Selected Issues and Analytical Notes

Abstract

Selected Issues and Analytical Notes

Climate Change, Environmental Policies and Output Trade-Offs1

This note evaluates the vulnerabilities of Costa Rica to global warming, drawing lessons from the relationship between Costa Rica’s ambitious environmental policies and its record of strong economic growth. First, the paper shows that due to the geographical position of the country, any significant increase in temperature due to global warming will put serious downward pressure on growth. Second, because in the past environmental policies included financial incentives to transition away from agriculture towards services, such as tourism, as the primary driver of growth, economic activity was not harmed. Going forward, it will be important to ensure that the legal and regulatory framework stimulates the growth of those sectors that are more resilient to climate change.

A. Introduction

1. Costa Rica remains one of the leaders in environmental policy in Central and also Latin America. According to the Environmental Performance Index (EPI) data compiled by the Yale Center for Environmental Law & Policy, Costa Rica performs better than other countries in Central America overall in outcomes of environmental policy (see chart below). Specifically, Costa Rica has the highest quality of water and sanitation in the region, the lowest risk of water and air pollution to human health (labeled “Health Impacts”), and the highest forest coverage (54 percent of land area in 2015). The overall air quality is on par with Panama, while the percentage of protected areas and species (labeled “Biodiversity and Habitat”) is just below Nicaragua’s (25 percent of all forested area). The category Climate and Energy, in which Costa Rica holds the third place, depends on the ratio of emissions to GDP, which has been going down with the highest rate in the region, and the emissions from electricity production that increased in the past (however, as of 2016 more than 98 percent of energy is generated from renewable sources). Overall, the composite index placed Costa Rica in 42nd place in the ranking of all countries in 2016, above all other Latin American economies.

A05ufig1

Environmental Performance in Central America

Citation: IMF Staff Country Reports 2017, 157; 10.5089/9781484304563.002.A005

Sources: Hsu, A et al. (2016) and staff calculations

2. In the future, the country aims to maintain an ambitious environmental agenda and reach carbon neutrality by 2021. Out of all Central American countries, Costa Rica has experienced the lowest growth in total greenhouse emissions since 1990. The Ministry of Energy and Environment committed voluntarily to reduce emissions further in absolute terms to reach 2005 levels by 2021 (see chart below). After 2021, the projected emission trajectory is consistent with the agreement reached at the United Nations Framework Convention on Climate Change (UNFCCC), which would result in an average global temperature increase below 2°C if all countries comply.

3. Under such ambitious environmental policies, Costa Rican growth has persisted as one of the highest in the region and elevated in global comparison too. Because environmental policies may increase regulatory burden and constrain certain types of on economic activity, they are often criticized as detrimental to economic growth and employment. Nevertheless, except for 2013 and 2014, Costa Rican real growth remained close to 4 percent, above the average of emerging markets and more than double the rate of advanced economies in 2016.

A05ufig2

Total Greenhouse Emissions, Percent Change Since 1990

Citation: IMF Staff Country Reports 2017, 157; 10.5089/9781484304563.002.A005

Sources: World Bank, country authorities and staff calculations
A05ufig3

Real Growth in Central America

Citation: IMF Staff Country Reports 2017, 157; 10.5089/9781484304563.002.A005

Sources: World Economic Outlook and staff calculations

4. Costa Rica’s ambitious environmental policies have likely had historically positive effects on economic growth and will continue to mitigate the effects of global warming. First, the geographical position of the economy and the already relatively high, although so far stable, yearly temperature implies a higher negative impact of global warming on economic activity, especially on agricultural output. Second, the paper shows that the reason why the environmental policies have not harmed growth is that they were implemented together with financial incentives for a structural transformation of the economy away from agriculture and towards services - tourism in particular - as the primary driver of growth.

B. Effects of Climate Change on Growth

5. Climate change affects Costa Rica through multiple channels. First, more frequent natural disasters may directly destroy private and public capital, resulting in a temporary declines in output and increases in unemployment. Therefore, Costa Rica’s already weak fiscal position may further deteriorate both due to a reduced tax base and increased expenditures on disaster relief and infrastructure rebuilding (Acevedo, 2014, IMF, 2016). Since areas prone to be affected tend to be poor, higher incidence of natural disasters can increase inequality. Second, Costa Rica is also moderately exposed to a permanent sea level rise. Even though the share of land area where elevation is below five meters is only 0.6 percent, the area is characterized by high tourism and real estate activity. Third, global warming can indirectly reduce economic activity through lower labor productivity, labor supply and agricultural crop yield as these variables negatively depend on the surrounding temperature (Graff Zivin, J. and Neidell, M., 2014).

A05ufig4

Natural Disasters in Latin America

Citation: IMF Staff Country Reports 2017, 157; 10.5089/9781484304563.002.A005

Sources: EM-DAT and staff calculations

6. Since mid-20th century both the frequency and intensity of natural disasters has increased in Latin America (see chart above). According to the international database of natural disasters, EM-DAT, both the frequency of climate change-related natural disasters as well as the number of people affected by disasters increased multifold since the 1950s world-wide and in Latin America in particular.2 IMF (2016) estimates that in the post-1990 period relative to the entire post-1950 period both the average direct damage annual cost in constant 2010 US dollars and the frequency per square kilometer of natural disasters doubled. As a percentage of GDP, the annual expected cost for a country like Costa Rica increased from 0.3 to 0.4 percent of GDP.

7. To evaluate the impact of global warming, staff estimated a global non-linear effect of rising temperature on annual economic growth. Following the approach suggested in Burke, Hsiang and Miguel (2015), staff estimated the following panel regression on annual data:

yit=f1(Tit)+f2(Pit)+gi(t)+βt+εit

where yit is annual GDP growth in country i and year t, f1(Tit) is the function of interest - a quadratic function of average annual country-specific population-weighted temperature Tit, f2(Pit) is a quadratic function of average annual country-specific precipitation, gi(t) is a country-specific quadratic trend function which by definition includes country-specific fixed effects, βt are time fixed effects and εit are random disturbances. The data set includes observations since the earliest period available (1961 for Costa Rica) to 2013 and covers 165 countries. Given the rich structure of time and country specific effects, the only coefficients that are common for all countries are the parameters of functions f1(Tit) and f2(Pit).

8. Based on the microeconomic evidence, aggregate economic activity should be a concave function of annual temperature, consistent with the specification above. The literature showed that an individual sectorial production function as a function of the surrounding temperature is approximately piece-wise linear (Graff Zivin and Neidell(2014)). Specifically, the output response to temperature is either flat or slightly increasing with temperature up to a threshold after which it is declining with temperature. Burke, Hsiang and Miguel (2015) show that if one aggregates individual sectorial production functions over time and across sectors, the resulting aggregate production function should be concave. Therefore, the chosen parametric specification for f1(Tit) as a quadratic function is consistent with this observation.3

9. According to the estimated global response of economic activity to temperature, Costa Rica’s GDP will be unambiguously negatively affected by global warming. The chart below plots the estimated function f1(Tit) together with the 90 percent confidence interval and the position of selected countries in the most recent year. The chart demonstrates that if the global temperature were to increase, it will have very different effects on different countries. For a country like Russia, which had an average yearly temperature of 5°C in 2013, a higher temperature will unambiguously increase economic activity. However, for Costa Rica, with average yearly temperature of 23 °C, global warming will lead to a decline in GDP growth. For Honduras, a slightly warmer country than Costa Rica, the outlook is even worse. The current country-specific marginal effects that correspond to the position on the estimated function are plotted above.

Figure 1.
Figure 1.

Estimated Global Response of GDP Growth

Citation: IMF Staff Country Reports 2017, 157; 10.5089/9781484304563.002.A005

Sources: IMF staff calculations
A05ufig5Sources: NOAA/OAR/ESRL PSD, IMF staff calculations.

10. The quantitative effects of rising temperature on the Costa Rican economy do not assume major changes in global emissions dynamics. This scenario, often referred to as “Business as Usual” represents the current state of policies regarding emissions. The scenario also has become more likely when on March 28 the U.S. rolled back Obama-era greenhouse regulations (Popovich, 2017). The scenario foresees 4.3°C increase in population-weighted global temperature. The country-specific temperature increases by 2100 are plotted on the chart. The Costa Rican average yearly population-weighted temperature under such scenario is expected to go up by about 3½°C.

A05ufig6

Forecasted Effect on Annual Growth under Current Policy Setting with 90 Percent Bands

Citation: IMF Staff Country Reports 2017, 157; 10.5089/9781484304563.002.A005

Sources: IMF staff calculations

11. By 2100, the adverse effect of climate change on annual Costa Rican growth is estimated to be about 3½ percent. To estimate the effect on growth one can substitute temperature projections into the estimate of f1(Tit) linearly interpolating temperature projections between years. Even though the temperature projection takes Costa Rica outside the historically experienced average yearly temperatures, it stays within the global distribution of historically observed temperatures. This means that the implied effect is not extrapolated out of the global sample, which makes the estimation more conservative. The fan chart with the 90 percent confidence interval derived from bootstrapping estimated parameters of f1(Tit) across countries is presented above and the estimated global effects by 2100 are presented below. By 2100 the negative effect on Costa Rican growth is significant and large at about 3½ percent. Economically, if average annual temperature increases by about 3½°C, Costa Rica may be unable to continue to produce agricultural goods at lower elevations and potentially lose its attractiveness as a tourism destination. Globally, the most negatively affected regions are Middle East, Sub-Saharan Africa, South Asia, and northern Latin, including Central America. The global response map also shows why the largest emitters - the United States and China - are not keen on constraining their emissions: the negative effect of the global warming for them is relatively mild.

C. Environmental Policies and Growth

12. Historically, Costa Rica has had to overcome significant environmental problems such as rapid deforestation. Apart from some variability, all estimates of forest cover in the 1980s point to a value between 20 and 25 percent (Kleinn et al., 2002). The deforestation at its peak reached 1 percent of the land area per year (UN environment, 2005). The deforestation was a result of conversion of land into agricultural and cattle-ranching areas as a response to high international prices of Central American beef and expansive crops such as coffee, sugar and bananas. The expansion of agricultural land was fueled by inexpensive government loans (Porras et al., 2013). The sharp decline in the international prices for these commodities in the 1980s and political instability in Central America brought the expansion of farm land to a halt and the forest cover rebounded naturally somewhat. The 1990s marked the beginning of relatively ineffective reforestation efforts via tax breaks that eventually lead to the introduction of the Payment for Environmental Services (PES) system.

13. Key legislation that supported reforestation, promoted the services sector, and led to the structural reorientation of the economy was enacted in 1996. Forestry law 7575 forbade land cover changes and limited the use of forested area for timber extraction. Most importantly the law created the PES program which rewards landowners for environmental services such as mitigation of emissions, protection of water, protection of ecosystems or scenic natural beauty for tourism or science. Among other issues, the law additionally established the Forest Fund for capacity building and research activities regarding how to protect and prevent damages to natural resources as well as the National Forest Financing Fund (FONAFIFO) to pay for reforestation and land restoration activities. The main source of financing for the PES program and the two funds is one third of the total fuel and hydrocarbon tax.

14. By rewarding conservation efforts, the PES system made the tourism sector more attractive than agriculture for an average landowner. To illustrate this idea, the chart below represents an individual landowner’s choice between investing in agriculture or tourism. The x-axis represents the share of land already used by tourism sector (or, as a proxy, the share of land area covered by forest). The y-axis represents the return on each of the two activities as a function of the share of land already used by the tourism sector. The return on agriculture should not depend on the activities of other landowners, unless the share of agricultural land is very small. However, the return on tourism activity, especially ecotourism, should have increasing returns to scale up to some saturation point. The increasing returns could be due to higher diversity of flora and fauna as forest area increases, higher attractiveness for tourists that want to visit several regions, higher likelihood of public investment in better infrastructure and lower crime, etc. In 1980, due to high international prices on agricultural goods, the return on agriculture was higher than on tourism resulting in an equilibrium with a larger share of agricultural sector and a smaller share of the tourism sector (see chart below). The introduction of the PES system in 1996 made tourism and conservation efforts more profitable than agriculture for enough individual landowners (the segment of the red line between the dashed blue and solid blue lines). That through increasing returns to scale tourism became more attractive for other individuals as well. Thus, the country started converging to a new equilibrium marked by the third vertical line by moving rightward along the blue lines.4 The shows that the number of international tourist arrivals took off at about the same time when the forest cover started recovering and was flat during the 1970s and 1980s.

A05ufig9

International tourist arrivals 1951-2015

Citation: IMF Staff Country Reports 2017, 157; 10.5089/9781484304563.002.A005

Source: Costa Rican Institute of Tourism, IMF staff calculations

15. As a result of the mechanism described above, the services sector became the main driver of economic growth. In 1983, agriculture represented 14 percent of the total value added, while the services sector represented 54 percent (see below). By 2015 the agriculture sector’s share in GDP had decreased to 5 percent, while the services sector’s share had increased to 72 percent. In 2017 Costa Rica leads the U.S. News ranking in ecotourism in the world and is a top-10 destination for adventure tourism. Higher forest cover also increased population density in the rest of Costa Rica which further facilitated expansion of office jobs, including exports of back-office services.

16. Even though the share of agriculture value added in GDP declined, since 1990 agriculture productivity has increased faster than in other countries in Central America (see chart). With less land available for agriculture and inability to expand it at the forested area expense, the agricultural good producers seemed to have started to use available resources more efficiently. The chart above shows the value added of agricultural sector in constant 2010 U.S. dollars for Costa Rica and the average for the other Central American countries. The value in 1980 is normalized to 100 for all countries.5 The chart implies that the productivity of Costa Rica accelerated when the forest cover started recovering around 1990 and was very close to the Central America average when forest coverage was low.

A05ufig10Source: WDI, IMF staff calculations

D. Conclusion and Policy Discussions

17. Going forward, it will be important to ensure that the economy is flexible enough to adjust its composition toward those sectors that are less affected by climate change. For example, one can re-estimate the regression described in the first part of this paper for agricultural sector growth instead of overall GDP growth as the dependent variable. In this specification, at current temperatures, the agricultural sector in Costa Rica is about 50 percent more vulnerable to increases in temperature than the economy overall. Therefore, it would thus be crucial to continue the structural transformation of the economy towards the sectors that are more resilient to the global warming.

18. The sectors that generate the largest amounts of emissions are agriculture and transportation. To meet the carbon neutrality goal by 2021, it will be important to maintain a high percentage of electricity generated using renewable sources, which in 2016 benefited substantially from abundant rains and reached 98 percent according to the Costa Rican Institute of Energy, ICE. Therefore, it is important to have an alternative generation plan if rainfall decreases in the future. As for agriculture, the Environmental Performance Index database states that Costa Rica has the highest excess use of nitrogen in the region, one of the main sources of emissions. Quantitatively, sugar production contributes about 5 times more to the total emissions than the ground transportation sector including taxis. To alleviate the problem, the authorities can consider schemes that financially incentivize low emissions of individual farmers. Regarding transportation, as the economy and population grow, it would be important to increase quality and quantity of public transportation options to keep the number of personal cars, the main source of emissions in the transportation sector, sufficiently low. However, to make public transportation more attractive it would be critical to address existing weaknesses in road infrastructure (AN IV).

19. Given the importance of environmental performance for exports and economy overall, it is desirable to incorporate it in the public policy framework. An important step in this direction is monitoring and publication of environmental accounts by the Central Bank jointly with the World Bank and other governmental agencies. The accounts include detailed information on water use, extraction, losses and efficiency; geographical land cover changes; and energy and emission dynamics. The public investment cost-benefit analysis should include environmental impact as one of its determinants. Since Costa Rica is expected to see the negative effect of global warming relatively soon, the authorities should step up capacity building efforts in this direction.

References

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  • Ministerio de Ambiente y Energía de Costa Rica, 2015, Contribución Prevista y Determinada A Nivel Nacional de Costa Rica.

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  • Acevedo, S., 2014, “Debt, Growth and Natural Disasters: A Caribbean Trilogy”, IMF Working Paper No 14/125, International Monetary Fund.

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  • Burke M., S. M. Hsiang and E. Miguel, 2015, Global Non-linear effect of temperature on Economic Production, Nature, doi:10.1038/nature15725.

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  • Popovich N., 2017, Trump’s Executive Order Pushes the U.S. Climate Pledge Further Out of Reach, New York Times.

  • Kleinn C., L. Corrales, D. Morales, 2002, Forest Area in Costa Rica: A Comparative Study of Tropical Forest Cove Estimates Over Time.

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  • Willmott, C. J. and K. Matsuura, 2001 Terrestrial Air Temperature and Precipitation: Monthly and Annual Time Series (1950-99).

1

Prepared by Dmitry Plotnikov.

2

These natural disasters include floods, storms, landslides and extreme temperatures.

3

Burke, Hsiang and Miguel (2015) conduct many robustness checks and show that the estimates of the global response function f1 are indeed robust. These include including lags of growth on the right-hand side, using a different data source, estimating the equation on different subsamples etc. See the paper for details.

4

This setup can be made more realistic if one incorporates dispersion of skills across the two activities. This will eliminate possibility of zero shares of services or agriculture in GDP.

5

The data for Nicaragua are available only starting in 1994. The series for Nicaragua are normalized to 100 times the average of other countries in 1994.

Costa Rica: Selected Issues and Analytical Notes
Author: International Monetary Fund. Western Hemisphere Dept.