 for 2008–12.
- ppm Parts per million.
- Sequestration Terrestrial or oceanic storage of CO2.
- tC Tonne (metric) of carbon.
- UNFCCC United Nations Framework Convention on Climate Change: Entered into force 1994, ratified by 192 countries; recognizes “Common but differentiated responsibilities” towards “Stabilizing GHG emissions at a level that would prevent dangerous anthropogenic interference with the climate system.”

*Source: _022208 (IMF PDF content provided).*

### Executive Summary   1

### Executive Summary

### Overview
- This paper reviews the fiscal implications of climate change, and the potential role of the Fund in addressing them.
- Key overarching points:
  - The potential fiscal implications are immediate as well as lasting, and liable to affect—in differing forms and degree—all Fund members.
  - Climate change is a global externality problem, calling for some degree of international fiscal cooperation.
  - Climate change has features—an intertemporal mismatch between the (early) costs of action to address climate change and (later) benefits, pervasive uncertainties and irreversibilities (including risk of catastrophe), and sharp asymmetries in the effects on different countries—that raise difficult technical and ethical issues, and hinder policy coordination.
  - In addition to itself impacting the public finances, climate change calls for deploying fiscal instruments to mitigate its extent and adapt to its remaining effects.

### Introduction and scientific projections
- IPCC (2007) projection under current policies (“business as usual,” BAU):
  - Global mean temperature will increase over the next century by 2.8 o C, with a 3 percent chance of rising 6 o C or more.
  - For a 3 o C rise, benchmark estimates for the loss of global GDP range from zero to 3 percent.
- Physical consequences highlighted include changed precipitation patterns, sea level rise (amplified by storm surges), more intense and perhaps frequent extreme weather events, increased prevalence of vector-borne diseases, and potential catastrophic events (e.g., reversal of the Gulf Stream or melting of the Greenland ice sheet).
- Potential economic consequences include productivity changes in climate-sensitive sectors, damage to coastal areas, stresses on health and water systems, changes in trading patterns and international investment flows, financial market disruption (and innovation), increased vulnerability to sudden adverse shocks, and altered migration patterns—all with potential implications for external stability.

### Fiscal aspects of mitigation
- Instrument choices and principles:
  - A range of fiscal instruments—taxes, cap-and-trade, or hybrids—can be used to face those emitting greenhouse gases, notably CO2, with a price reflecting the damage they cause others.
  - Both the level and (especially) the future path of such “carbon prices” are critical.
  - The paper addresses key issues in instrument design, such as the possibility of a “double dividend” from carbon pricing, administrative considerations, and effects on fossil fuel extraction.
- Carbon price views and revenue:
  - Views on appropriate carbon prices vary widely, but often imply fairly modest initial values.
  - The potential revenue is sizable, but does not transform the public finance outlook.
- International aspects:
  - Cross-country flows under international cap-and-trade are sensitive to the rule for allocating emission rights.
  - Under common stabilization objectives, they could in some cases be sizable relative to GDP.
  - Many current fiscal measures affect emissions; effective policy-making and international coordination would be facilitated by greater simplicity, transparency, and coherence in domestic energy taxation.
  - Current international cooperation in mitigation policies is limited and flawed, but shows potential—though the difficulties inherent in carbon credit schemes remain problematic, and measures to reduce deforestation elusive.
- Innovation:
  - Supportive tax and spending policies are needed to enable technical progress addressed to climate problems—but require careful design and close monitoring.

### Fiscal aspects of adaptation
- Role of public spending:
  - Much adaptation will occur through normal market reactions, but additional public spending may be needed to provide and strengthen various public goods, and to facilitate private sector adjustment.
- Assessment of needs:
  - There has been little assessment of the extent and timing of likely public spending needs, especially in developing countries.
  - Rudimentary estimates suggest additional total costs in poorer countries in the tens of billions of dollars annually.

### Implications for the Fund
- Policy alignment and advice:
  - Key policy recommendations—such as the need in many countries to raise and broaden energy taxes, and the importance of identifying and preparing for fiscal risks—reinforce current Fund advice in these areas.
  - Many of the design and practical issues lie within the established expertise of the Fund, and so could be the object of Fund advice.
- Surveillance and capacity:
  - Preparedness for the fiscal challenges from climate change, and progress towards mitigation objectives, could be raised in bilateral surveillance work in those limited cases in which they are potentially so substantial as to affect external stability.
- Institutional position:
  - The Fund’s universal membership, global perspective, and expertise make it well-positioned—drawing on the environmental and sectoral expertise of other institutions—to inform the discussion of fiscal implications of climate change that are of multilateral interest, likely to intensify as negotiations towards a successor to the Kyoto protocol gather pace.
  - The potential implications for the fiscal work of the Fund appear quite modest, and can be accommodated within the prospective budget envelope.

*Source: Executive Summary, _022208 - Executive Summary   1*

### Introduction

### _022208 - Introduction

### Key messages
- Hotter and lower-lying countries—often already the most vulnerable—are most at risk, while some temperate countries may benefit from moderate temperature rise.
- Most likely aggregate damage is expected in the latter part of the century, but near-term severe events (e.g., Hurricane Katrina, the 2002 drought in Ethiopia, floods in Europe) illustrate immediate challenges.
- Core actions must be anticipatory; policy responses need consideration far in advance of damage to be averted.
- Fiscal implications of climate change can be immediate and powerful, directly affecting tax bases and spending programs, and creating a case for purposive use of fiscal instruments for mitigation and adaptation.
- The paper reviews fiscal implications and the possible role of the Fund; it builds on Jones and others (2007) and complements analysis in the Spring 2008 WEO.

### The economics of climate change
- Climate change is an externality problem requiring international coordination; emitters do not internalize aggregate damage and so emit more than is collectively desirable.
- Counterfactual mitigation: slowing and then (starting in 2020–40) cutting global emissions (by 60–80 percent).
- Asymmetries:
  - High-income economies generated about 80 percent of past fossil fuel-based emissions.
  - Within a decade, most emissions will come from outside the OECD.
- Stock nature and timing:
  - Global temperature depends on cumulative stock; emissions take decades to have full effect and decay.
  - Little can be done to avoid temperature rise in the next decades; intertemporal mismatch between early costs and late benefits.
  - Discount rate choice is critical in policy assessment.
- Uncertainty and catastrophe risk:
  - Relationships between emissions, interventions, market responses, and damage are very unsure.
  - Extremely costly events (e.g., reversal of the Gulf Stream, collapse of the West Antarctic Ice Sheet) are possible; probabilities are likely low but unknown.
- Interactions with other market failures:
  - Innovation may convey externalities requiring policy support.
  - Design of mitigation instruments may be affected by revenue and wider tax-system impacts.
  - Deforestation (~20 percent of GHG emissions) may be hindered by weak property rights and governance.
- Exhaustibility of fossil fuels:
  - Extraction timing decisions (when to extract oil, gas, coal, or cut trees) affect mitigation outcomes.

### Impact effects on public finances and policy implications
- Direct fiscal impacts:
  - Slow-moving productivity changes and risk of more intense shocks can reduce revenues and increase spending.
  - Examples: reduced agricultural productivity, impacts on tourism or fishing rights, increased incidence of vector-borne diseases, population movements.
  - Fiscal impacts likely most adverse where wider vulnerabilities to climate change are greatest.
- Fiscal instruments have purposive roles:
  - Mitigation instruments often are sources of public funds (e.g., carbon pricing); adaptation instruments are often uses of public funds.
  - Given distortionary costs of raising revenue, there is a marginal preference for revenue-raising over revenue-using measures.
- Uncertainty and irreversibility considerations:
  - Low-probability, high-impact events can dominate policy assessments; uncertainty may justify aggressive responses (Weitzman, 2007).
  - Irreversibility argues both for precautionary action and for delaying action to await better information or technology; assessments differ.

### Fiscal instruments for mitigation — principles and design
- Best-targeted policy: charge an appropriate price for GHG emissions (Pigovian pricing).
- Pigovian pricing:
  - Charge a price for emitting CO2 equal to the present value of the social damage caused.
  - Efficiency requires the same carbon price for all emissions, however and wherever they arise.
  - Future path and credibility of the carbon price are critical because of the stock nature of the externality and long-lived energy investments.
  - Pigovian policy implies a steady increase in the real carbon price; the discount rate is a key determinant of the optimal path.
- Supply-side and exhaustibility effects:
  - A carbon tax rising at the market interest rate would not affect extraction timing; incidence may fall on resource owners if long-run supply is inelastic.
  - High fossil fuel prices do not substitute for carbon pricing; they may increase resistance to carbon pricing.
- Revenue use and “double dividend”:
  - Receipts from carbon pricing can be used to reduce other distorting taxes, increase public spending, or reduce debt.
  - The “double dividend” (mitigation plus overall tax efficiency gain) is not guaranteed because of tax interaction effects (raising energy prices can reinforce labor tax distortions).
  - Historical example: Germany shifted around 3 percent of total tax revenue in this way in 1996–99.
  - The best use of revenue will vary by country; developing countries may strengthen revenue mobilization, developed countries have used “green tax swaps” to reduce social contributions.
- Exhaustibility and rate path:
  - Some argue fossil fuels are extracted excessively rapidly, implying a carbon price rising at less than the market interest rate could be appropriate to shift emissions into the future.
  - Property-rights insecurity can affect extraction incentives (evidence: reduces oil production but increases deforestation).
  - Aiming for too rapid an increase in the carbon price risks increasing current emissions.

### Instrument choice — taxes, cap-and-trade, hybrids
- Carbon pricing implementation options:
  - Carbon tax: specific rate on all emissions or on fossil fuels.
  - Cap-and-trade: fixed total emission rights issued and tradable; permit price functions as carbon price.
  - Hybrids: combine price variability of cap-and-trade with quantity flexibility of tax (e.g., cap-and-trade with a maximum price).
- Equivalence and uncertainty:
  - Tax and cap-and-trade can be equivalent in aggregate emissions and revenue if permits are auctioned and abatement costs known.
  - If permits are allocated free, governments forego revenue relative to carbon taxation.
  - Equivalence fails when abatement costs are uncertain; carbon taxation is likely preferable to pure cap-and-trade in that case.
  - No instrument assures credibility; carbon taxes provide price certainty, cap-and-trade provides emissions certainty.
- Cross-country revenue allocation:
  - Under carbon tax, revenue commonly remains in the country where the tax is levied (destination basis), but could be levied on origin basis (country of extraction) or used for global public goods.
  - Under international cap-and-trade, countries with cheap abatement would sell emission rights to those with costly abatement; transfers depend on allocation of rights.

### Rates, revenue and international flows — evidence and model approaches
- Indicative carbon price magnitudes (estimates vary widely):
  - Many studies: starting carbon price often in the order of US$15–US$60 per ton of carbon (/tC) — equivalent to around US$2–US$8 per barrel of oil, or 5–20 cents per gallon of gasoline.
  - Meta-study modal value: around US$20/tC; median: US$48/tC (distribution strongly right-skewed) (Tol, 2007).
  - Stern Review (2007) estimate: US$312/tC.
  - Nordhaus (2007) suggests a starting carbon price of around US$17/tC.
  - For comparison: the current EU-ETS forward price (for delivery in late 2008) is around € 83/tC.
- Importance of future path:
  - Real increases in the carbon price over time are more important than initial level.
- Models referenced for fiscal analysis:
  - This paper focuses on two integrated assessment models: the “IGSM” and “MiniCAM.”
  - The forthcoming WEO uses the G-cubed model of McKibbin and Wilcoxen (1998), similar to IGSM but with explicit international capital flows.
  - Results are reported for three stabilization objectives (450 ppm, 550 ppm, 650 ppm), with discussion focused on stabilization at 550 ppm.
  - In the IGSM, the carbon price rises from about US$75/tC to US$380/tC (nearly US$50 per barrel of oil) by [text ends].

*Source: _022208 - Introduction*

### 2060. It is far lower throughout under MiniCAM (note the different scales), as

### _022208 - 2060. It is far lower throughout under MiniCAM (note the different scales), as

### Fiscal instruments and revenue potential
- Potential revenue from appropriate carbon pricing is around 1–2 percent of global GDP until mid-century.
- Revenue increases throughout the century (except under the more aggressive MiniCAM scenarios).
- MiniCAM baseline emissions: reaching US$135/tC by 2060.
- Stern (2007) example: strong mitigation reducing marginal damage to US$105/tC.
- Country example (United States):
  - A tax of US$55/tC would raise around US$80 billion a year.
  - This is equivalent to 30 percent of the corporate income tax, or enough to rebate the first US$560 of payroll taxes to all workers.
- The figures in MiniCAM imply region-specific revenue effects; a 2 point increase in the tax ratios in Africa, FSU/East Europe and India by 2060 is highlighted.
- Table 1 (MiniCAM output) reports regional revenues in percent of GDP (select regional examples noted in the text and table):
  - Africa: 450 alternative 2020 = 2.5; 2060 = 1.3 (table includes many other year/alternative cells).
  - China: 450 alternative 2020 = 2.5; 2060 = 0.6.
  - India: 450 alternative 2020 = 2.6; 2060 = 0.1.
  - United States: 450 alternative 2020 = 0.9; 2060 = 0.5.
  - West Europe: 450 alternative 2020 = 0.7; 2060 = 0.2.
  - Note: Table 1 is sourced to IMF staff calculations using MiniCAM output.

### Cross-country flows under international cap-and-trade
- International flows from cap-and-trade depend on allocation method (proportional to BAU emissions vs. per capita).
- Under allocation relative to BAU: flows are much less than 1 percent of GDP (except under 450 ppm alternative).
- Under equal per capita allocation: Africa and India have inflows of around 1 percent of GDP in 2020, rising steadily thereafter in Africa.
- Allocation rules produce markedly different effects for particular regions; example:
  - The Former Soviet Union (FSU) sells permits under allocation relative to BAU but buys under per capita allocation.
- Results are model-specific; G-Cubed (Table 2) shows different magnitudes and patterns:
  - Annual emission rights proportional to initial emissions (G-Cubed, percent of GDP):
    - United States: 2020 = 0.02; 2030 = 0.11; 2040 = 0.22.
    - China: 2020 = 0.32; 2030 = 2.16; 2040 = 5.95.
    - Less developed countries: 2020 = -0.11; 2030 = -0.59; 2040 = -1.44.
  - Annual emission rights proportional to population share (G-Cubed, percent of GDP):
    - United States: 2020 = -0.02; 2030 = -0.32; 2040 = -0.32.
    - China: 2020 = 0.33; 2030 = 1.96; 2040 = 5.46.
    - Less developed countries: 2020 = 0.71; 2030 = 1.08; 2040 = 0.77.
- Caution urged in interpretation: model differences (BAU projections, regional coverage) yield divergent conclusions (e.g., China modest buyer/seller in MiniCAM figures but large seller in G-Cubed Table 2).

### Domestic equity, compensation, and policy design
- Carbon pricing affects household real incomes directly (fuel use) and indirectly (commodity prices); regressivity likely in both developed and developing countries.
- Distributional impact depends on pass-through to consumers vs. suppliers and consumption patterns (e.g., gasoline vs. kerosene impacts).
- Compensation and mitigation options:
  - United States example: carbon price around US$50/tC raises electricity and gas prices around 12 percent and gasoline around 8 percent; reconfiguring the earned income tax credit and social security payments can largely offset regressivity (Metcalf, 2007).
  - Targeted benefits (e.g., winter supplement to pensioners in the United Kingdom) can protect vulnerable groups.
  - Reduced indirect tax rates on energy-intensive products (e.g., lower VAT on electricity) are poorly targeted and compromise climate objectives.
- Developing-country priorities:
  - Eliminate remaining fuel subsidies (explicit and implicit); examples cited: 17 percent of GDP in Azerbaijan and 10 percent in Yemen (subsidy prevalence noted).
  - Complementary measures (e.g., Ghana: elimination of school fees for primary and secondary education with fuel price increases) can protect the poor.
  - Beware unintended effects (e.g., higher kerosene prices inducing substitution to burning wood, with health and deforestation consequences).

### Earmarking, auctioning, and fiscal governance
- Earmarking revenue from carbon pricing is generally undesirable but may help overcome political resistance; tight earmarking can overly constrain public finances.
- No clear economic rationale for linking mitigation revenue directly to adaptation spending (example: CDM proceeds to an Adaptation Fund questioned).
- Cap-and-trade fiscal implications:
  - Realizing full fiscal benefits requires selling rights rather than allocating free (grandfathering).
  - Grandfathering foregoes sizable public finance benefits:
    - EU-ETS foregone benefit estimated in order of €40 billion annually.
    - Recent U.S. proposals foregone benefit estimated at US$130–US$370 billion (in 2015).
  - Grandfathering may be defensible for sunk investments made before substantive emissions charges were foreseeable; where unavoidable, record the value of grandfathered rights as a tax expenditure.
- European Commission policy example: proposes full auctioning of EU-ETS permits for power companies from the start of 2013, and for all others by 2020 (text notes this proposal).

### International coordination, trade measures, and instrument choice
- Fully coordinated approach: uniform carbon price with cross-country transfers to address fairness—but national fiscal incentives impede cooperation.
- Importer/exporter incentives: importers may use carbon taxes/tariffs to extract rent from exporters; exporters may manipulate supply—potentially leading to carbon taxes that are too high from a global perspective (Strand, 2007).
- Noncooperation currently results in too little mitigation given projected BAU damage.
- Leakage and efficiency:
  - Emissions concentrated among relatively few countries (25 accounting for about 80 percent); wider agreement likely needed for efficient mitigation.
  - Mitigation costs vary markedly across countries, supporting gains from trade and a case for “broad-but-shallow” agreements over “narrow-but-deep.”
- Measures to encourage cooperation:
  - Adopt minimum (not harmonized) carbon tax rates to protect countries wishing to set relatively high rates.
  - Selective border tax adjustments (BTA): remit carbon price content of exports and impose corresponding charges on imports—preserves domestic mitigation while addressing competitiveness, but risks WTO inconsistency and practical implementation challenges (assessing carbon prices implicit in taxes paid abroad).
- Administrative and currency issues:
  - Carbon tax common to several countries must be specified in terms of a basket of currencies since it is a specific (not ad valorem) charge; cap-and-trade market price maps automatically into national currencies.
  - Assurance of compliance differs by instrument: tax schemes require confidence that others are not offsetting impacts via subsidies or tax breaks; trading schemes require governance confidence in permit schemes and use of quota rents.

### Current measures, policy coherence, and first steps
- Systematic carbon pricing is rare; no country has a carbon tax in the strict sense uniform across uses and sectors.
  - Closest examples: Denmark, Norway, Sweden, and the Climate Change Levy in the United Kingdom (each with significant exemptions).
  - EU-ETS is the most extensive cap-and-trade but covers about 45 percent of GHG emissions.
- Many fiscal instruments affect emissions indirectly (fuel excises, tax treatment of company cars, extraction fiscal arrangements).
- Effective carbon pricing requires:
  - Greater coherence in energy tax policies.
  - Less extensive exemptions.
  - Possible “unbundling” of fuel excises in higher income countries to focus excises on mitigation objectives as congestion pricing improves.
- Cross-country coordination impeded by diverse instruments and complexity; coordination would be facilitated by:
  - Greater coherence, simplicity and transparency of fiscal policies toward energy.
  - Coordinated data gathering and analytical work to assess implied effective rates of taxation on carbon emissions (OECD/European Environment Agency database cited as example).
- First policy step in many countries: increase fossil fuel taxes and equalize them across types; many systems favor diesel and leave international aviation and shipping largely uncharged.
- Auctioning vs. grandfathering: auctioning rights captures fiscal benefits; grandfathering has distributional and incentive costs and should be transparently recorded if used.

*Source: IMF staff calculations using MiniCAM and IGSM output.*

### Box 1. Carbon Credits and the Clean Development Mechanism

### Box 1. Carbon Credits and the Clean Development Mechanism

### Role and mechanism of carbon credits and the CDM
- Carbon credits enable those subject to emissions restrictions to meet them in part by purchasing emissions reductions from those not so restricted.
- The CDM supports emissions-reducing projects in lower income countries; such support is creditable against Kyoto commitments.
- The CDM has had about US$8 billion of cumulative trades in primary markets.
- The CDM has been the primary means of encouraging mitigation in developing countries.
- Criticisms of the CDM include that it is overly-bureaucratic; efforts to address this include strengthening programmatic as well as project-based support.

### Fundamental difficulties with credit schemes
- Two fundamental difficulties with credit schemes (which would also apply, for example, to schemes providing payment for avoided deforestation):
  - Identifying the baseline relative to which emissions reductions are measured.
  - Ensuring that such reductions are not undone by increases elsewhere.

### Mitigation through reduced deforestation
- Little progress has been made in mitigation through reduced deforestation, which accounts for about 20 percent of emissions and is often reckoned a particularly cheap form of abatement.
- The lack of progress reflects:
  - Conceptual challenges posed by carbon credit schemes.
  - Problems in forestry governance.
- The World Bank’s recently-launched Forest Carbon Partnership Facility may provide progress by offering both capacity building and piloting of incentive schemes.

### Innovation and fiscal incentives
- Proper carbon pricing is a critical anchor for efficient innovation; technical progress (for instance, in developing carbon sequestration technologies) will be pivotal in dealing with CC.
- Innovation needs to be guided by carbon prices (present and prospective) that reflect the social gains from developing less carbon-intensive technologies.
- Risks of low carbon pricing combined with strong public support of innovation:
  - Politically tempting to set a low carbon price and instead provide strong public support of innovation, but this risks wasting resources by substituting, at the margin, relatively expensive R&D for relatively inexpensive mitigation.
- Fiscal instruments can help overcome market failures in climate-related R&D:
  - Market failures include the inability of innovators to appropriate the full social benefits and the desire for rapid, wide diffusion of new technologies.
  - General R&D support measures should apply to climate-related innovation, but there may be a case for further fiscal measures reflecting:
    - The costliness of catastrophic outcomes (putting some premium on geoengineering solutions).
    - Energy security concerns.
    - Sector-specific issues such as the inability of private insurers to cope with particular risks from nuclear power.
- Targeted public research spending may be preferable to additional tax incentives:
  - Many countries already offer generous R&D incentives.
  - Evidence exists that these incentives increase spending on R&D and patenting.
  - Tax reductions may do little for innovative start-ups, since they are relatively unlikely to have any taxable income.
  - Public spending to support private innovation can potentially be better targeted where social returns are likely to most exceed private returns, though not without risk of waste.

### Cost-effectiveness of fiscal instruments for renewable energy development
- Fiscal measures used to encourage the development of renewable energies include:
  - Capital grants and low interest loans for renewable energy capacity and development of energy technologies.
  - Feed-in tariffs.
  - Tax credits.
- The cost-effectiveness of these fiscal instruments remains unclear and should be monitored.
- OECD (2004) finds the cost of displacing emissions by these means to be considerably higher than most estimates of the marginal damage those emissions cause.
- Learning-by-doing may make current assessments too pessimistic, highlighting the importance of monitoring such spending—including through tax expenditure analysis—to inform policy formation.

### Fiscal implications of adaptation (contextual links)
- Much adaptation will occur as spontaneous private sector adjustment, with limited fiscal impact; examples include relocation of ski resorts.
- More intense weather events may trigger financial innovations, including growth in weather derivatives and catastrophe bonds; such market responses will have fiscal effects but generally manageable.
- Efficient private sector adaptation requires an appropriate carbon price path, with a role for fiscal instruments in financing adaptation and facilitating market adjustments.
- Public goods and adaptation:
  - Adaptation will require increased public expenditure on climate-related public goods and to protect programs driven by other concerns.
  - Information acquisition and dissemination (for example, on changing precipitation patterns) is a public good requiring public intervention.
  - Traditional public expenditure items potentially affected include transport networks, water and health systems, and sea defenses.
  - Full “climate-proofing” is generally not optimal; some residual climate risk may be accepted.
  - Most adaptation-related public spending is likely national, but some regional or global cooperation may be required (for example, to improve management of water systems or regional weather forecasting).
- Donor support for vulnerable countries:
  - Institutional and financial weaknesses in many most vulnerable countries create scope for donor support in meeting adaptation costs.
  - Signatories to the UNFCCC are committed to helping “developing countries that are particularly vulnerable to the adverse effects of climate change in meeting costs of adaptation to those adverse effects.”
  - Funds have been created, but delivered financing is around US$26 million (UNDP, 2007), though committed amounts are larger.
- Uncertainties and irreversibilities require balancing precautionary spending on adaptation against the risk of undertaking costly expenditures that may prove unnecessary.

*Source: Box 1. Carbon Credits and the Clean Development Mechanism (extracted from the provided IMF PDF content).*

### Section II.B point to gradualism and flexibility in incurring sunk costs to deal

### Section II.B point to gradualism and flexibility in incurring sunk costs to deal with adaptation

### Gradualism, flexibility, and project design
- Gradualism and flexibility in incurring sunk costs to deal with adaptation is essentially a matter of project design (for example, in identifying efficient adaptation options for coastal zones (IPCC, 2007)).
- To the extent that public investments are more likely to involve heavy sunk costs, the option value of waiting may be significant.

### Reducing barriers to private sector adaptation
- Market failures that may impede private adaptation:
  - Private agents may be imperfectly informed (systematic CC may be hard to infer where the natural climate is variable).
  - Credit market imperfections may hamper adaptation requiring substantial investments.
  - Insurance may be unavailable or unaffordable.
  - The Samaritan’s dilemma may lead to inefficiently low adaptation.
  - The private sector may discount too heavily (so spending too little on projects more robust to climate developments).
- The Samaritan’s dilemma: the tendency for under-insurance by those who expect external help in the event of adversity; those supplying the help would wish to limit its extent by committing to relatively low support—but their benevolence means they cannot do so credibly.

### Fiscal instruments and targeted policy responses
- Fiscal instruments, particularly tax measures, may not be the best response to the failures above:
  - If expectation of ex post assistance leads to excessive location in flood-prone areas, taxing the use of such land is one response.
  - Where administration is weak, zoning regulations—even if less efficient (in denying use even to those willing to pay a proper price)—may be more practicable.
  - Tax breaks or subsidies for insurance reduce public revenues but do not overcome the Samaritan’s dilemma, since they do not address potential donors’ inability to commit to limiting ex post support.

### Dealing with fiscal risks via insurance and financial innovation
- Insurance reduces consequent welfare losses and implicit fiscal risks (though it does not reduce physical damage and may introduce moral hazard).
- Making insurance mandatory is one response to the Samaritan’s dilemma; in many developing countries market insurance may be unavailable or unaffordable at actuarially fair rates.
- Scope for public intervention to provide or facilitate access to risk markets (example: in Malawi the World Bank and donors provide drought insurance).
- Strengthening wider social insurance schemes improves resilience to extreme weather events.
- Recent financial innovations:
  - The Caribbean Catastrophe Risk Insurance Facility (CCRIF), launched with donor support in 2007, pays out in the event of parametric trigger points being exceeded and is estimated to offer premia about 40 percent below market rates, providing rapid payment if disaster strikes. Limitations include contentious verification and limited pooling benefits among countries subject to correlated shocks.
  - Sovereign catastrophe bonds, for which principal is forgiven if disaster strikes, tap global capital markets and are likely to become increasingly attractive as the market develops.
- Open question: whether further innovations could deal with longer-term climate risk, and the uncertainty surrounding some risks (Heal and Kristrom, 2002).

### Fiscal self-insurance and recognition of fiscal risks
- Enhanced fiscal self-insurance will be difficult to achieve in many low-income countries, but fiscal risks should be assessed and recognized.
- Part of an appropriate response to increased uninsured losses is increased precautionary public saving, which conveys benefits when disaster strikes and via improved ratings and reduced risk premia when it does not.
- Given other fiscal challenges and possible scale of damage, achievable self-insurance may often be limited.
- An important first step is to recognize the fiscal risks involved.

### How Much?—Assessing the fiscal costs of adaptation
- Evidence on likely aggregate costs of appropriate adaptation measures is scant, especially for lower income countries; evidence on likely fiscal costs is even rarer.
- Many higher income countries have costed public projects to protect against adverse impacts of CC, but with few estimates of aggregate fiscal cost.
- Little is known of fiscal costs in the poorest and most vulnerable countries; gap reflects scientific uncertainties (e.g., paucity of meteorological stations in Africa) and limited attention to climate issues in national development programs.
- Examples and emerging estimates:
  - Coastal protection costs for a rise of around 0.2–0.3 meters over the century are found to be less than one percent of GDP for the 15 most-affected countries by 2080 (Nicholls and Tol, 2006).
  - In some exposed small islands in the Pacific: 5–13.5 percent of GDP in Micronesia, and 3.9–9.1 percent in Palau (for sea level rise protection costs).
  - These estimates likely understate total adaptation costs because they deal only with sustained sea rise at mid-point estimates and exclude costs of coping with storm surge and other associated effects or with more dramatic rise.
- Emerging aggregate adaptation cost estimates for developing countries (very rough; do not distinguish public and private costs):
  - The World Bank (2006) puts the cost of climate-proofing existing investments in developing countries at US$10–US$40 billion per annum. Even excluding outlying estimates within the study (which are as high as US$100 billion), this is a wide range: from around 10 to 40 percent of net ODA. Climate-proofing ODA and the most exposed concessionally-financed investments is estimated to cost US$4–US$8 billion annually.
  - UNDP (2007) estimates an annual cost of climate-proofing development investment, by 2015, of around US$44 billion per annum, with an additional US$2 billion to strengthen disaster response—and a further annual US$40 billion in strengthening social safety nets.
  - UNFCCC (2007) estimates suggest an annual investment cost for agriculture, health, water and coastal protection, of around US$40 billion per annum by 2030—perhaps half of which might fall on the public sector. It also reports a very wide range for additional infrastructure needs, of US$8–US$130 billion annually.
- Caveats on these estimates:
  - Extremely rudimentary, generally derived by applying to current activities a rough adjustment for climate-proofing.
  - May overstate costs insofar as full climate-proofing is unlikely to be optimal.
  - May understate costs to the extent they do not capture the need for additional projects and often focus on trends in temperature and water availability, neglecting challenges from increased variability (e.g., in water supplies).
- Assessing fiscal challenges from adaptation in developing countries requires far better understanding of likely country-specific magnitude; currently hard to judge where and when costs rise to macroeconomic significance.
- Strong case for increased assistance to developing countries to support adaptation efforts to avoid jeopardizing achievement of the Millennium Development Goals (point stressed by Stern (2007) and UNDP (2007)).
- Even with expanded resources, adaptation needs must compete with other uses of scarce funds; “win-win” opportunities exist where spending promotes climate resilience and is warranted on other development grounds.
- While benefit-cost ratios seem high for many measures of public spending on adaptation, the same is true for many nonclimate-related items.

### Implications for the fiscal work of the Fund
- Climate change raises fiscal risks and design issues potentially of macroeconomic significance, in some cases immediate, and within the Fund’s established expertise.
- Fiscal challenges from CC are reminiscent of those from aging—where the Fund has urged early action—but are marked by greater uncertainty and more dire extreme outcomes.
- Technical issues of tax design and implementation are ones in which the Fund has considerable experience (cap-and-trade schemes raise similar issues).
- The fiscal challenges reinforce many aspects of existing Fund fiscal advice: avoiding inappropriately low fossil fuel prices, recognizing and preparing for shocks affecting public finances, and the value of tax expenditure analysis.
- The Fund need not acquire scientific, environmental, or sector-specific skills where other institutions (World Bank, UNDP, UNEP, IEA) have expertise; instead the Fund can draw on others’ skills.
- Fiscal aspects of climate change may arise in a range of Fund activities:
  - Technical assistance in designing and implementing fiscal instruments for mitigation, or in monitoring climate-related expenditures; or advice on assessing and managing fiscal risks from more intense extreme weather events (FAD could support Area Departments).
  - Bilateral surveillance to discuss fiscal and macroeconomic consequences of CC with members whose external stability may be affected; Article IV consultations could raise such issues where of macroeconomic significance.
  - Multilateral surveillance to discuss international cooperation in fiscal measures addressing spillover effects from national emissions, with the Fund’s role depending on institutional developments in climate policy cooperation.
  - Policy Development and Research Work to inform public debate on fiscal and macroeconomic consequences of alternative fiscal responses.
  - Lending arrangements: the Exogenous Shocks Facility already provides for support to countries hit by extreme weather events.
- Overall assessment: the potential implications for the Fund’s fiscal work appear quite modest; much is being done elsewhere, and areas in the Fund’s domain can be accommodated within the existing resource envelope.

### Appendix — Glossary (selected entries)
- BAU Business as Usual: The outcome under current policies (generally referring to a path of GHG emissions).
- BTA Border Tax Adjustment: Remitting tax on exports, charging tax on imports.
- Carbon price A price charged—whether in the form of a tax or a permit price—for emitting CO2, payable in addition to the price of the resource itself.
- CC Climate Change.
- CDM Clean Development Mechanism: Provision under Kyoto Protocol for industrialized (‘Annex B’) countries to credit against their emissions targets financing of projects reducing emissions in non-Annex B countries.
- CO2e CO2 equivalent.
- EU-ETS European Union Emission Trading Scheme.
- Geoengineering Deliberate climate modification (e.g., using aerosols to reflect solar radiation).
- GHG Greenhouse Gas.
- IAM Integrated Assessment Model: Seeks to combine major socio-economic and physical processes and systems that characterize the human influence on, and interactions with, the global climate.
- IPCC Intergovernmental Panel on Climate Change.
- Kyoto protocol Protocol to UNFCCC committing industrialized (“Annex B”) countries to (differentiated) GHG emissions reductions relative to 1990, for 2008–12.
- ppm Parts per million.
- Sequestration Terrestrial or oceanic storage of CO2 (e.g., in depleted oil and gas fields).
- tC Tonne (metric) of carbon.
- UNFCCC United Nations Framework Convention on Climate Change: Entered into force 1994, ratified by 192 countries; recognizes “Common but differentiated responsibilities” towards “Stabilizing GHG emissions at a level that would prevent dangerous anthropogenic interference with the climate system.”

*Source: Section II.B, _022208 - Section II.B point to gradualism and flexibility in incurring sunk costs to deal (IMF PDF).*

### Box 2. The Science of Climate Change

### Box 2. The Science of Climate Change

### Key greenhouse gases and sources
- Carbon dioxide (CO2) currently accounts for about 75 percent of GHG emissions; burning fossil fuels—petroleums, coal and natural gas—contributes 55 percent, and deforestation 20 percent.
- Methane, mainly from agricultural activity, contributes 15 percent.
- Nitrous oxides, generated by industrial and agricultural activities (including nitrogen-based fertilizers) account for most of the remaining 10 percent.
- Some man-made factors reduce global warming, most importantly aerosols (particles resulting from sulphur emissions and reflecting sunlight), though these decay relatively quickly and have more localized effects.

### GHG concentration trends and projections
- The concentration of GHGs in the atmosphere—conventionally measured in parts per million (ppm) of CO2 equivalent (CO2e)—has risen from about 280 ppm in 1750 to around 430 ppm now.
- It is currently rising by more than 2 ppm per annum, and under business as usual (BAU) could increase to around 750 ppm by 2100.

### Temperature response and projections
- Temperature rises more than linearly with GHG concentration.
- By the best current estimate (IPCC, 2007), the global average temperature has increased by about 0.75 degrees Celsius (°C) since 1960 (with the cooling effect of aerosols roughly offsetting the warming effect of GHGs until about 1980).
- Under BAU, the average global temperature might rise by the end of the century by between 2.2 and 6.4 °C above pre-industrial levels (5–95 percent confidence; IPCC (2007)).
- Strong mitigation might limit this to 1–3 °C.

*Source: Box 2. The Science of Climate Change.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2008/_022208.pdf_