‘Building back better’ has an aspirational climate investment component. For sufficient capital to flow to low- or zero-carbon assets, policymakers must both incentivize the rebalancing of portfolios around climate-friendly instruments and develop a more consistent global reporting framework.
Responding effectively to the climate crisis will require a profound reallocation of capital from high-carbon to low- or zero-carbon assets. The operation of the international financial system is critical to this transition. The additional capital spending on physical assets needed to achieve climate policy goals may be equivalent to around 2 per cent of global aggregate GDP between 2026 and 2030. This will only be affordable if investment is transferred from fossil fuel industries.
Ensuring that finance flows to low- or zero-carbon solutions is a highly complex process. Because it will involve coordination between several parts of the financial system, no class of institution can solve the problem independently. Compounding the challenge is the current global economic situation, characterized by surging inflation, slowing or negative GDP growth and rising debt in many markets. This could mean that tackling climate change does not appear an immediate priority for financial policymakers, regulators or investors. Yet the need is urgent, given the severity of existing climate impacts and the likely length of the timescale for the net zero transition (starting already in this decade). In short, the world has only one shot at getting climate finance right, which means it needs to use all the tools available.
A first principle is that mobilizing capital at sufficient scale will rely on leverage of public financial mechanisms to generate much larger private financial flows. Several public instruments are considered effective in this respect. They include risk mitigation instruments such as guarantees and government loans, which can be provided through national development banks (NDBs) with the support of multilateral development banks (MDBs). Secondly, central banks and financial regulators are increasingly recognizing the systemic threat climate change poses to financial stability, and thus the potential role of levers such as climate-related macroprudential regulation and new monetary policy approaches. Additionally, there has been much discussion of the environmental implications of fiscal responses to the COVID-19 pandemic, and by extension the role of national discretionary fiscal stimulus to propel climate action.
Mobilizing capital at sufficient scale will rely on leverage of public financial mechanisms to generate much larger private financial flows.
Emerging markets and developing economies (EMDEs) concentrate most of the world’s physical potential for renewable energy generation and nature-based climate solutions. They also tend to be the most vulnerable to the physical impacts of climate change, and thus share strong reasons to seek climate investment. But the capacity of different EMDEs to attract international finance for climate solutions varies. It depends on the enabling environment, and on investor perceptions of risk in each country. EMDEs normally have higher political, regulatory and macroeconomic instability (factors often related to, or exacerbated by, currency devaluation), as well as significant exposure to inflation risk and higher levels of indebtedness.
One of the impediments to progress is the lack of a global framework defining low-carbon investments, without which it is harder for EMDEs to attract the capital they need. (The issue is discussed in more detail in this chapter in the section on ‘Global reporting’.) The proposed creation of a ‘Climate Club’, announced by the German G7 presidency in June 2022, seeks to address this gap by supporting the development of a globally consistent investment taxonomy.
The original idea of a climate club was that participating countries should agree on an international carbon price. Although reaching a common carbon pricing mechanism globally is not feasible, the World Bank and the International Monetary Fund (IMF) have recently focused on incentivizing and supporting countries to reform fossil fuel subsidies and establish a carbon tax, so that the costs arising from greenhouse gas emissions are internalized in investment decisions. However, depending on the inclusivity of such a club’s membership, and the stringency of its membership criteria, the establishment of an intergovernmental forum of this nature could create political tensions – particularly with large emerging and emitter markets, notably China and India.
With this context in mind, this chapter explores how different parts of the financial system might interact to assist the world’s shift to a net zero investment model, and how such a transformation could be achieved at a moment when multiple economic and other crises confront political leaders and financial policymakers. The chapter outlines the critical nodes of international cooperation needed to raise climate investment opportunities in EMDEs, and assesses potential solutions that include leveraging public finance to generate private sector funding, de-risking investments through multilateral guarantees, and supporting climate action through central banks and financial regulators.
The picture so far
Lessons from COVID-19, fiscal and inflationary pressures, political tensions
Economic challenges associated with the COVID-19 pandemic, Russia’s invasion of Ukraine, and ongoing climate impacts have significant implications for the transition to net zero. To date, the evidence on the fiscal feasibility of such a transition is mixed. On the one hand, policy support that governments introduced during the pandemic sent an important signal that rapid, large-scale investment is possible in response to global crises. By inference, COVID-19 action therefore also demonstrated the principle that capital could be reallocated at scale to address other threats to human well-being – such as the climate crisis. Since then, the ‘build back better’ movement has emphasized the need for climate-compatible policy responses, as evidenced for example by the provisions of the US government’s Inflation Reduction Act of 2022.
On the other hand, the mobilization of national budgets during and since the pandemic has generated new concerns about fiscal sustainability. This is of particular concern for EMDEs, where expansionary fiscal policies have led to further indebtedness and have triggered capital withdrawal from some markets. Should such pressures go unaddressed, or intensify, it will be harder for many governments to find the financing or political support needed to promote the net zero transition.
A further potential distraction from climate finance reform is the current inflationary picture, affecting advanced and developing economies alike. Western sanctions on Russian exports of oil and gas have contributed to substantial energy price increases, a key component of higher inflation rates in many countries. While the UK is a notable example in the developed world, some of the largest secondary impacts of the Ukraine invasion have occurred in oil-importing developing economies. Many of these, coincidentally, hold great potential for renewable energy deployment and energy efficiency, and include India, Kenya, Malawi, Pakistan and Uganda. In addition to the situation in Ukraine, climate impacts have contributed to higher energy prices in EMDEs such as China and Brazil, where droughts have hindered hydropower generation.
Meanwhile, political tensions between the world’s two largest greenhouse gas emitters, China and the US, continue to threaten the global fight against climate change. The impacts on climate diplomacy are potentially significant, given that the success of the 2015 Paris Agreement will in large part depend on the efforts of these two countries. Climate strategies not only in the US, but globally, are also highly dependent on imports of Chinese renewable energy technology. This creates vulnerabilities for technology-importing countries should their political relations with China deteriorate.
Overall, the headwinds outlined here translate into a risk that governments and financial institutions will not act radically enough to curb climate change, and that they will focus instead on issues such as addressing short-term inflationary pressures at the expense of critical longer-term climate action.
Policy development and climate investment: mixed progress
Notwithstanding the challenges mentioned above, the financial sector has made modest progress towards a net zero transition in recent years. Initiatives have involved both public and private sector players. First, several central banks have announced that they will require financial institutions to comply with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), a body established in 2015 to promote transparency around climate risk exposures in financial markets and to aid the pricing of such risk. Second, the coalitions formed under the UN Race to Zero framework, notably the Glasgow Financial Alliance for Net Zero (GFANZ), seem to have committed enough in assets under management to cover the financing needs of the net zero transition (although it is far from guaranteed that these sums will be translated into actual climate investments). Third, while considerable scepticism surrounds private financial institutions’ climate pledges – considered by some to consist of little more than ‘greenwashing’ – public institutions such as central banks and financial sector supervisory bodies are working to ensure the integrity of those commitments. They are cooperating internationally on the issue, particularly through the Network for Greening the Financial System (NGFS).
Investment in the low-carbon transition has also been galvanized, to a degree, by geopolitical events. Russia’s full-scale invasion of Ukraine in early 2022 made it clear that the solution to energy security should be to invest in clean energy, not to lock economies further into fossil fuel infrastructure. Investments in energy efficiency and clean energy have increased in many countries in response to fuel price inflation, and as a means to reduce exposure to fluctuations in the supply of Russian oil and gas. Less positively, the war in Ukraine has concurrently stimulated investment in fossil fuel exploration, as consumer countries have scrambled to shore up hydrocarbon supplies for existing infrastructure that will not be replaced immediately.
In short, the ultimate impact on emissions of the current energy crisis is still unclear, and is likely to vary from region to region.
Global reporting: the missing link?
As mentioned, a central issue blocking further progress remains the lack of common reporting tools so that investors can determine the net impact of different investment profiles, understand the characteristics of assets compatible with a net zero transition, and seek investment opportunities accordingly. The current patchwork of partial reporting systems seems too large and fragmented – with some practitioners lamenting that financial institutions have to provide an ‘alphabet soup’ of data to comply with different requirements.
There is an urgent need for uniform standards and metrics so that portfolio alignment with net zero commitments is defined consistently. A clear global taxonomy of net-zero-consistent investments would also help to ensure the integrity of private finance commitments to the climate transition.
This underlines several points. First, a large amount of climate disclosure data continues to be produced in relatively haphazard fashion. Second, the databases concerned have yet to be systematized or made openly available – a prerequisite if the information in them is to become useful for decision-making. Third, there is an urgent need for uniform standards and metrics so that portfolio alignment with net zero commitments is defined consistently. A clear global taxonomy of net-zero-consistent investments would also help to ensure the integrity of private finance commitments to the climate transition – reducing the risk of capital being allocated to assets that may appear compliant on paper but be less sustainable in practice.
A global framework is also vital for determining whether public investment into the post-COVID-19 economic recovery is consistent with climate goals. Such a framework could help to resolve dilemmas around the choice of investment structures, given the difficulty of assessing the relative merits of (a) purely public investments which can be leveraged to generate complementary private finance in related activities, or (b) more complex jointly funded projects. While the former may be preferable in terms of speed and value for money, the latter may be more effective at raising private capital.
At the same time, climate investment disclosure mechanisms, though clearly useful for financial decision-making, have a potential drawback. By revealing risks and problems more transparently, they can actually make it harder for EMDEs to attract climate finance. Reporting of exposures in countries in which physical climate impacts are the harshest – often EMDEs – can lead to capital withdrawal.
Market perceptions of risk may also reflect the dominance of infrastructure in net-zero-consistent investments. As an asset class, infrastructure is considered high-risk due to its substantial upfront costs and lengthy payback periods. This is particularly the case in countries where governance and institutions are weak, and where domestic capital markets are less developed. Projects promoting adaptation to climate change tend to be particularly complex. Not only do these normally involve large-scale infrastructure, but many have what can be described as an ‘agency’ issue: that is, because the investments are a public good, the future beneficiaries are to some extent unclear. This can make it challenging to attract finance.
Finally, the public–private interactions central to financing climate-related infrastructure investment carry a risk of systemic corruption. Such risk is increased at times of crisis (as was the case at the height of the COVID-19 pandemic). Emergency public expenditure usually occurs at speed, and thus potentially bypasses sound procurement processes. In the context of the low-carbon transition, this has added relevance because investment in climate change mitigation and adaptation will become increasingly urgent as climate action is delayed.
Leveraging public mechanisms to raise private climate finance
Given the huge sums involved and the fiscal constraints mentioned above, climate investment is only likely to be effective under a global approach that overcomes the current limitations of multilateral policymaking. Depending on the circumstance, several types of institution may need to be recruited to work on the issue, and they will often need to interact with each other. As outlined below, these include national development banks (NDBs), multilateral development banks (MDBs), central banks and financial regulators.
The role of NDBs and fiscal policy
NDBs can provide public equity capital in combination with private sector debt, thereby ensuring a level of public sector control over investment decisions. Public–private partnerships (PPPs) could provide the instrument of choice for climate-sustainable investments, for example financing long-term concessions in the power sector (including both renewable energy generation assets and transmission/distribution infrastructure). When NDBs co-finance infrastructure projects, they help reduce risk, lower borrowing costs and increase financial leverage.
NDBs, particularly those with domestic fiscal support, are useful when borrowing costs are high and financing conditions difficult, as they can offer lower interest rates than other lenders to the right projects. For example, the terms of NDB lending to projects accredited as net-zero-consistent can be more favourable than the terms available from commercial banks for similar projects. Additionally, NDBs can add grants to the financing mix to lower the interest rates on their loans, particularly when projects are less commercially viable.
Tax breaks and public spending can complement NDBs in stimulating climate investment. An example is the above-mentioned US Inflation Reduction Act of 2022, which targets investment in cheap, clean energy to reduce energy costs. The rationale is that by investing $369 billion in clean energy, the US government will lower household bills by $500–1,000 per year.
MDBs and multilateral guarantees
MDBs can contribute to de-risking – and thus stimulating – climate investment in EMDEs by offering multilateral sovereign guarantees backed by advanced-economy governments. These guarantees protect investors and lenders. As perceptions of climate investment risk in EMDEs increase, the use of such ‘multi-sovereign’ guarantees can enable developed countries with high credit ratings to join together in backing infrastructure projects in the developing world; this reduces costs and can expand EMDE access to capital markets, particularly for small states that would otherwise struggle to find financing.
The US is a prominent example of an advanced economy which has provided sovereign guarantees on EMDE bond issuance for infrastructure investment. The US has preferred the guarantee mechanism over more onerous forms of traditional aid, because it offers scale, speed and efficiency at a low cost to the guarantor country. Arguably, adapting existing sovereign bond guarantee programmes so that they can be used for climate investment in developing economies should be straightforward. This could be effective in de-risking investment in EMDEs, channelling capital to low- or zero-carbon infrastructure and reducing emissions globally.
Establishing multilateral guarantees could also accelerate international cooperation on the much broader topic of climate-related financial reporting and compliance. The process of setting up multi-sovereign guarantees could encourage coordination between investment regimes, as it would oblige governments to collectively define climate assets that are suitable for institutional investors seeking ‘safe havens’.
Central banks and financial regulators
Central banks and financial regulators have important roles to play in the net zero transition. They can mandate the use of transition plans by multinational financial institutions; incorporate climate adjustment criteria into monetary policy and financial regulation instruments (for example, through collateral rules and capital adequacy requirements); and manage their own asset purchase programmes and portfolios so that their holdings are more climate-aligned.
Changes to collateral frameworks
The adjustment of collateral frameworks according to the emissions profiles of investments should follow broadly the same selection criteria used for multi-sovereign guarantees. Essentially, this would consist of lowering the market value of an asset used as collateral for a loan (increasing the ‘haircut’ taken by the borrower, in other words) if that asset exceeds a certain threshold of emissions or climate risk. Equally, central banks could apply the same process in reverse: reducing the haircut associated with environmentally more sustainable assets. They could arguably even go further and determine the eligibility of assets for use as collateral based on the emissions profiles of those assets.
Market signalling: prioritizing purchases of climate-friendly bonds
Central banks’ market behaviour, via asset purchases and management of their portfolios and reserves, can boost climate-consistent investment by sending signals to institutional investors. The debate on this area originally developed around the use of ‘green’ quantitative easing (QE) by central banks in the aftermath of the 2008–09 global financial crisis. Green QE means prioritizing the purchase of so-called ‘green bonds’ (a specific category of asset, the proceeds from which are directly committed to climate-related activities), or of other bonds associated with climate-friendly sectors and assets.
By choosing to sell off polluting assets first, thus altering the climate weighting of their portfolios, central banks would send a very strong signal, which market players could emulate by rebalancing their own holdings accordingly.
Especially when markets face headwinds such as the COVID-19 pandemic or the energy crisis associated with the Russian invasion of Ukraine, central banks can perform a crucial service by prioritizing which bonds to purchase, or keep in their portfolios, and which to divest. By choosing to sell off polluting assets first, thus altering the climate weighting of their portfolios, central banks would send a very strong signal, which market players could emulate by rebalancing their own holdings accordingly. If central banks were to exclude carbon-intensive assets from their bond holdings, this would be an important step in going beyond the conventional risk approach to bond portfolio management (which essentially balances three objectives: liquidity, safety and returns). In other words, central banks could manage their portfolios according to climate risk as well as credit risk, and could extend such an approach to several areas of their work – including management of their policy portfolios, the execution of asset purchase programmes, and the pursuit of other monetary policy goals.
Conclusions and next steps
This chapter has argued that the essential first step towards shifting the international financial system to net zero and attracting private finance to climate investment opportunities in EMDEs is to ensure regulatory consistency. Central banks and financial regulators should lead the process of determining what net zero alignment means for the financial system, and of setting out specifically which financial products – or characteristics in financial products – investors should look for to weight their portfolios accordingly.
By cooperating through bodies such as the NGFS – but also through non-climate-specific economic forums – central banks and financial regulators should establish high-level principles to inform the design of a single taxonomy of climate investments. This would facilitate efforts to harmonize the patchwork of existing systems and ensure the comparability of metrics and reporting standards. Coordination in this area can also aid the identification of global best practices on net zero portfolio alignment.
Leadership and political will are needed to drive these proposed changes, but it is not yet clear what the most effective and realistic structures should be. Should coordination be led by public institutions, political leaders, or persons or entities within the private sector? A further consideration, partially alluded to above, is that coordination needs to happen beyond the existing – i.e. non-financial – international climate architecture. Climate issues should be integrated into all countries’ broader financial, economic and development objectives.
The strongest push for reform may come from the G7. In 2021, the G7 stated that its finance ministers and central bank governors supported ‘mandatory climate-related financial disclosures that provide consistent and decision-useful information for market participants and that are based on the TCFD framework’. The G7 could intertwine this proposition with the creation of its aforementioned ‘Climate Club’. The two efforts could be coordinated through a dedicated working group, which would establish data production requirements, conduct modelling to generate information for investment decision-making, and create guidance on climate alignment for portfolios across financial institutions of all types.
Once in place for G7 countries, such a system could serve as a template for other countries or groupings to follow. The G20, although facing challenges of unity and cohesion in the context of Russia’s invasion of Ukraine, might play a similar – and potentially even more powerful – role along similar lines in the future. This could build on the activities of its working group on sustainable finance.