How can we use fiscal policy to combat the effects of extreme weather events?

Featured Article: What are the fiscal risks from extreme weather events and how can we deal with them? By Luis Alejos

Focus region: Latin America and the Caribbean

Latin America and the Caribbean is one of the most vulnerable regions to the impacts of climate change in the world. This vulnerability means that governments face great challenges when it comes to innovative climate solutions, especially so for the finance and planning ministries.

Between 1998 and 2020—in the last two decades—the World Meteorological Organization (WMO) reports that the impacts of weather-related events, including heatwaves or floods, have claimed more than 312,000 lives in the region and affected more than 277 million people. At the same time, the rise in global temperature increases the fiscal risks from natural disasters.

Indeed, extreme weather events can cause considerable human losses, significant economic damages and can put great financial pressure on fiscal accounts. For example, in 2016, hurricane Matthew hit many countries in the region, including The Bahamas, Haiti, and the Dominican Republic. It claimed 585 lives and caused estimated economic damages of more than US$10 billion. In 2020, hurricane Eta struck Central America and Mexico, mainly impacting Guatemala and Honduras, and caused at least 165 deaths and economic damages surpassing US$6.8 billion.

The question to be asked, then, is what can finance ministries do to manage these risks?

To adequately manage negative shocks, finance ministries should have quality information to measure the impact of climate change on the fiscal accounts, use financial instruments to mitigate natural disaster impacts, and develop a framework to manage fiscal risks. To this end, the IDB is working together with LAC countries to improve natural disaster risk management. Some actions being implemented include:

  • Measuring public expenditure in climate change and natural disasters: The IDB has elaborated a budget tagging methodology, which allows for the identification and measurement of climate and disaster-related expenditures. The methodology maintains coherence through the introduction of primary and secondary purpose classification, essential to account for the multisectoral nature of climate change actions. For example, a primary functional climate change classification can tag expenditures based on purpose or intent, while a secondary purpose classification can tag activities, actions, or products based on impact, within all primary expenditure categories.

  • Measuring the fiscal impact of natural disasters: A separate methodology has been developed to measure the direct and indirect fiscal impact of climate-related natural disasters, complementing the information obtained by budget tagging. The methodology also allows for the identification of the opportunity costs incurred by budget reallocations triggered by natural disasters. For example, it is estimated that the occurrence of at least one extreme event per year is associated with an increase in the fiscal deficit of 0.8% of GDP for lower middle- income countries and 0.9% of GDP for the low-income group in the same year. However, it is important to note that the effects for high- and upper middle-income countries are far more modest and are not statistically significant.

  • Developing financial strategies to mitigate natural disaster risk: Natural disaster insurance is often used as a financial mechanism to mitigate disaster risk. This type of insurance offers coverage against the occurrence of natural disasters in exchange for a premium. Furthermore, the issuance of catastrophe bonds is another option. These bonds are tradable instruments that transfer the risk of a catastrophic event from the issuing government to capital markets.

  • Prioritizing climate resilient public investments: Damages to public energy and transportation infrastructure are among the main impacts of floods, storms, and other natural disasters. The strengthening of national public investment systems through the introduction of risk and vulnerability analysis, as well as resilient infrastructure prioritisation, are required to adequately manage disaster risk.

  • Strengthening disaster risk governance: In 2012, the IDB developed the Index of Governance and Public Policy in Disaster Risk Management (iGOPP), comprised of 245 indicators that evaluate the legal, institutional, and budgetary conditions that are considered fundamental for disaster risk management policies to be effectively implemented. The iGOPP can be used to establish baselines for policy reforms in the region and to monitor and evaluate their impact.

Find the full article on the IDB blogs page.

To learn more about this subject, the IDB invites you to read the book Fiscal Policy and Change Climate: Recent Experiences of Ministries of Finance in Latin America and the Caribbean.