Latin-America green low carbon transition

Low-carbon transition in Latin America: what are the risks and the main constraints?

By AFD economists Guilherme Magacho, Antoine Godin, Marion Hémar and Emmanuelle Mansart Monat

A hundred and eighteen billion US dollars. This amount, which represents 2.7% of the GDP of Latin America and the Caribbean, is the annual investment in “renewable power generation, energy efficiencies, electrification of heat, transportation, and power grids” the region needs to align with the Paris Agreement’s objective on climate change. To meet this target, countries in the region are adopting policies and fostering technological changes that are generating rapid structural change across the world.

However, as low-emission “sunrise” industries gain importance and high-emission “sunset” industries decline, Latin America’s transition towards a greener economy is not yet guaranteed. The low-carbon transition exposes countries across the region to risks that can affect their macroeconomic stability. It is only by identifying those risks, and by taking into account the constraints they create, that they will be able to achieve a successful low-carbon transition.

Beyond financial risks, three dimensions of macroeconomic exposure

Recent studies highlight the financial risks associated with the stranded assets of large fossil fuel corporations. However, the macroeconomic risks of the low-carbon transition go beyond financial ones, especially when it comes to developing countries.

Other important sources of instability, such as rising public debt, higher inflation, trade imbalances and unemployment, might result from the transition, constraining economic growth, investment opportunities and, consequently, the low-carbon transition itself.

It is thus important to analyse the macroeconomic exposure that these rapid structural changes might impose on Latin American economies. This is even more necessary in a context where their access to green finance is limited by high capital costs and the use of monetary and fiscal policies to finance green investments could be constrained by balance-of-payments and fiscal imbalances.

To analyse these potential systemic vulnerabilities, we propose a methodology to determine each developing country’s exposure to the low-carbon transition. Our tool allows us to analyse countries’ direct and indirect dependence on sunset industries, accounting for the productive and commercial interrelation among industries. We estimate various indicators to measure the different dimensions of exposure: socio-economic, trade (or external) and fiscal. As shown by the map below, most Latin American countries, particularly those of South America, are exposed to at least one of these dimensions.

 Authors’ elaboration based on Eora Global Multi-region Input-output table

External and fiscal exposure

Latin American countries are less diversified and less competitive in high-tech goods than most developed economies, as they do not have the productive and technological capabilities to produce them. Therefore, they need to import most of the machinery, equipment and inputs necessary to reduce emissions in other industries. This will demand high volume of foreign currency during the transition.

Moreover, high-emission intensive industries may face a reduction in export revenues due to either a decline in the volume of sales or a price decrease. The higher demand for foreign currency and the reduction of its supply may lead to balance-of-payment constraints, damaging macroeconomic stability. Our external exposure indicator captures the dependence on sunset industries to attract foreign currencies.

Venezuela and Bolivia are good examples of countries with high external exposure, mainly driven by the export of petroleum gases and crude petroleum. Sunset industries account for 42% of Bolivia’s and 68% of Venezuela’s net raise of foreign currency, indicating that a low-carbon transition may substantially affect their capacity to import.

Furthermore, for many countries, sunset industries, such as fossil fuels, are very important sources of fiscal revenues. The Andean economies present high fiscal dependence on hydrocarbon revenues (Ecuador, Venezuela, Bolivia and, to a lesser extent, Colombia), mining revenues (Chile) or a mix of the two (Peru). The low-carbon transition therefore poses an eminent risk: governments need to increase spending while the transition itself may reduce fiscal revenues.

Bolivia and Venezuela rank among the top five countries most dependent on sunset industries to raise fiscal revenues. In the case of Bolivia, about 30% of fiscal revenue is directly or indirectly dependent on these industries, whilst 25% of Venezuela’s fiscal revenue depends on sunset industries. Moreover, as the Green Complexity Potential ranking shows, they are not capable of migrating their productive structure to green industries in the short- or medium-term (Bolivia ranks 168th and Venezuela ranks 202nd), which means that the low-carbon transition may impose significant fiscal risks.

Socio-economic impacts

Socio-economic vulnerabilities are also an important part of understanding the overall macroeconomic impact of the low-carbon transition. If countries depend on sunset industries to generate employment and labour income, the transition may increase inequalities and without well-structured social protection systems, the transition process can be excessively costly.

A study from the International Labour Organization (ILO) showed that the low-carbon transition will destroy many jobs in highly carbonised industries, such as fossil fuel electricity and extraction, and will generate many others in low carbon activities, such as renewable energy, agriculture and plant based production. Although the worldwide net impact is positive, countries where sunset industries are responsible (directly and indirectly) for generating most of the jobs and paying a large share of wages are those with the highest exposure to the low-carbon transition in the socio-economic dimension.

Brazil, Argentina, Peru, Ecuador and Colombia are examples of countries with high socio-economic exposure. Sunset industries account directly and indirectly for about 4% of employment in these economies, amounting to more than 5% of total wages. Nevertheless, especially in the case of Brazil and Argentina, they are relatively less dependent on these industries from an external exposure perspective. Due to their relative export diversification (agricultural products account for a significant share), their dependence on these industries to raise foreign currency is not as high as in Venezuela and Bolivia – even though it might have negative consequences for global efforts to protect biodiversity.

It is also important to highlight that socio-economic exposure does not always lead to socio-economic vulnerability: this depends on the share of the population covered by social protection benefits, which can be measured using ILO’s Social Protection Coverage (SPC). In the case of Peru, Bolivia and Ecuador, the high socio-economic exposure reflects in high socio-economic vulnerability due to low levels of social protection coverage. In these countries, only about one-third of the population is covered by at least one social protection benefit, whilst in Colombia and Venezuela, social protection coverage is about 55%, and in Brazil and Argentina, it is about two-thirds, which makes the population less vulnerable.

The indicators of Latin American countries’ macroeconomic exposure and vulnerabilities discussed here can help support a multidimensional analysis of the low-carbon transition, as different constraints emerge in different domestic and international contexts. In light of these data and based on their political mandate, decision-makers will be in a position to better arbitrate for a just and inclusive transition. Long-term de-carbonisation targets demands massive investments and it will only be achieved if they are coherent with short- and medium-run development needs. This is especially relevant for developing countries, where high exposure usually means high vulnerabilities and risks.

This analysis focusing on Latin America is inspired from our research paper “Developing countries’ macroeconomic exposure to the low-carbon transition”, available for download here