Annex 12. Entry points for greening PFM systems

How to support authorities in greening a PFM system?

Economic governance measures, in particular PFM, are critical to accelerate the green transition.  A structured approach to environmentally sustainable, climate resilient, low carbon and resource efficient development (encouraging low carbon paths, avoiding carbon lock-in of infrastructure investments) can be encouraged at both central levels of government, notably ministries of finance and economic planning through enhanced PFM systems, and line ministries. EU support to partner authorities could contribute to:

• Integrating climate and nature related issues into the various stages of the budget cycle. Actions focusing on supporting PFM systems, and budget support operations have the capacity to encourage fiscal reforms addressing nature and climate challenges influencing processes that are centre to government.

Potential entry points for integrating the green dimension along the budget cycle include (See IMF on Climate-Sensitive Management of Public Finances – “Green PFM”):

• • Strategic Planning and Fiscal Framework: medium term fiscal frameworks (MTFFs), fiscal risk assessments and fiscal strategies.
  • Budget preparation: budget circular, policy impact assessments, budget tagging (to compare allocations vis-à-vis policy objectives), medium-term budgetary frameworks.
  • Budget execution, accounting and reporting: adapting chart of accounts and financial management information system (FMIS), expenditure tagging^[54] (to compare actual vs planned spending), greening public procurement and public investment management systems.
  • Control and audit: internal and external audits, oversight bodies.

• Determining finance options, potentially implying a mix of budgetary resources including fiscal tools and the phasing out of harmful subsidies, stemming from dialogue between ministries of finance and line ministries. These can be accompanied by risk-sharing instruments and private and public insurance tailored to the local risks.
• Strengthening of internal controls and external audit, building the capacity of partner authorities, legislature and civil society organisations to analyse climate and environmental issues (including in the relevant reports) and to assess to what extent they are being integrated in the different stages of the budget cycle.
• Improving oversight, information and analysis of public climate and environmental action. This can be done through environmental expenditure reviews and technical, non-partisan organisations that act as “honest brokers” to national or territorial stakeholders facing issues in ensuring a just transition. Available information and analysis can help institutions in strengthening governmental commitments, addressing political economy issues, and increasing credibility of green public action.
• Extending a green PFM approach to subnational governments, and in line with the promotion of a green and circular economy, to State Owned Enterprises.
• Encouraging explicit high-level support from government (e.g. Minister of Finance, Prime Minister, President).

Are climate and environmental risks adequately identified, measured and considered for planning?

Environmental and climate risks are among the main risks to the global and local economy. While the identification of risks can be done through risks and vulnerability assessments, at territorial or sector level, there may be no systemic instruments in place for quantitative estimates. It remains crucial to have forms of assessments on potential impacts and to include an environmental and climate change related risk dimension into the fiscal risk management. The assessment can be guided by:

• The extent to which national budgets can be impacted by climate and environmentally related stresses and shocks (e.g. droughts, floods, hurricanes, soil degradation, affected ecosystem services including food provisioning and water provision, biodiversity loss…). It is important to assess the impacts of climate change and environmental degradation on macro-economic stability, tax revenues, the disruption of economic activities and public services, the generation of additional spending (e.g. reconstruction after climate-related disasters, climate proofing, rehabilitation or reconstruction, new investments to compensate the reduction in agricultural production, de-polluting operations, rise in healthcare costs, …).
• The estimated cost of action and of inaction. Climate vulnerable countries need to invest now to reduce future damage and economic disruption from disasters, decrease their disaster recovery spending, and provide a quicker return to normal economic activity (i.e., investing in resilience). Costing may imply using risk information on specific events (e.g. storms, floods, wind, heat waves…), and calculate the resources needed for risk mitigation, preparedness and potential response.
• The definition of development paths for climate and environmental action. The level of uncertainty over climate future has decreased over the years, with an improved understanding of impacts on natural systems and human economic activities. This allows public actors to define a vision for climate and environmental action in the medium term. Tools such as stress-tests (see below) help local authorities engage in participatory processes with their communities and decide on future climate and environmental investments.

To which extent can improved revenue and expenditure management provide fiscal space for climate and environmental priorities?

The fiscal framework can act as a supporting instrument for climate action and improved natural resources management as drivers of social and economic opportunities. Essential steps include:

• Apply Green DRM. Domestic revenue mobilisation is part of a social contract that underpins social cohesion and contributes to shaping good governance. Applying a polluter-payer principle shall generate revenues, while primarily supporting environmental protection including pollution abatement. Domestic revenues also help finance set priorities such as new adaptation investments. Green taxes can be justified through:
  • Environmental protection itself, leading to a healthier environment and reducing the local impact of climate and environmental issues.
  • Ensuring that all costs are taken into account in the composition of goods and services prices (such as environmental degradation including water, air or soil pollution).
  • Steering the behaviour to green choices e.g. the promotion of energy savings and an incentive for companies to innovate in sustainability.
  • Discouraging environmentally damaging practices e.g. unreasonable use of certain pesticides, plastics, drinkable water.
  • The generation of revenue for governments, allowing other taxes to be lowered or climate and environmental projects to be carried out.
• Estimate and keep track of climate change and environmental efforts in the budget. The definition of climate/environment-relevant expenditure and its coverage, as well as the estimation of related spending are important prerequisites for budget allocation decisions. A systemic identification and monitoring of budgets allocated to climate and environmental action facilitate a systematic move towards national and international environmental and climate change related long-term objectives, contribute to raising awareness, improve transparency and accountability (through reporting), and may help in preparing more climate and environment responsive budgets in the future (e.g. CPEIR, tagging). In addition, practices like budget tagging can help to bring in additional private finance, for instance, through green bond financing schemes.
• In expenditure management, it is crucial to identify budget elements that negatively impact the environment or that contribute to climate change. The elimination of harmful/perverse subsidies (e.g. to fossil fuels) are typically included in environmental fiscal reform measures to create new financial resources.

References

^[54]  Budget tagging is a process that allows identifying, measuring, and monitoring specific expenditure that are related to a certain objective or policy. Climate budget tagging, for instance, has been in place in many countries inside and outside of the EU. It can be done throughout budget preparation and implementation. The quality of tagging depends on the quality of the classification system, the clarity of the budgetary and activity definitions (i.e., defining which activities can be eligible for tagging), the level of understanding of agents in charge of the classification. More importantly, the usefulness of tagging heavily lies on its capacity to influence decision making, shall it be on acting upon expenditure slippages if they occur, or on influencing future budgets and ensuring they improve their capacity to consider climate and environmental issues.