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IMF Country Report No. 22/329

ARMENIA

TECHNICAL REPORT – QUANTIFYING FISCAL RISKS FROM CLIMATE CHANGE

October 2022

This Technical Assistance Paper on Armenia was prepared by a staff team of the International Monetary Fund. It is based on the information available at the time it was completed in July 2022.

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Title Page

FISCAL AFFAIRS DEPARTMENT

Armenia

Quantifying Fiscal Risks from Climate Change

Jason Harris, Bryn Battersby, Mehdi Raissi, John Zohrab, and Jyoti Rahman

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Technical Report

September 2022

The contents of this report constitute technical advice provided by the staff of the International Monetary Fund (IMF) to the authorities of Armenia (the “TA recipient”) in response to their request for technical assistance. This report (in whole or in part) or summaries thereof may be disclosed by the IMF to IMF Executive Directors and members of their staff, as well as to other agencies or instrumentalities of the TA recipient, and upon their request, to World Bank staff and other technical assistance providers and donors with legitimate interest, unless the TA recipient specifically objects to such disclosure (see Operational Guidelines for the Dissemination of Technical Assistance Information— http://www.imf.org/external/np/pp/eng/2013/061013.pdf).

Disclosure of this report (in whole or in part) or summaries thereof to parties outside the IMF other than agencies or instrumentalities of the TA recipient, World Bank staff, other technical assistance providers and donors with legitimate interest shall require the explicit consent of the TA recipient and the IMF's Fiscal Affairs Department.

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This technical assistance (TA) was provided with financial support from the European Union.

Contents

• ABBREVIATIONS AND ACRONYNMS

• PREFACE

• EXECUTIVE SUMMARY

• Recommendations

• I. CLIMATE CHANGE AND ARMENIA

• A. Climate Change Risks in Armenia

• B. Climate Change Commitments and Framework

• II. FISCAL RISKS FROM CLIMATE CHANGE

• A. The Nature of Climate Change Fiscal Risks

• B. Approaches to Quantifying Climate Change Fiscal Risks

• III. QUANTIFYING CLIMATE CHANGE FISCAL RISKS IN ARMENIA

• A. Climate Scenarios

• B. Baseline Scenario

• C. Integrating Climate Change Scenarios into Fiscal projections

• D. Expenditure Rigidity, Adaptation, and Policy Implications

• E. Discrete Fiscal Risks of Climate Change in Armenia

• IV. FUTURE WORK PROGRAM

• A. Refinements and Extensions

• B. Broader Fiscal Risk Work Program

• BOXES

• 1. Summary of Kahn et al (2021)

• 2. Climate Change Fiscal Risk Analysis in the United Kingdom and Georgia

• 3. Summary of the Disaster Module

• 4. Akhouryan Irrigation Project Feasibility Study Climate Change Risk Assessment

• FIGURES

• 1. Annual Average Temperature Projections for Armenia

• 2. 2080-2100 Average Temperature Increase Above 1990-2000 Baseline

• 3. Temperature Changes in the Unmitigated Scenario

• 4. Precipitation Changes in the Unmitigated Scenario

• 5. Variance in Annual Average Temperatures

• 6. Frequency of Climate-Related Natural Disasters in Armenia

• 7. Extreme Temperatures and Droughts

• 8. Mitigation Target and GHG levels – 1990 to 2017

• 9. Projection of GHG Emissions with Energy Mitigation Scenarios

• 10. Estimates of GDP Impact from Increases in Temperature

• 11. Illustrative Long Run Fiscal Sustainability Analysis with Climate Change

• 12. Nominal GDP Growth and its Drivers (2012-72)

• 13. Demographic Trends and Projections

• 14. Labor Productivity Level Relative to OECD

• 15. Growth in GDP Deflator

• 16. Baseline Fiscal Projections

• 17 Macroeconomic Effects of Climate Change

• 18. Effects of Climate Change on Fiscal Projections (2012-72)

• 19. Effects of Expenditure Rigidity (Volatile Scenario, 2072)

• 20. Effects of Expenditure Rigidity, Volatile Scenario (2012-72)

• 21. Effects of Faster Adaptation, Unmitigated Scenario (2012-72)

• 22. SOE Assets and PPP/PPA Contingent Liabilities

• TABLES

• 1. Transmission Channels to Supply Side

• 2. Climate Change Related Impacts on Public Finances

• 3. Key Fiscal Indicators Under Different Climate Scenarios

• 4. Examples of SOEs and PPP Climate Change Risk Exposures

• 5. Projected Hydroelectric Losses from Climate Change

Abbreviations and Acronynms

Preface

At the request of the Deputy Minister of Finance of Armenia, a team from the IMF's Fiscal Affairs Department (FAD) undertook an in-person mission from July 14 to 25 in Yerevan, to quantify long term fiscal risks from climate change. The mission team was led by Mr. Jason Harris and included Mr. Bryn Battersby (both FAD), Mr Mehdi Raissi (IMF Resident Representative), Mr. John Zohrab (FAD regional advisor), and Mr. Jyoti Rahman (FAD short-term expert).

The mission team met with the Minister of Finance, Mr. Tigran Khachatryan, and his team from the Ministry of Finance: Deputy Minister Avag Avanesyan, Mr. Ara Avetisyan (Head of Fiscal Risk Management Department), Mr. Narek Karapetyan (Macro Policy Department), Hrayr Yesayan (Budget Department), and Samvel Khanvelyan (Public Debt department).

From other agencies, the team met with Deputy Minister Gayane Gabrielyan (Ministry of Environment), Deputy Minister Arman Khojoyan (Ministry of Economy), Acting Director Levon Azizyan (Bureau of Meteorology), Deputy President Davit Grigoryan (Urban Development Committee), Deputy Ministers Vache Terteryan and Kristine Ghalechyan (Ministry of Territorial Administration and Infrastructure), Board Member Hasmik Ghahramanyan (Central Bank of Armenia) and Director Armen Nurbekyan (Dilijan Training and Research Center).

The mission team also met with Armineh Manookian Salmasi and Irina Ghaplanyan from the World Bank, Natia Natsvlishvili, Diana Harutunyan and Hovhannes Ghazaryan from the United Nations Development Program, Messrs Joao Pedro Farinha and Gregorio Belaunde from the Asia Development Bank and Messrs Frank Hess and Andrea Baggioli from the EU Delegation to Armenia.

The mission undertook a series of working sessions with Ministry of Finance, Ministry of Economy and Central Bank of Armenia staff where approaches to fiscal and climate change modelling were introduced. The mission team is grateful to Mr Richard Hughes, Chair of the United Kingdom's Office of Budget Responsibility, Pierre-Alain Bruschez from the Swiss Federal Finance Administration and Shota Gunia from the Georgian Ministry of Finance for joining these sessions and presenting on their countries experience in assessing and reporting on fiscal risks from climate change.

The mission team would like to particularly thank Messrs. Ara Avetisyan and Hayk Ohanyan for their excellent assistance and guidance, Mr. Mehdi Raissi, IMF Resident Representative, and his team for their guidance and administrative support. The mission would also like to thank Ms. Lilit Simonyan and Ms. Marietta Sahakyan for the interpretation support provided.

Executive Summary

Armenia's climate has already begun warming, and if carbon emissions are not reduced, temperatures are projected to continue rising sharply. Average temperatures have already increased by 1.2 degrees since the 1990s. Under an unmitigated emissions scenario, Armenia's average temperature could rise by around 5.6 degrees by 2100, and be accompanied by lower rainfall, a 40 percent drop in water flows and a sharp increase in climate related natural disaster such as droughts. However, if global emissions can be reduced in line with global commitments made at the Paris Climate Accords, average temperatures could be stabilized at current levels.

Armenia's climate exposure is high compared to other countries, with above average temperature rises and variability likely to lead to extreme weather events. Armenia's increase in average temperatures is above global averages. However, the greatest risk comes from high year to year temperature volatility, which increases the impact of climate change, leading to more severe events around rising mean temperatures (hot years are even hotter). Armenia's temperature variance is already high – only three countries have more variable average annual temperatures – and is projected to increase further under unmitigated scenarios. Given these exposures, the Ministry of Finance should develop capacity to assess the long-term fiscal risks from climate change (see recommendations).

The fiscal impact of climate change is analyzed from three complementary perspectives to understand the potential impact over the next 50 years. First, the impact of higher temperatures on the economy is assessed based on empirical analysis of past temperature changes on growth. Second, the flow through of slower economic growth is applied to long-run fiscal projections to identify building fiscal pressures. Third, the cost of climate change-related discrete fiscal risks is assessed to identify the state's direct exposures to climate risks.

Rising volatility and temperatures will have increasing long term impacts for both the economy and sustainability of the public finances, increasing fiscal risks significantly. Three scenarios are explored: the Paris scenario, the unmitigated scenario where emissions continue, contributing to higher temperatures only, and a volatile scenario which accounts for both the higher temperatures and increased volatility. Under the worst case 'volatile scenario', climate change could reduce GDP per capita by 18 percent relative to baseline by 2072, and in the absence of any fiscal policy response result in public debt levels increasing at an unsustainable pace to 140 percent of GDP. Most of this is due to the volatility in annual temperatures; accounting for temperature alone, GDP would be only 3 percent smaller, and public debt of 62 percent of GDP by 2072. These compare to the benign Paris scenario where GDP is unchanged from baseline, and public debt is 46 percent of GDP. These estimates are conservative, only accounting for changes in temperatures, and do not incorporate potential non linearities from tipping points such as melting of the permafrost.

Should the extreme scenarios unfold, the government has some policy levers at hand:

• First, the unmitigated scenarios assume carbon emissions continue rising, whereas it is within our control to reduce emissions and prevent this scenario. Armenia's ability to reduce global emissions is minimal, given its 0.02 percent share of total emission. Still, this is a collective action challenge, and Armenia has committed to keeping emissions below 40 percent of 1990 levels, requiring curbing projected growth.

• Second, even in the unmitigated scenario, the government can make the economy more resilient by increasing their adaptability to higher temperatures. In the unmitigated scenario, reducing the time it takes for the economy to adapt to higher temperatures from 30 to 20 years could reduce the impact on GDP by 1.7 percentage points, and reduce public debt from 62 to 54 percent of GDP by 2072. This requires investing in resilient infrastructure, adjusting technologies, and regulatory changes.

• Third, the government can adjust its fiscal settings in response to the gradually slowing economy. The projections assume that other than the revenue impact from slower growth, other fiscal policy settings remain unchanged from baseline and that nominal primary expenditure levels are held constant at baseline levels. The results show that climate change makes an otherwise sustainable fiscal scenario deeply unsustainable. This can be resolved by policy makers continually trimming expenditure to match slower economic growth, keeping deficits and public debt in check, but translates into a 14 percent reduction in real primary spending per capita relative to the baseline in 2072.

Higher and more volatile temperatures, reduced rainfall and more frequent climate change related disasters expose the government to range of discrete fiscal risks. In contrast to the broader macroeconomic and fiscal pressures associated with climate, these discrete risks relate to direct exposure of the state through its guarantees, on-lent loan portfolio, SOEs and PPPs. These are concentrated in the energy, water, and transport sectors, with large hydroelectric and water transmission projects, both of which are likely to be heavily impacted by a 40 percent decline in water flows. Climate change related natural disasters could damage infrastructure and generate force majeure events for PPPs, and higher temperatures can compromise the efficiency of thermal power plants and the transmission framework. Further analysis of these risks is necessary to identify, assess and inform mitigation actions; a process that is already underway. In addition, the government may also have to provide support to affected households and businesses, provide costly rescue operations, forfeit revenues in affected regions.

Assessing risks from climate change comes amidst a broader fiscal risk agenda that has led to a range of improvements since the 2018 Fiscal Transparency Evaluation last took stock. These include expanding the coverage of the fiscal risk statement to include risks from the environment, litigation and financial sector, as well as more comprehensive assessments of PPPs. Still, to increase the impact and tractability of the fiscal risk statement for policymakers, the Fiscal Risk Statement (FRS) should include a clear summary and guidance as to where the key risks lie, broaden the statement to include summaries of risk assessments published elsewhere, providing clearer and more standardized assessment of different risks, and working with other agencies; link identified risks to concrete policy measures. The report could provide one-off chapters provide deeper discussion on issues such as climate change (as per this report), and the bleak demographic outlook, which will create major pressures on future health and pension spending.