globally, committing to be on a trajectory consistent with the global goal of limiting the increase in global average temperature to 1.5C.<sup>36</sup> This goal is also consistent with that noted in Costa Rica’s long-term National Decarbonization Plan. Through global value chains, international commitments also have a bearing on countries’ specific GHG emission trends (Kaltenegger et al. 2017). The implementation of an orderly transition, particularly in the case of ambitious NDCs, is key to the mitigation of transition risks for the banking sector (NGFS 2020b).

Bolivia, Paraguay, and Uruguay are the largest emitters of GHG when adjusting for the size of their economy. While Mexico and Brazil are the largest emitters of GHG in absolute terms, this is not the case when we account for the size of their economies and look at emissions per unit of GDP (Figure 7).<sup>37</sup> Bolivia, Paraguay, and Uruguay sit around or below the median emitters of the sample countries but are in the higher end of CO2e per unit of GDP, which is largely explained by their agricultural sector emissions.

To obtain a preliminary indication of banks’ loans value-at-risk to the transition to a low carbon economy, we analyze the sectoral distribution of bank loans to nonfinancial corporations. We find that more than one quarter of banks’ credit portfolios in Argentina, Uruguay and Bolivia are tilted towards transition-sensitive industries that are also high CO2 emitters. The relatively higher exposure to transition risks in these countries is driven by the agricultural sector, and to a greater extent in Uruguay where agriculture explains two-thirds of the total exposure (Figure 8). Although we could not retrieve credit outstanding information with the required granularity to compare Paraguay across LAC, data from Paraguay Central Bank show that banks allocate around 30 percent of their total credit portfolios to the agricultural sector. This allocation is larger than the exposure to all transition-sensitive sectors in the rest of our sample of countries. Banking systems less exposed to transition risks are in El Salvador, Costa Rica, Colombia, and Chile.

LAC firms operating in transition-sensitive sectors already present signs of stress, especially those in the fossil fuel and agricultural industries. In the event of materialization of transition risks, the effects on the banking sector may be greater if ex-ante firms are financially stressed.<sup>38</sup> Available firm-level data show that 26 percent of the LAC firms that operate in transition-sensitive sectors had annual interest payments exceeding profits as of 2019 (Figure 9). This share is six percentage points higher than firms operating in non-transition-sensitive sectors. In terms of individual sectors, fossil fuels have the higher share of firms with an ICR below or equal to one, at 32 percent, and heavy industry the lowest at 23 percent.<sup>39</sup> When we look at the share of outstanding debt that financially distressed firms hold, firms' higher vulnerability in transition-sensitive sectors is more pronounced at 38 percent, which is 12 percentage points higher than firms in

> 36 Costa Rica commits to an absolute maximum of net emissions by 2030 of 9.11 million tons of carbon dioxide equivalent (CO2e) including all emissions and all sectors covered by the corresponding National Emissions Inventory. 37 We consider emissions from carbon dioxide, methane, nitrous oxide, and F-gases measured in tonnes of carbon dioxide equivalents (CO2e). Emissions other than carbon dioxide (CO2) are particularly relevant for LAC. CO2 emissions represent 75 percent of GHG at the global level, a figure 20 percentage points lower for LAC (Data obtained from Climate Watch).

> 38 See Grippa and Mann (2020) for an exercise that uses firm-level information to conduct transition risk stress testing.

> 39 Compounding our findings, Ramírez, Thomä, and Cebreros (2020) find a sizable exposure of banks in LAC to transition risk driven by companies increasing fossil fuel production. For instance, the authors show that Brazilian companies could increase their oil and coal production by 40 percent and 11 percent in the next 5 years.

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