Emerging markets and developing economies (EMDEs) are among the most vulnerable to the effects of climate change, and have the greatest need for climate investment. However, most climate-related private capital still flows to advanced economies.
Foreign direct vs foreign portfolio investment
The amounts of climate-related finance potentially available to countries at different levels of development, and the nature of financial sector reforms required to realize such investments, will be determined to a significant degree by the type of finance that works best in a given environment and its overall availability.
International private finance flows can be divided into foreign direct investment (FDI) and foreign portfolio investment (FPI). On a global aggregate scale, the largest FDI flows are usually between advanced economies, mainly through mergers and acquisitions. However, FDI is also the primary source of international finance for EMDEs, which receive larger FDI inflows than they do portfolio inflows. Most of this FDI consists of greenfield investment.
FDI is popular in EMDEs because it leads, with greater certainty, to the establishment of new enterprises or operations, and offers several advantages to both recipient countries and investors. These include its facilitation of technology transfer while offering protection for proprietary information (particularly for new technologies, as is usually the case for renewable energy); and its potentially catalytic effect on human capital development (e.g. through employee training in newly established enterprises). FDI also boosts domestic fiscal revenue (as investment projects start to earn income) because new companies contribute to receipts of corporate tax, income tax and royalties. In addition, FDI is less volatile than FPI and therefore less susceptible to sudden reversals of flows. The share of FDI in total international inflows is normally higher in countries with higher country risk indicators, and where the quality of institutions is perceived as lower. FDI is more likely to flow to these countries than other forms of capital due to their inefficient financial markets, since in these cases foreign investors prefer to operate directly instead of relying on local arrangements.
To date FDI into EMDEs has historically focused on projects associated with harmful climate impacts, including in manufacturing, mining and other natural resource extraction sectors. In particular, FDI in the last few decades has been linked to oil and gas exploration, with companies from advanced economies investing in resource-rich EMDEs such as Angola and Nigeria.
Even if FDI is refocused on net zero-consistent assets, it seems unlikely that there will be enough finance of this type available to meet overall requirements for green investment.
This is beginning to change: in recent years, the importance of the primary sector in FDI has waned, while investment in renewable energy projects has risen. In 2019, the number and value of greenfield FDI projects in renewable energy reached a record high. However, these capital flows were still concentrated in developed markets rather than in EMDEs.
But even if FDI is refocused on net zero-consistent assets, it seems unlikely that there will be enough finance of this type available to meet overall requirements for green investment. Total global FDI flows in 2021 amounted to $1.6 trillion, far below the $3.5 trillion annual increase in capital spending on physical assets potentially needed. Even if FDI went predominantly into ‘greener’ assets and projects, an increase in portfolio investment would still be needed to close the net zero financing gap.
How to increase portfolio flows into net zero-consistent assets in EMDEs – albeit not to the exclusion of FDI – is therefore a critical task for financial policymakers. Institutional investors have recently shown some responsiveness to the climate crisis. However, their activities continue to focus on advanced economies, while financial institutions are reorienting their portfolios too slowly relative to the timeframes advocated by climate policymakers.
The next section explores the major obstacles for both FPI and FDI in more detail.
Obstacles to net zero finance
Inconsistent regulation and government policy
Net zero commitments currently cover around 32 per cent of financial institutions’ assets under management. In other words, 68 per cent of global assets are unconnected to a net zero target. This may partly reflect inconsistent climate-related financial regulations – and a lack of uniform definitions of net zero compatibility – across different jurisdictions. Because commercial financial institutions are typically multinational, they cannot commit to targets that are interpreted very differently across the countries in which they operate. (This issue is covered in more depth in Chapters 3 and 4.)
Obstacles to international climate finance also include the effects of uneven or preferential national policy support, such as feed-in tariffs (see Chapter 3) and interest rate subsidies offered by national development banks (NDBs) for solar and wind power project finance, exchange rate uncertainty, political and governance risks, and market information failures.
As a result of such factors, around 90 per cent of private climate finance stays within national borders. Where international climate finance flows occur, their geographical distribution is highly unequal. According to the Climate Policy Initiative, 67 per cent of such flows in 2019/20 were concentrated in Western Europe, the US, Canada and China. The relative lack of capital flows to EMDEs other than China is a function of the uneven availability of private investment in particular. Whereas climate investment in advanced economies (Western Europe, the US, Canada and Oceania) was primarily funded from private sources in 2019/20, EMDEs relied mainly on public sector financing. Non-OECD countries, in particular, obtain most of their climate finance from domestic public sector sources. A prominent example is sub-Saharan Africa, where climate investment was 88 per cent publicly funded in 2020.
Risk aversion towards EMDEs and climate investment
EMDEs hold most of the world’s potential for renewable energy generation and nature-based climate solutions. These countries also tend to be the most vulnerable to the physical impacts of climate change. However, EMDEs usually also suffer from higher political, regulatory and macroeconomic instability compared to advanced economies. This is often reflected in lower sovereign credit ratings and a reduced capacity to access debt markets.
In addition, net zero-consistent energy investment is usually perceived as riskier than traditional investment. Most net zero-consistent investments are in infrastructure, an asset class treated by investors as especially risky due to high upfront costs and long payback periods. Investors are particularly wary of projects around adaptation to climate change, as these not only generally involve large-scale infrastructure but also suffer from an ‘agency’ issue: that is, the investments are in public goods for which the ultimate financial benefit, while potentially very significant, is hard to measure and accrues to the country as a whole.
The issue of risk aversion was illustrated in a 2021 joint study by the International Energy Agency (IEA) and Imperial College Business School, which assessed global risk and return data for renewable energy and fossil fuel investments. Although renewable energy produces higher returns in EMDEs than fossil fuel assets do (136 per cent for renewables versus 114 per cent for fossil fuels), annualized volatility (a measure of investment risk) is higher for renewable energy (at 6.9 per cent) than for fossil fuels (5.4 per cent). This can deter investment or force EMDEs to secure climate investments on less favourable terms than developed economies.
A related dilemma for policymakers in EMDEs is that improved climate risk transparency and disclosure – while desirable in principle to ensure that net zero alignment is factored into financial decision-making – may ultimately deter investors by identifying climate risks. Although a more nuanced understanding of exposures can help financial institutions manage climate risk, there is also a chance of such information precipitating capital withdrawal from countries where physical climate impacts are highest. This is particularly the case if conventional approaches to assessing credit risk and investment risk – rather than approaches that perhaps might incorporate innovative or more holistic climate action metrics – continue to determine financial decision-making.
An example of the impact of prevailing risk exposure methodologies can be seen in the 2017 announcement by Moody’s Investors Service, a credit rating agency, that it might downgrade island states’ sovereign credit ratings due to physical climate risks that were likely to increase government borrowing costs. A separate example concerns a study by Beirne et al., which tested the effects of climate vulnerability on fiscal sustainability and the pricing of sovereign risk for a sample of 40 developed and developing countries. The results of the study suggested that climate risks significantly increase the cost of sovereign borrowing.
Macroeconomic weakness and energy security responses
Prospects for net zero investment are complicated by the economic fallout from the COVID-19 pandemic and Russia’s war in Ukraine.
The fiscal pressures associated with the pandemic have worsened many EMDEs’ debt vulnerability. This has limited many governments’ ability to invest in climate action, as well as their capacity to leverage private finance. According to the IMF, about 55 per cent of countries in the G20’s former Debt Service Suspension Initiative (DSSI) are at high risk of, or already in, debt distress. This underlines the importance of debt relief in reducing impediments to climate investment in EMDEs. Proposals for ‘debt for climate’ swaps are re-emerging. Such swaps involve a debtor nation agreeing to certain climate action – such as investing in decarbonization or climate change adaptation – in return for receiving debt relief. Such arrangements allow debtor nations to finance climate projects domestically, in local currency, instead of making further external debt payments in a foreign currency. This enables countries to reduce their indebtedness while freeing up fiscal space for climate investment.
The conflict in Ukraine has heightened policy concerns about energy security. Some countries have sought to shore up their energy supplies in the short term by increasing imports of fossil fuels from non-Russian markets, or by investing more in hydrocarbon exploration.
The economic effects for EMDEs of Russia’s war in Ukraine include higher commodity prices, supply chain disruptions, systemic inflationary pressures and policy uncertainty. Among climate-specific impacts, the critical minerals used in renewable energy applications have become less affordable. In many cases, EMDEs are net importers of such raw materials, potentially rendering climate investment vulnerable to imported inflation and/or supply shortages.
The conflict in Ukraine has also heightened policy concerns about energy security. In principle, the war has strengthened the case for investment in renewables, as it has highlighted the risks of relying on imports of Russian fossil fuels. However, in practice, some countries have sought to shore up their energy supplies in the short term by increasing imports of fossil fuels from non-Russian markets, or by investing more in hydrocarbon exploration. The result is that some EMDEs could become even more locked into fossil fuel-reliant infrastructure, with the war in Ukraine risking reversing years of progress on investment in clean energy.
A similarly challenging picture is evident in the broader sustainable development space. Data from the UN Conference on Trade and Development (UNCTAD) show a collapse in investment flows to sectors relevant to progress on the UN Sustainable Development Goals (SDGs). The value of SDG-aligned greenfield projects in EMDEs announced in 2021 – although 10 per cent higher than in the previous year – was well below pre-pandemic levels, and 41 per cent lower than in 2020 in least developed countries (LDCs). Although renewable energy project finance has remained stable in the past two years, 60 per cent of such investment has stayed in advanced economies, with 85 per cent of this coming purely from private sources. This underlines the idea – noted earlier – that private capital is not flowing to where it is most needed: it finances climate-sustainable investment in developed economies even as most opportunities for such investment are widely known to reside in EMDEs.
ESG compliance requirements
Another challenge to institutional climate investment in EMDEs concerns the fiduciary duties associated with financial institutions’ environmental, social and governance (ESG) responsibilities. ESG issues can be acute in countries with inadequate or unstable regulatory systems, making it hard for private investors to enter otherwise promising markets for climate finance while still meeting their ESG obligations.
