The policy community has made multiple proposals in recent years for achieving a step change in the flow of public international climate finance into EMDEs. However, achieving a breakthrough will be very difficult because all the ideas ultimately require more official budget support from traditional donor governments.
According to the OECD, developed countries provided $94.1 billion in public international finance for climate action through bilateral channels, multilateral channels and export credits in 2022. This compares with total climate finance flowing to EMDEs of $244 billion in the same year. But while the bulk of climate finance in future will need to come from private sources, maximizing available public international finance is critically important to closing the climate finance gap.
This is because it is one of only a few ways – other than through the savings of enterprises and individuals – to finance climate mitigation projects in low-income countries or highly indebted emerging economies. Both categories of country typically lack access to private capital markets. The use of public international finance is often also the only way to fund climate change adaptation projects, even where a country has access to private markets, because the high social returns associated with measures to adapt to climate change and increase resilience to its impacts may be impossible to convert into commercial returns. Furthermore, public international finance remains a key tool for mobilizing private finance, and is often essential to enabling a country with excessive sovereign debt to reduce the real burden of that debt (as measured by net present value, or NPV) even though there may also be a private sector contribution.
In recent years, researchers in think-tanks and universities, along with some policymakers, have proposed multiple routes to increase the total available amount of public international finance for climate action. Given that the administrative, political and financial constraints on increasing public international finance vary from one donor country to another, having multiple routes to choose from improves the chances of achieving an overall expansion.
Given that the administrative, political and financial constraints on increasing public international finance vary from one donor country to another, having multiple routes to choose from improves the chances of achieving an overall expansion.
However, while some routes have been partially successful, or may have a reasonable chance of delivering some additional finance in future, achieving a sustained breakthrough in the scale of public international finance provision for climate action will be very difficult. The detailed reasons vary, but ultimately come back to the underlying need for official budget support of all of the approaches proposed. Consider each route in turn:
Official development assistance
The most direct approach has been to lobby for higher levels of climate-related official development assistance (ODA) from traditional (i.e. advanced-country) donors. Bilateral ODA with climate objectives has increased gradually over the past decade, reaching nearly $50 billion in FY 2021/22 – a sum equivalent to 32.9 per cent of total bilateral ODA from members of the OECD’s Development Assistance Committee (DAC). However, the severe constraints on public finances in many advanced countries – following the rise in fiscal pressures associated with the COVID-19 pandemic and increased geopolitical tensions, and also the competing non-climate-related demands for ODA, including support for humanitarian assistance and reconstruction in Ukraine – make it unlikely that climate-related ODA provision will rise much more sharply than the current trend rate in future.
Broadening the range of ODA providers
Another approach is to try to broaden the range of countries providing climate-focused
ODA beyond the advanced economies. China will not agree to formal climate finance commitments under the United Nations Framework Convention on Climate Change (UNFCCC), but is potentially an important new source of such funding on a voluntary basis; China’s outward flows of public grants, interest-free loans and concessional loans for both climate and non-climate purposes averaged $7.6 billion a year over the five years to 2018. Very large infrastructure investments associated with the country’s Belt and Road Initiative (BRI), some of which may be ODA-supported, have been scaled back, but instead the Chinese authorities are now showing greater interest in following global sustainability standards, thereby increasing the potential for a positive climate impact from what is being spent. Another potential source of growing assistance is the oil-rich Gulf states. The United Arab Emirates (UAE), for instance, has allocated $30 billion of public finance to establish the climate-focused Alterra Funds, of which $5 billion will help with risk mitigation capital and encourage investment flows into the Global South. It is unclear whether some of this will count as ODA, however. Both the Chinese and UAE contributions are potentially significant, but these start from a relatively low base and appear unlikely to make a big difference to the trend for total climate-focused ODA in the short term.
Special Drawing Rights
Special Drawing Rights (SDRs), a global reserve asset issued by the IMF, have recently been tapped as an additional source of public finance for climate resilience. The IMF established the Resilience and Sustainability Trust (RST) in October 2022 to make 20-year loans funded in large part by ‘surplus’ SDRs following the global $650 billion allocation of new SDRs in 2021. This allocation left several major countries with additional SDRs that they did not immediately need. So far, the RST has received contributions worth $40.9 billion, and 17 countries have received commitments of financial support.
But the scope for using SDRs to deliver public finance for climate action on a much larger scale, as some commentators have advocated, is likely to be limited. One reason is the underlying mismatch between the RST’s liabilities, which need to be highly liquid, and the trust’s 20-year loan assets. The RST uses a multi-layered risk management framework to maintain the reserve asset characteristics of the channelled SDRs, minimizing the need for direct budgetary contributions. But it is not clear that this can be made to work on a very large scale. Indeed, some IMF members – including Germany – have already chosen to fund their contributions to the RST from ODA rather than from rechannelled SDRs, while the US has not as yet made any financial commitment.
A further possible constraint on scaling up the RST is the mismatch between, on the one hand, the IMF’s conventional role and expertise in short-term macroeconomic stabilization and, on the other, the focus of the RST on long-term development finance.
A further possible constraint on scaling up the RST is the mismatch between, on the one hand, the IMF’s conventional role and expertise in short-term macroeconomic stabilization and, on the other, the focus of the RST on long-term development finance (albeit focused on reducing risks to balance-of-payments stability). Technical support from the World Bank Group, along with proposals to channel a further batch of surplus SDRs directly to the African Development Bank (AfDB) and Inter-American Development Bank (IADB), may partly address this concern. But lending by multilateral development banks (MDBs), even if funded through SDRs, would still need to be secured by risk-bearing capital, the supply of which is constrained. Nor do SDRs represent essentially ‘free money’, as some have argued. The initial allocation of SDRs does indeed have no cost to the recipients. But as soon as SDRs are converted into hard currency, they incur a risk-free interest rate (currently 3.4 per cent) just as other forms of public borrowing do. Loans from the RST charge this rate plus a margin.
Lastly, use of SDRs to fund lending by international financial institutions (IFIs) adds to global economic demand and boosts global liquidity. Where the total amount involved is in the tens of billions of dollars, the impact globally is insignificant. But if it is done on a much larger scale, i.e. in the trillions, this could force up inflation and interest rates globally, resulting in significant unintended costs.
Increasing MDB climate finance
Many advocates of climate action argue for an increase in the financial capacity of the MDBs through a general capital increase. They claim that this would be the most cost-effective way of boosting public international climate finance, given the ability of such institutions to leverage ‘paid-in’ capital from shareholders by borrowing on private markets.
However, this route to increasing climate finance is far from straightforward in practice. Paid-in capital contributions to the MDBs typically have to be financed from ODA and are therefore subject to public finance constraints on the banks’ leading shareholder governments. In addition, the bulk of MDB finance consists of loans, equities and guarantees, rather than grant aid. As a consequence, projects and recipients need to meet minimum credit requirements. Furthermore, in most MDBs, the vast bulk of finance provision, including that funded by borrowing on private markets, is effectively guaranteed by public capital. Just 10 per cent of this capital is paid in, while the other 90 per cent is ‘callable’ – meaning that shareholders can be called on to contribute additional capital if the initial paid-in capital is depleted by losses. Shareholders are very reluctant to see any demand made on callable capital. This, together with the need to maintain the lowest possible cost of finance, means shareholder governments expect MDBs to maintain a very high triple-A credit rating, which further constrains the finance they can offer.
Further practical considerations include the fact that the range of MDB financing objectives is much broader than climate action alone. Any increase in general financing capacity needs to be shared between action on climate change mitigation, adaptation, loss and damage, and efforts targeting other Sustainable Development Goals (SDGs). There is also a difficult interplay between a general capital increase and the fraught issue of governance of the MDBs. China and other emerging economies agreed to a general capital increase for the World Bank in 2018, but without an increase in their own voting weights to reflect their growing role in the world economy; the same also happened with the IMF quota increase in 2023. But it is far from clear that such countries would be willing to agree to a further capital increase on the same basis. In addition, any suggestion that China should increase its voting weight and influence in the World Bank is likely to meet strong opposition from the US, particularly from Congress.
The World Bank has often drawn on voluntary contributions from a subset of shareholders (without recognition in formal voting weights) to boost its resources, but such an approach can only go so far. Some of the largest shareholders in the bank – for instance, the US and China – may not take part in such initiatives. Others will also hold back, on the grounds that it is unreasonable to expect them to fill a gap left by the world’s largest economies. Overall, voluntary contributions to the World Bank will not be sufficient to make a significant difference to the climate finance gap.
Ajay Banga’s response
At their 2023 summit, G20 leaders called for ‘better, bigger and more effective’ MDBs. But they did not say how this should be achieved. While each MDB has taken its own approach, the response of the World Bank, as the largest MDB, is the most important.
Since becoming the bank’s president in 2023, Ajay Banga has sought to increase the contribution it is making to climate action by drawing on its existing capital resources – in some cases, as mentioned above, assisted by voluntary contributions from a subset of shareholder governments. He has also drawn on advice on private finance mobilization from a new Private Sector Investment Lab.
Banga’s approach partly reflects the fact that making better use of existing capital is the most practical way to boost the bank’s contribution to climate action in the short term. It also helps him make the case for a general capital increase, on the grounds that all other routes to increasing the bank’s financial capability have been fully exploited.
In the autumn of 2023, the World Bank’s mission statement was revised (somewhat controversially) to read: ‘To create a world free of poverty – on a liveable planet.’ The World Bank Group has also increased its provision of climate financing by 10 per cent in the year to June 2024, to a record $42.6 billion.
Specific policy development and new initiatives at the World Bank and other MDBs have so far focused on the following main areas:
- Expanding the use of hybrid capital. This is essentially capital, provided voluntarily by governments, foundations or the private sector, that can be used to support risky lending through the absorption of losses but does not have voting rights associated with it.
- Enabling private institutions to co-invest in portfolios of World Bank-originated projects rather than just in individual projects, thereby allowing private institutions to diversify their risk exposure.
- Developing a method to sell on matured loans and other assets already on the World Bank’s balance sheet without triggering an unacceptable increase in required yield (given that it will not be desirable or even possible to pass on the bank’s preferred-creditor status to private investors). This has the scope to free up existing MDB capital for further project origination and lending.
- Increasing the use of guarantees. In principle, this should enable the World Bank to deploy less capital, for a given amount of financing mobilized, relative to the amount of capital that would be required with outright lending. This is because the World Bank, as guarantor, can rely on the credit of both the recipient and provider of the funds. The bank announced in February 2024 that it would triple its provision of guarantees to $20 billion a year by 2030. It accompanied this announcement with the creation of a one-stop shop to house all of the bank’s guarantee expertise.
- Improving private investor pricing and perceptions of developing-country risk. The World Bank announced in March 2024 that it would publish historical default data on public and private projects going back to 1985.
Reflecting this work, in April 2024 the World Bank announced a funding boost of $11 billion for new financing tools, including a Portfolio Guarantee Platform, a hybrid capital mechanism and a Liveable Planet Fund. The bank argued that this initial injection of funding could mobilize a total of $70 billion over 10 years, implying a leverage ratio of six to 10 times the initial funding allocated on certain elements. However, it remains unclear how much additional risk the public sector will take on as part of the leverage process.
The World Bank is also focusing on securing the largest possible replenishment for the International Development Association (IDA), an arm of the bank that provides concessional financing (including grants and zero-interest loans) to low-income countries. IDA’s resources are replenished every three years through voluntary ODA contributions, and the next replenishment is due to be completed in December 2024. The so-called ‘V20’ group of countries vulnerable to climate change are calling for a tripling in the replenishment, from $93 billion in the IDA20 replenishment cycle that ended in December 2021 to $279 billion in IDA21. Other advocacy groups are targeting a smaller but still ambitious replenishment of $115 billion.
Relaxing MDB capital adequacy requirements
A further potential approach to increasing MDBs’ climate financing capacity from within existing resources is to loosen current capital adequacy requirements. This has been discussed extensively following the recommendations of an independent review of capital adequacy frameworks for the G20, and could result in a substantially bigger increase in MDB lending capacity than the measures enacted so far.
The capital adequacy framework review argued that the MDBs are too conservative in their risk management. More specifically, the review argued that the banks underestimate (a) the extent to which preferred-creditor status reduces the risk on their loans relative to those of commercial lenders; and (b) the extent to which the existence of callable capital would enable them to lend more without jeopardizing the triple-A credit ratings essential to maintaining low-cost funding. According to modelling by independent researchers in the G20 Independent Expert Group on Strengthening Multilateral Development Banks, aggressive implementation of such ‘capital efficiency-related’ recommendations could boost lending capacity by up to $40 billion a year.
But, as with deployment of SDRs, there is no free money. Even with no change in average asset quality linked to a rapid expansion in lending – and it seems unlikely that asset quality would remain the same in such a case – MDBs and the shareholders standing behind them would still incur an increased absolute ‘expected loss’ from MDB operations relative to unchanged capital. While ‘normal’ losses should be covered from income on the finance provided, exceptional losses would need to be covered by additional financial contributions from shareholders, unless the shareholders were willing to see the total capital resources of the MDBs reduced or, in extreme cases, to see a demand made on callable capital. Therefore, another way to look at this proposal for increased lending relative to unchanged capital is that it effectively pre-empts a future contribution to MDBs’ capital in line with existing shareholder weightings, thereby avoiding the question of voting shares.
There is no problem with this in principle, but it illustrates that changes to capital adequacy weightings are ultimately also subject to the same public finance considerations as other sources of additional public finance. Leading shareholders in the MDBs are therefore likely to be cautious about using this approach to achieving a rapid scaling up of MDB climate finance operations.
Taken together, the efforts to boost climate finance available from MDBs are clearly worthwhile, but seem unlikely to deliver the kind of step change in public international finance that has been called for.
Sovereign debt restructuring
Proposals to address the high levels of existing public debt in many EMDEs also represent a potential route to raising public international finance for climate action. Around 60 per cent of low-income countries are at high risk of debt distress or already in debt distress, and in a number of cases their net debt service payments have turned negative. Reprofiling maturities and reducing the NPV burden of outstanding debt outright or through ‘debt-for-climate swaps’ – in which a country receives debt relief in return for environmental commitments – will typically release domestic fiscal resources, some of which may then be devoted to climate action.
Around 60 per cent of low-income countries are at high risk of debt distress or already in debt distress, and in a number of cases their net debt service payments have turned negative.
Such transactions can also provide a helpful means to embed new climate commitments in agreements that are legally binding in international law. But this approach typically requires substantial credit enhancement using public finance provided by MDBs or bilateral donors. It may also be linked to a longer pause in private market access for the countries concerned than would otherwise be the case, and the debtor countries will often also require cooperation from ‘new’ sovereign lenders (notably China) and private sector lenders. Thus, while debt relief could be the most effective way to deploy public finance to support climate action in a given country, this will need to be judged on a case-by-case basis. And it is not a way of avoiding the wider constraints on provision of public international finance.
Debt clauses that postpone future debt service payments on export credits and other sovereign financial obligations in the event of climate-related weather shocks are similarly a means to step up provision of public climate finance. But since the debt service obligation is only postponed for a relatively short period rather than written off, such clauses may not avoid the need for permanent provision of public finance following the shock.
New global taxes
In light of the constraints on established sources of public finance, several proposals have been made to establish new international taxes as a means of raising public finance for, among other goals, climate action. Potential sources of such revenue include billionaires, financial transactions, hydrocarbon producers and shipping. However, despite the theoretical merits of some of these proposals, and the progress made in recent years on greater tax harmonization (such as the OECD’s global minimum corporate tax), the likelihood of such ideas being implemented and raising significant amounts of additional revenue appears low in the present geopolitical environment.
Conclusion on scaling up public international climate finance
The above brief review has illustrated the wide range of approaches being undertaken or proposed to increase the volume of public international finance for climate action. While some of these approaches have been partially successful, none has yet been implemented on a very large scale, nor are most of the approaches free of the constraints on advanced-country public spending linked to current economic conditions.
It is therefore more important than ever to use existing public international finance as effectively as possible – particularly with respect to mobilizing private finance, where the potential upsides are very large. This is the subject of the next section.
