Abstract
Climate change could potentially impact Ecuador’s savings and investment balance through physical risks to capital, a potential transition away from fossil fuels, or the need to invest for climate change adaptation and mitigation. Although data limitations and uncertainties prevent a full quantitative assessment of this impact, illustrative applications of standard external sector assessment models can provide a useful framework for considering the potential implications of climate change. Additional data, such as costing of climate change adaptation and mitigation plans will be key to determining how climate change will impact the optimal savings and investment mix. Further, since climate change is a global phenomenon, such an assessment would need to be done for all countries to ensure multilateral consistency.
Savings and Invesment Dynamics and Climate Change1
Climate change could potentially impact Ecuador’s savings and investment balance through physical risks to capital, a potential transition away from fossil fuels, or the need to invest for climate change adaptation and mitigation. Although data limitations and uncertainties prevent a full quantitative assessment of this impact, illustrative applications of standard external sector assessment models can provide a useful framework for considering the potential implications of climate change. Additional data, such as costing of climate change adaptation and mitigation plans will be key to determining how climate change will impact the optimal savings and investment mix. Further, since climate change is a global phenomenon, such an assessment would need to be done for all countries to ensure multilateral consistency.
A. Introduction
1. Climate change may impact Ecuador’s sustainable savings and investment balance. Physical risks from climate change (e.g. more frequent natural disasters), transitional risks from a shift away from fossil fuels, or large investment needs to adapt and mitigate climate change may all impact the savings and investment balance to varying degrees. While research on the external sector and climate change has been mostly limited to the direct impact on trade, consideration of the impact on the savings and investment balance can shed light on implications for climate change on macroeconomic sustainability. It also highlights the importance of climate change as a macro-critical issue.
2. Although data limitations and several uncertainties prevent a full, multilaterally consistent, quantitative assessment, illustrative applications of standard models provide a framework for considering how climate change might impact the savings and investment balance. Additional data, such as costing of climate change adaptation and mitigation plans, for both Ecuador and globally, would be critical for determining the optimal savings and investment mix in a multilaterally consistent way. However, this SIP uses illustrative applications of standard External Balance Assessment (EBA) models as a framework for considering how climate change might affect Ecuador’s current account norm
Physical Risks
3. Climate change presents the physical risk of damage to capital both from increased exposure to natural disasters or more gradual impacts of global warming.2 Theoretically, the overall impact of natural disasters on the current account (CA) is somewhat ambiguous.3 On the one hand, the associated destruction of wealth can negatively affect consumption, while a lower present value of income may deter investment. On the other hand, the damage in physical capital may lead to an increase in investment in the aftermath of natural disasters. These dynamics may also be affected by the degree of financial openness with a higher degree of openness allowing countries to smooth shocks to maintain consumption. Empirically, Rasmusen (2004) and Laframboise and Loko (2012) find that CAs worsened in the wake of natural disasters, while Prati et al. (2011) found that natural disasters raise the CA in countries with low financial openness, and reduce it in countries with high financial openness as such openness can enable countries to smooth consumption in response to the shock and rebuild productive capacity. Although so far there is limited empirical analysis on the impact of gradual global warming on savings and investment balance, related uncertainties and the potential for losses in productivity could also deter investment.
4. Natural disasters may call for precautionary savings. The CA in the EBA-Lite framework includes a dummy variable based on historical economic damages for natural disasters (relative to other countries to ensure multilateral consistency), and the sign of the effect on the CA depends on the degree of financial account openness the degree of financial account openness. However, climate change may necessitate additional precautionary savings than implied by this adjustor based on historical data if natural disasters become more recurrent or more severe.
5. While physical risks related to climate change have been identified for Ecuador, estimating additional required precautionary savings is subject to uncertainty and would also need to factor in multilateral considerations. According to the 2019 Norte Dame Global Adaptation Initiative (ND-GAIN) Index, which measures a country’s exposure, sensitivity, and capacity to adapt to the impacts of climate change, Ecuador registered a higher vulnerability score at 0.44 compared with the average for LA6 countries of 0.41.4 A geospatial analysis on climate change risks based on countries’ latitudes found that Ecuador is susceptible to large potential increases in heat and humidity related to climate change (McKinsey, 2020). The study identified high risks for Ecuador in terms of the share of the capital stock vulnerable to flooding and the share of outdoor working hours affected by extreme heat. That said, projecting the full physical impact of climate change in Ecuador is particularly challenging, given its varying topography and climate conditions (Chimborazo and Vuille, 2021). For example, some suggest the possibility for more droughts or more flooding in Ecuador depending on the region and time of year (Campozano et al., 2020). In addition, investments in disaster resilient capital could mitigate the need for some precautionary savings as discussed below.
Transitional Risks
6. Climate change may also present a transitional risk if there is an earlier than anticipated global shift away from fossil fuels. Oil exports made up 34 percent of Ecuador’s export base on average over 2016–20. The consumption-based module in the EBA-Lite framework used to derive a medium-term current account norm assumes that Ecuador can use its entire proven reserve base (around 8.3 billion barrels or 45 years of production). A decline in global fossil fuel demand during this period (for example as countries aim to meet commitment emissions reductions) could result in stranded oil assets that can no longer be extracted on a commercial basis. However, the supply and price response of a global transition away from fossil fuels. complicates estimating the impact of potential transition. For example, oil producers may have incentives to accelerate production where feasible ahead of a transition and declining investment in oil fields could contribute to price increases (IMF, 2019b). Applying a simple sensitivity analysis to the consumption-based model for Ecuador, holding prices and production constant, suggests that for a 10 percent reduction in the reserve base (around 4 years of production) would increase the current account norm by 0.1 percentage points of GDP.
7. Financial and real diversification would serve as important mitigating factors for transition risks. Financial diversification could involve investing any oil export surpluses in low-carbon assets (e.g. through a well-governed sovereign wealth fund). Real diversification would involve developing non-oil sectors of the economy, including through broader efforts to boost competitiveness.
Investment Needs
8. Climate change could present additional investment needs to support climate change adaptation and mitigation. If such investments enhance productivity or ensure economic sustainability, a lower current account norm might be warranted. While the EBA-Lite consumption-based module does not consider the possibility of allocating resource wealth to finance productive investment, the EBA-Lite Investment Needs model aims to account for this. It draws on the idea that capital scarcity would lead to a higher marginal product of capital. If the marginal product of capital is higher than the cost of borrowing, it would be optimal to use resource windfalls to finance investment.
9. Investment needs have not typically been a determining factor in Ecuador’s external sector assessment given its relatively high capital stock. IMF estimates of the stock of public capital show that Ecuador ranks relatively high compared with its peers. Survey-based competitiveness indicators like the WEF Global Competitiveness indicator also suggest that infrastructure is one of the few areas where Ecuador does not lag peers. However, climate change could present additional investment needs for adaptation or mitigation. Ecuador’s relative susceptibility to climate related disruptions suggests adaptation needs, and Ecuador has made specific mitigation commitments under the Paris Agreement to reduce emissions by 9 percent (or 21 percent conditional on support of the international community) (See Section V).
10. An application of the investment needs model to Ecuador, suggests a significantly lower current account norm. A critical assumption of the model is the efficiency of public investment, with higher levels of public investment efficiency translating into more productive capital and thus lower current account norms. Applying the baseline oil reserve and production assumptions5 and a 50 or 75 percent public investment efficiency assumption,6 would generate medium term current account norms of -0.6 percent of GDP and -2.1 percent of GDP respectively.
Public Capital Stock 2017
(In percent of GDP)
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A006
Sources: IMF Public Capital Stock Database. World Economic Forum Global Competitiveness Index1/ The World Economic Forum’s Global Competitiveness Index combines official data and survey responses from business executives on several dimensions of competitivenessPublic Capital Stock 2017
(In percent of GDP)
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A006
Sources: IMF Public Capital Stock Database. World Economic Forum Global Competitiveness Index1/ The World Economic Forum’s Global Competitiveness Index combines official data and survey responses from business executives on several dimensions of competitivenessPublic Capital Stock 2017
(In percent of GDP)
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A006
Sources: IMF Public Capital Stock Database. World Economic Forum Global Competitiveness Index1/ The World Economic Forum’s Global Competitiveness Index combines official data and survey responses from business executives on several dimensions of competitiveness
WEF Competitiveness Index, 2019 1/
(Score 1–100, 100=best)
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A006
Sources: IMF Public Capital Stock Database. World Economic Forum Global Competitiveness Index1/ The World Economic Forum’s Global Competitiveness Index combines official data and survey responses from business executives on several dimensions of competitivenessWEF Competitiveness Index, 2019 1/
(Score 1–100, 100=best)
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A006
Sources: IMF Public Capital Stock Database. World Economic Forum Global Competitiveness Index1/ The World Economic Forum’s Global Competitiveness Index combines official data and survey responses from business executives on several dimensions of competitivenessWEF Competitiveness Index, 2019 1/
(Score 1–100, 100=best)
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A006
Sources: IMF Public Capital Stock Database. World Economic Forum Global Competitiveness Index1/ The World Economic Forum’s Global Competitiveness Index combines official data and survey responses from business executives on several dimensions of competitiveness
Investment Needs Model Current Account Norms
(In percent of GDP)
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A006
Source: IMF staff calculations.Investment Needs Model Current Account Norms
(In percent of GDP)
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A006
Source: IMF staff calculations.Investment Needs Model Current Account Norms
(In percent of GDP)
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A006
Source: IMF staff calculations.11. However, a key limitation to applying the investment needs model to assess the impact of climate change is that the productive returns from adaptive or mitigation capital may differ from traditional capital. Investment in climate adaptation may not necessarily be productive since it may only involve protecting or repairing existing capital from climate-related losses rather than contributing to higher output. In fact, some have argued that investment in adaptive capital could lead to lower output growth since fewer resources would be available for productive capital, continuous adjustments in the capital stock to adapt may lead to lower capital efficiency, and shifting more investment to repairing or replacing capital may involve less innovation and technology transfer (Batten, 2018; Fankhauser et al., 1999; Pindyck, 2013). Other models like the IMF’s Debt-Investment-Growth Natural Disasters (DIG-ND) model have attempted to model climate adaptive investments more directly, by incorporating investment in ‘resilient’ capital that would reduce the rate of capital depreciation and simulating natural disaster shocks. However, these applications of this model have typically involved small economies where the size of the natural shock is considerable.7 Meanwhile, investment in climate change mitigation may yield cost-saving productive returns as evidenced by some microeconomic studies,8 but low-carbon investments could also be less productive than traditional carbon-intensive investments.
B. Conclusions and Policy Implications
12. Illustrative applications of standard EBA-Lite models have shown that climate change may impact the savings and investment balance in Ecuador, but the overall direction of the impact is uncertain. More frequent natural disasters or a transition away from fossil fuels may warrant higher precautionary savings. Climate mitigation and adaption needs on the other hand may suggest that a shift toward higher investment may be warranted, depending on the productivity of investments.
13. Nevertheless, several questions remain when determining how climate change considerations would affect the optimal savings and investment mix and multilateral considerations informed by a global analysis of all countries would need to be taken into account for a decisive assessment.9 First, a fuller understanding of Ecuador’s specific investment needs for climate change and the potential returns on such investment is warranted, particularly given its relatively high levels of capital stock. A second question is how climate change will impact different exporting sectors of the economy. This could include how commodity prices would respond to climate-related supply shocks. Third, is how the response to climate change will be financed. Models like the investment needs model assume debt financing, but drawing precautionary savings built up or financial innovations (e.g. debt for climate swaps), might unlock lower cost financing. Finally, the impact of climate change on Ecuador’s savings and investment balance would need to be evaluated in a multilateral context. The current account and real effective exchange rate are measured relative to other countries, and as such are determined by both a country’s own characteristics and foreign country characteristics. Such analysis is complicated by the fact that the varying impact of climate risks across countries could lead to some redistribution of incomes, and changes in relative prices and trade flows.
14. Costing of climate adaption and mitigation measures for both Ecuador, and more broadly, will be key to assessing the implications for the savings and investment and the optimal mix. Currently, such information is limited. For example, the Institute for Global Environmental Strategies Nationally Determined Contributions Database does not have financial needs estimates for around 60 percent of the 197 countries (including Ecuador).10 The varying results of the investment needs model according to different public investment efficiency assumptions also highlights the importance of public investment management in any strategic climate-related investment
References
Batten, S. (2018). Climate change and the macro-economy: a critical Review. Bank of England working papers, (706).
Campozano, L., Ballari, D., Montenegro, M., & Avilés, A. (2020). “Future meteorological droughts in Ecuador: decreasing trends and associated spatio-temporal features derived from CMIP5 models.” Frontiers in Earth Science, 8, 17.
Chimborazo, O., & Vuille, M. (2021). “Present-day climate and projected future temperature and precipitation changes in Ecuador.” Theoretical and Applied Climatology, 143 (3), 1581–1597.
Fankhauser, S., Smith, J. B., and R. S. J. Tol 1999. “Weathering climate change. Some simple rules to guide adaptation investments,” Ecological Economics, 30 (1):67–78.
Feng, A. and Li, H. 2021. “We Are All in the Same Boat: Cross-Border Spillovers of Climate Risk Through International Trade and Supply Chain,” IMF Working Paper 21/13.
IMF (2019a). Fiscal Monitor: How to Mitigate Climate Change,
IMF (2019b). “The Revised EBA-Lite Methodology,” IMF Policy Paper.
Laframboise, N. and B. Loko. 2012. “Natural Disasters: Mitigating Impact, Managing Risks,” IMF Working Paper 12/245.
Marto, Ricardo, Chris Papageorgiou, and Vladimir Klyuev. “Building resilience to natural disasters: An application to small developing states.” Journal of Development Economics 135 (2018): 574–586.
McKinsey, 2020. “Climate Risk and Response: Physical Hazards and Socioeconomic Impacts.” January.
Pindyck, R. S. (2013). Climate change policy: what do the models tell us? Journal of Economic Literature, 51 (3), 860–72.
Prati, A., L.A. Ricci, L. Christiansen, S. Tokarick and T. Tressel. 2011. “External Performance in Low-Income Countries,” IMF Occasional Paper 272.
Rasmussen, T.N. 2004. “Macroeconomic Implications of Natural Disasters in the Caribbean,” IMF Working Paper 04/224.
Rexhäuser, S., & Rammer, C. (2014). Environmental innovations and firm profitability: unmasking the Porter hypothesis. Environmental and Resource Economics, 57 (1), 145–167.
Prepared by Deirdre Daly (SPR).
Physical risks may not be limited to those directly impacting the country. For example, in a study on cross-border spillovers of physical climate risks through international trade and supply chain linkages finds that foreign climatic disasters in major trading partner countries lower the home-country stock market valuation for the aggregate market and for the tradable sectors. Exposures to foreign long-term climate change risks also reduce the asset price valuations of the tradable sectors at home (Feng and Li, 2021).
See also the discussion on natural disaster shocks in The Revised EBA Lite Methodology (IMF, 2019b).
Ecuador most vulnerable indicators included the projected impact of climate change on cereal yields (rice, wheat, and maize) and dam storage capacity.
Both the standard consumption-based allocation model and the application of the investment needs model use conservative assumptions about oil price and production movements including reserves limited to the proven reserve base,
In other words, 50 or 75 percent of public investment spending translates into productive capital.
Marto et al. (2017) for example apply the model to Vanuatu using a 2015 cyclone as the basis for a shock where post-disaster needs exceed 60 percent of GDP.
For example, Rexhauser and Ramer (2014) find that investments in resource efficiency positively effects firm profitability.
These questions consider limitations to using standard EBA-Lite models to understand the impact of climate change on the savings and investment balance However, there may be further limitations such as the potential for dynamic effects.
Institute for Global Environmental Strategies Nationally Determined Contributions Database.
