Simplicity is the key to closing the climate finance gap

Conventional, publicly capitalized financial instruments are the only way to mobilize private finance on a very large scale.

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Published 18 April 2024 Updated 19 April 2024 4 minute READ

One of the most important topics at this week’s spring meetings of the IMF and World Bank is how to close the enormous climate finance gap.

More than $1.7 trillion was invested in clean energy alone in 2023, according to the IEA. But this compares poorly with a total estimated climate finance need of $8 trillion a year today, rising to $10 trillion a year after 2030.  

Moreover, less than 3 per cent of total global climate finance in 2020/21 went to or within least developed countries (LDCs) and only 15 per cent went to or within emerging and developing economies (EMDEs) excluding China.

These countries therefore face a particularly acute financing gap, with a need to spend an additional $1 trillion a year on climate related goals by 2025 (4.1 per cent of GDP) and around $2.4 trillion per year by 2030 (6.5 per cent of GDP).

Given very high public debt in many advanced countries, acute domestic spending pressures, and the continuing need for development finance outside the climate sphere, the scope to increase the amount of public international finance for climate action is limited.

Using public finance to leverage private finance

Policy makers have therefore focused on how to use the scarce public finance that is available to crowd in a much larger contribution from private finance - ‘moving from billions to trillions’. 

Of the $89.6bn mobilized by advanced country governments in 2021 for climate action in developing countries, only $14.4bn was from the private sector.

So far this strategy has not worked. Of the $89.6 billion provided and mobilized by advanced country governments in 2021 for climate action in developing countries the OECD estimates that only $14.4 billion was from the private sector, slightly lower than the amount mobilized four years earlier.    

In part this failure reflects the recent deterioration in conditions for private international development finance, with the rise in US interest rates, growing concern over geopolitical risk, and increased debt distress. But it also suggests a fundamental flaw in the approaches being taken. 

The numerous initiatives proposed to turn this situation around follow two basic approaches. 

‘Blended finance’ techniques may involve the public sector taking on some of the risk that the private sector would otherwise have to bear.

One approach uses international public finance to improve public policy, address infrastructure bottlenecks, strengthen local finance skills, or demonstrate innovative financing approaches, thereby creating an environment in which large volumes of private finance will flow.  

This technique can result in very large multiples of private finance generated for a given public finance contribution. But it is hard to measure the true degree of leverage, and interventions necessarily take time to implement.

The other approach is to deploy public finance directly alongside private finance with the goal of improving the risk/return trade-off on investment projects.

These ‘blended finance’ techniques may involve the public sector taking on some of the risk that the private sector would otherwise have to bear or accepting a below market return on its investment with a view to subsidizing the returns of private sector co-investors.  

International Financial Institutions (IFIs) have also raised limited ‘hybrid’ capital with the same risk bearing characteristics as public capital, but without voting rights.

This kind of intervention has the potential to be faster than traditional lending and may also involve a substantial leverage multiple. But scaling up has not happened, due two main factors.

Lack of clarity and appropriate business models

First is the frequent lack of clarity about the underlying mechanism that is driving the proposed financing techniques. It is often not clear what the underlying risks are and who is bearing them, whether there is a subsidy, and if not, whether this is because the private sector is assumed to be mis-pricing the risk.  

For example, significantly increasing the risk born by multilateral development banks (MDBs) doesn’t only affect shareholders through their paid-in capital, but also through callable capital which is ten times as large. Proposals for much greater use of public sector guarantees are often unclear on the extent of risk that remains with the public sector.

An equally important factor is that new blended finance techniques are typically being retrofitted into existing public finance institutions. While understandable, this has often resulted in considerable complexity stretching the available expertise, inhibiting the creation of new instruments that genuinely leverage private finance, and restricting the scope to design new public finance institutions with appropriate business models for the type of financial services required.

Thus deploying IMF special drawing rights (SDRs), a liquid asset, to support long-term lending operations in the Resilience and Sustainability Trust has required tortuous negotiations.  

It remains hard for MDBs to sell on matured loans to the private sector because of the loss of preferred creditor status this usually entails. MDBs are tightly constrained by the necessity of preserving triple A ratings. And typically they are not designed to undertake insurance with the underwriting skills and financial model this requires.  

Having full clarity on risks and the most appropriate business models may not matter too much when the volume of transactions is relatively small. But if business is to be scaled up rapidly to address the climate finance gap, both are essential. Finance ministries will not write blank cheques.

A simplified model

To break through this logjam the international community should develop a new, highly simplified, model for publicly capitalized lending, guarantee, insurance and equity instruments. 

This should be delivered through new ring-fenced windows in existing IFIs and climate development funds if possible, or failing that, through the creation of new international institutions.

Crucially the risk taken on by shareholders capitalising these entities would be strictly limited to their paid in capital and there would be no callable capital, preferred creditor status or country lending quotas.

To break through this logjam the international community should develop a new, highly simplified, model.

Supported by their public capital, the instruments would be funded through conventional borrowing on private markets. But private lenders would have no more recourse to public support in the event of losses than they would if they were lending to privately capitalised financial institutions.  

The new instruments would add value to what the private sector does by having a clear mission to focus solely on climate mitigation and adaptation (without the alternative of investing in other potentially more attractive assets), and by their willingness to accept substantially lower returns than required by the private sector (albeit still sufficient to cover impairments over time).

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They would not address the entire finance gap, as they would not be suitable for deployment in the least developed countries or those undergoing severe debt distress.  There may also be limited scope to deploy them in adaptation projects.  

But they should still be able to make a substantial contribution in fast-growing developing economies such as India, Indonesia or Vietnam.  $90 billion of new public capital accumulated over 3 years could support $600 billion of new finance using a conservative 15 per cent capital ratio comparable to that of strong private financial institutions.

This approach would give public shareholders clarity on the extent of their liability, deliver genuine leverage of private sector finance, and enable the resulting finance to be deployed flexibly to target the most important gaps in current private climate finance provision.  

Renouncing the special features of current IFI structures in these new instruments might appear counterintuitive. But it is the attempt to have our cake and eat it that has led to the failure of efforts to leverage private finance for climate action to date.