Enabling Net Zero Markets: Greening Public Financial Management

A nation’s ability to mobilize resources to combat and cope with climate change is primarily constrained by its resources and financial capacity, which vary dramatically across developing contexts.  While external sources of funding like the Green Climate Fund (GCF) are critical to meeting a nation’s Paris Agreement goals, they are often out of reach without domestic financial systems and processes to absorb such funds and use them productively. To achieve the proper level of financing for national climate initiatives, countries should first look domestically and identify how public financial management (PFM) systems can be tailored to reflect climate priorities and how fiscal tools could be utilized to spur a net-zero market economy through targeted incentives. Doing so can encourage innovative climate entrepreneurs to cultivate solutions, reduce barriers to green investment, and lower future climate-related macro-fiscal risks, contributing to future public revenues. With the right assistance and political momentum, policy champions, leaders, and finance ministers can facilitate this transition through sequencing and tailoring existing PFM frameworks to achieve pressing climate objectives without a complete overhaul. The good news is that governments already possess the core fiscal instruments to catalyze a broader green market shift. The development community can also assist at all stages throughout this transition to provide critical support, particularly in developing contexts where foundational PFM systems often remain weak.

Green PFM: An Integrated Framework for the Budget Cycle

Robust PFM is at the heart of a well-functioning public administration, transforming public resources (collected through taxes and fees) into activities and services and creating funding channels to support fiscal policies tied to national objectives and strategies (e.g., Nationally Determined Contributions). It can target and address the underlying causes of distortionary market behaviors that encourage high emissions and climate-vulnerable growth by creating the enabling environment, capacity, and incentives that promote public and private investments to facilitate an equitable and just climate transition.

Akin to other priority-based budgeting approaches (e.g., gender-responsive budgeting), green PFM integrates specific-issue topics into existing PFM practices and processes. Similarly, existing PFM systems can be adapted through a sustainable, green lens. At the core of all PFM is the annual budget cycle, through which line ministries develop, execute, monitor, and have their budgets audited. IMF’s holistic approach to green PFM presents the key entry points for integrating climate commitments across the budget cycle through conceptual presentation supplemented by country case studies, whose core concepts are described below.

Legal Precondition. The budget cycle must be underpinned by strong legal foundations that will decrease the likelihood of policy reversals arising from economic or political changes and sustain the forward momentum and continued application of green PFM practices. Demand for green PFM reforms originates with climate awareness and commitment among internal (e.g., legislative branch) and external stakeholders (e.g., civil society, private sector, media) and can be promoted through active public consultation meetings and workshops. Active dialogue and public participation are critical for building greater accountability and deeper fiscal transparency around plans and expenditures that lead to meaningful climate action. As an example, using a local systems approach, the USAID Guatemala Biodiversity Project improved coordination among government authorities and facilitated consensus-building dialogue between the private sector and civil society at both the subnational and national legal levels. This cooperation was crucial to rectifying existing legal and regulatory contradictions and led to 10 policies and legal provisions in sustainable livestock and protected areas.

Strategic planning and fiscal framework.  Every budget cycle begins with priority-setting at the strategic planning phase, establishing the fiscal framework and resource constraints. Green priorities should be integrated into medium-term fiscal frameworks (MTFF), which outline the budget’s macroeconomic assumptions and establish the macro-fiscal baseline, ensuring that climate change initiatives fall within the country’s fiscal means and are sustainable across multiple budget cycles. For instance, introducing a carbon tax could significantly expand the tax base and fiscal space (see below). Climate-related fiscal risks should also inform the fiscal framework, including the uncertainty of costs associated with mitigation (e.g., costs associated with transitions to a low carbon economy) and adaptation due to climate change (e.g., natural disasters affecting infrastructure and weather patterns affecting agriculture yields).

Budget Preparation. During the budget preparation phase, climate-related instructions and requirements are integrated into annual budget circulars (critical guidance documents that provide operational guidelines and targets to sectoral ministries), motivating agencies to consider line items based on GHG emission factors, climate-friendly investment projects or use carbon pricing methods. As budgets are developed in line with the circulars, ministries should then incorporate climate initiatives into their own budget priorities – including green public investments and subnational government financing (see next section). Green budget tagging can support monitoring climate-related and tax expenditures by “tagging” individual components based on whether they negatively or positively impact green objectives. Such outcome-targeting aligns well with program and performance budgeting, where USAID and other partners have provided extensive support.  

Budget Execution and Accounting. In an effective green PFM system, legislatures approve budgets which must then be executed, monitored, and reported based on climate-related expenditures (for instance, through leveraging the green tagging system). Budget execution systems should also build flexibility and responsiveness that tackle climate-related emergencies while ensuring robust accounting systems are in place to prevent leaks and deter corrupt activities during vulnerabilities.

Control and Audit. Specific expertise is needed to implement control and internal/external audit methodologies to assess the efficiency and efficacy of climate-related expenditures. Development partners can step in to build the capacity of a government’s internal (e.g., Congressional oversight bodies) and external audit institutions (e.g., Supreme Audit Institutions) to carry out ex-post evaluations that assess whether budgets have been implemented in line with climate goals and national strategies. Such oversight frameworks should also be built for sub-national governments where a sizable piece of the budget may be executed. For example, the USAID Vietnam Governance for Inclusive Growth Program created an auditors’ manual used by the State Audit Office of Vietnam that featured detailed steps in audit planning, implementation, and reporting on specific environmental issues, including projects, environmental impact assessments, waste management, water pollution, and climate change.

Targeted Fiscal Tools to Spur Market Action

With the green PFM framework serving as a holistic guide underpinning climate-responsive budget formulation and expenditures, specific fiscal tools can be deployed in line with the budget cycle to stimulate market movements in the green space and achieve national climate objectives.

Carbon Taxation and Tax Expenditures. Carbon pricing (charges on the carbon content of fossil fuels or their emissions) is an essential mitigation instrument that encourages low-carbon investment and lowers energy consumption choices by raising the cost of carbon-intensive assets. Carbon pricing also generates domestic revenue, which can be used to fund further green investments, and may dovetail well with carbon credit markets as emitters seek to reduce their tax obligation through purchasing credits, as they provide funds to support communities engaged in sustainable income-generating activities. Tax expenditure policies can also complement the introduction of certain green tax policies. For example, subsidies and expenditures that support energy efficiency projects can smooth the impact of carbon pricing when implemented in the future. Environmental tax revenues can also be redistributed to support the livelihoods of vulnerable households adversely impacted by green fiscal policies (e.g., those working in unsustainable, high-emitting industries).  

Example: Colombia passed a national carbon tax on liquid fossil fuels to encourage and fund environmental conservation efforts in 2016. This tax encouraged fuel distributors to reduce their carbon tax obligation by buying carbon credits from renewable energy and forest protection projects. In this context, the USAID Bio-REDD+ project helped 19 Afro-Colombian and indigenous communities in Colombia establish 8 REDD+ projects. These projects generated carbon credits for sale, funding forest conservation and community services, and the model is being adopted and scaled for use in other areas of the country. The Colombian Ministry of Finance estimates this tax will generate USD $250 million in annual financing for conservation and restoration projects.

Public Investment.  Fiscal policies that combine green investments with carbon taxation can demonstrate a strong multiplier effect. Targeted public investment, underpinned by robust environmental impact assessments used for their approval and selection, can help align market expectations on a green transition and crowd-in private investment. Resilient infrastructure is critical for adaptation purposes, whether it improves early warning systems, dryland agriculture, or efficient water resource management. Significant public investment should also flow into re-skilling and up-skilling the workforce through training and policies that facilitate transitions to green jobs. To amplify impact, private investment can be mobilized through developing bankable, climate-resilient public-private partnership projects with appropriate risk-sharing arrangements in project design: technical assistance that USAID projects can support. Global methods that are in development to support climate-informed public investment and asset management include the International Monetary Fund’s new climate module for the Public Investment Management Assessment (PIMA) and the World Bank’s collation of approaches to climate-smart public investment management.

Example: The USAID B+WISER project in the Philippines advanced conservation finance through the design and replication of payment for ecosystem services (PES) schemes, working closely with governments, the private sector, and local communities to leverage investments in forest protection. Together with private investment and local fee collection and retention initiatives, B+WISER leveraged $58.7 million in public and private investment for forest and biodiversity protection, and 30,000 people, including women and indigenous peoples, received increased economic benefits.

Subnational Government Financing. Subnational governments (SNGs) play a crucial role in a nation’s climate transition, delivering services for adaptation, identifying and taxing large emitters, and constructing resilient infrastructure. Central governments can incentivize SNGs through fiscal transfers explicitly tied to low-carbon investments or green policies and require reporting obligations and monitoring of performance indicators for their usage. Equalization mechanisms could also play a role in ensuring that the SNGs that are more vulnerable to climate change receive additional resources. Expenditure tagging is then necessary to monitor how transferred funds are being used and whether to its climate-positive objectives.

Example: The USAID Mozambique Coastal Cities Adaptation Program (CCAP) developed a Local Government Self-Assessment tool used to assess levels of climate change preparedness and resilience in three coastal cities and then helped the cities develop mechanisms to become climate resilient, including potential financial needs. Municipal councils ratified resulting adaptation plans to inform city planning and budgeting decisions, with participating cities raising $5.07 million in climate change adaptation funding from public and private sources. The city of Pemba, for example, mobilized $2 million to address climate-related priorities identified in its local adaptation plan.

Conclusion: A Word on Strategic Sequencing

Green PFM reforms require many years of iteration and are nascent in most countries. A medium- to long-term strategy is critical, and countries must make strategic decisions on priority entry points in line with existing national priorities and capacity constraints. As the IMF recommends in their Green PFM framework, strategies must be sequenced appropriately, with concrete action plans and realistic timelines, and should pilot practices and processes in key ministries before full roll-out. For instance, green PFM systems only make sense if basic elements of a functional traditional PFM system, like financial compliance and budget preparation, are in place, which is further required to access public climate finance. As capacity gaps are identified, development partners can play an important role in providing training, grants, international expertise, and global best practices to ensure that PFM reforms will sustain over time through building state capacity. As such, the development community must support governments in their transition journeys, as greening PFM processes and tailored fiscal policies have the potential to unlock significant market interest in the climate-positive space.