Is Carbon Tax the Answer to Climate Change Investment Needs in Latin America and the Caribbean?

Latin American and Caribbean countries are highly vulnerable to the effects of climate change due to their varied geography, dependence on economic sectors that will be adversely impacted by changes in hydrometeorological conditions and entrenched structural weaknesses. At the same time, the region lacks the fiscal space to ramp up public policies to mitigate climate shocks and reduce greenhouse gas (GHG) emissions. Carbon taxes have increasingly been proposed as an instrument to finance climate investment in emerging and developing countries. However, only five countries in the region have adopted a carbon tax.

A new technical paper from Daniel Titelman, Christine Carton, Michael Hanni and Noel Pérez Benítez for the Task Force on Climate, Development and the International Financial Architecture examines whether carbon taxation could finance the investment required to offset the economic losses in terms of growth and productivity caused by climate change in Latin America and the Caribbean. The analysis focuses on six economies—the Dominican Republic, Guatemala, Honduras, Jamaica, Paraguay and Peru—characterized by high climate vulnerability and limited fiscal space. Two climate scenarios are simulated: a moderate pathway with a 2.4 degrees Celsius temperature increase and a severe 4.9°C increase by 2100.

Main findings:

• Rising temperatures will significantly reduce total factor productivity (TFP) growth, from -0.2 percent in 2004–2023 to -0.6 percent under the 2.4°C scenario and -0.8 percent under the 4.9°C scenario. Correspondingly, average gross domestic product (GDP) growth would decline to 1 percent and 0.2 percent, respectively, by 2050, with Caribbean economies such as Jamaica experiencing outright contractions.
• To bridge the output gap between these scenarios, a reformed carbon tax priced at $50 per ton of CO2e and with broader coverage could generate around 1.4 percent of GDP—enough to finance only 12 percent of the necessary investment to compensate for GDP growth losses due to rising temperatures.
• Carbon taxation, while useful, must be complemented by broader fiscal reforms, concessional finance and debt-relief mechanisms to sustainably fund climate adaptation and mitigation.

Policy recommendations:

• There is substantial scope for mobilizing additional tax revenues in Latin America and the Caribbean. Tackling tax evasion and avoidance stands out as a major challenge and opportunity for the region. Towards the medium term, the region will necessarily require structural tax reforms to generate the resources necessary to support climate investment and growing social demands.
• Faced with the urgency of large-scale front-loaded climate investment, domestic resource mobilization efforts must be accompanied by measures at the international level to lower the cost of capital and improve term structures for emerging markets and developing countries. Multilateral development banks (MDBs) have significant leverage on the cost of capital for climate investment in the region. Meanwhile, an area for further development for national development banks (NDBs) is increasing their participation in climate adaptation projects.
• Given the close links between climate change and debt vulnerability in the region, creating viable climate debt restructuring and relief mechanisms will be key to opening up the fiscal space needed to drive a public investment push. In the absence of an institutionalized debt restructuring mechanism, vulnerable countries, particularly in the Caribbean, could benefit from debt-for-climate swaps.

As laid out in this paper, the economic consequences of an intensification of climate change are likely to be stark, and would severely hurt development. Overall, the paper highlights how a carbon tax would be one of many resource mobilization measures necessary to ensure fiscal sustainability and promote private investment to address climate change.