Constraints on increasing public international finance mean policymakers must better utilize the finance already available, particularly in mobilizing private finance for climate action in EMDEs. This will require careful comparative assessment of the different routes available, the creation of new institutional vehicles, and a means of holding countries to account.
The IMF has estimated that private finance will need to account for 90 per cent of the mitigation finance (alone) going to EMDEs excluding China. Anticipating this, in 2015 the major international financial institutions (IFIs) set the goal of ‘moving from billions to trillions’ – that is, using the billions of dollars of international public finance available from bilateral donors and multilateral institutions to mobilize much larger amounts of private funding for meeting the SDGs, including for action on climate change. But the effectiveness of this effort has so far been limited. Of the $115.9 billion provided and mobilized by advanced-country governments for climate action in developing countries in 2022, only $21.9 billion was sourced from the private sector (according to the OECD definition, which does not include private finance mobilized through improvements to the local business environment). The latter figure was up sharply from 2021, but still represented only 19 per cent of the total. Moreover, it could be argued that some funding included in this figure, such as funds fully guaranteed by the public sector, should strictly have been classified as public finance rather than private finance.
Why is private finance falling short?
Private lenders and investors may be deterred from supporting certain projects (or demand a very high return for doing so) due to a range of factors. Some of these are generic to all kinds of investment. For example, risk may increase because of perceived macroeconomic or political instability in EMDEs. According to one estimate, at the end of 2023 yields on emerging-market hard-currency debt were around 9 per cent, roughly double the yield paid by the US government (4.8 per cent). Other generic factors pushing up risk may include regulatory uncertainty or corruption. Meanwhile, costs may also be increased – and hence returns reduced – by lack of local skills, poor infrastructure, discriminatory local taxes and lack of access to the latest technologies.
According to one estimate, at the end of 2023 yields on emerging-market hard-currency debt were around 9 per cent, roughly double the yield paid by the US government (4.8 per cent).
Other factors are specific to green investment. These include the presence of distorting fossil fuel subsidies, lack of information on climate risks, and the absence of a well-developed investor base in advanced countries for green projects in the developing world.
In both the non-climate-specific and climate-specific cases, the risks perceived by the private sector may be higher than the actual risk. This could be because asset managers lack experience investing in EMDEs, or because inadequate public data exist on historical default experiences (making it hard for investors or lenders to judge risk). In theory, this gap in risk perceptions should eventually be addressed through competition as the development over time of new information sources enables investors to achieve above-normal returns. But this may take too long to be useful, or may not happen at all due to market failure.
A further constraint on the use of private investment and lending in support of green finance is that a substantial proportion of the projects requiring financing, particularly in low-income countries, are for climate change adaptation rather than mitigation. Private financing of adaptation is generally thought to be harder to secure than private financing of mitigation. This is because of the difficulty of structuring projects to capture a share of their benefits in a way that pays a return on the capital invested. Total adaptation financing requirements have been estimated at $600 billion a year by 2050.
The factors above explain the long-standing problem of there being a shortage of ‘bankable’ climate action projects. However, in the past two years there has been a further deterioration in this situation. This reflects several new developments. First, the sharp rise in international real interest rates has had a disproportionate negative effect on the viability of renewable energy investments relative to hydrocarbon-intensive investments, as the ratio of financing to running costs is typically higher in the renewables sector. Second, public debt in many EMDEs has increased, with the combined external debt stock of countries eligible for IDA support reaching a record $1.1 trillion in 2022. Third, the movement towards ‘de-risking’ and ‘decoupling’ in global markets for goods, capital, labour and technology may disproportionately disadvantage projects in EMDEs by prompting potential partner countries to adopt more insular approaches to trade and investment. Fourth, the campaign by populist politicians against climate-friendly policies in several advanced economies may increase regulatory barriers and discourage financing.
How can public finance make a difference?
The deployment of public international finance can increase the flow of private finance for climate action by (a) improving the general business environment, and (b) mitigating financial risk in specific projects.
Improving the general business environment
This approach entails using public finance to improve public policy, address infrastructure bottlenecks, strengthen local finance skills or demonstrate innovative financing methods. The idea is that a process of ‘fire-starting’, as it is sometimes termed, can create an environment in which much larger volumes of private finance will flow to climate-related projects.
This method has long been the traditional approach of MDB finance, and can generate very large multiples of private finance relative to the size of the initial public finance. But the true degree of leverage achieved is difficult to measure with confidence, and interventions often take a long time to implement.
Mitigating financial risk in specific projects
The second approach is to deploy public finance directly alongside private finance – in what is known as ‘blended finance’ – with the goal of improving the trade-off between risk and return on investment projects. Blended finance can involve the public sector taking on some of the risk that the private sector would otherwise bear, or accepting a below-market return on a given investment in order to subsidize the returns of private sector co-investors.
This kind of intervention has the potential to be faster than traditional MDB finance. It may also generate a substantial leverage multiple (though this may not reach the very high levels that are possible with fire-starting). So far, however, the use of blended climate finance has been limited and has not been introduced at scale. This could partly be due to uncertainty over the underlying mechanisms deployed. With a number of blended-finance mechanisms, it is not immediately clear what the underlying risks are or who is bearing them. Nor is it clear sometimes whether a public subsidy is involved – and, if not, whether this is because the private sector is assumed to have been mispricing the risk previously. For example, proposals for greater use of public sector guarantees are typically unclear as to the extent of risk to be taken on by the public sector, and whether such risk is fairly priced. This lack of clarity over how a mechanism works reduces confidence among policymakers in donor-country finance and development ministries, and limits the scope for scaling up.
Another factor is that new blended-finance techniques are almost always ‘retrofitted’ into existing public international finance institutions. This often results in a high degree of complexity, and stretches the available financial engineering expertise while increasing time delays. Imposing the existing MDB financial architecture on blended-finance transactions may also inhibit the creation of new instruments that could genuinely leverage private finance, and limits the scope to use business models appropriate to the type of financial service required.
As discussed earlier, it is not straightforward for MDBs to sell on matured loans to the private sector (and recycle the underpinning capital) because of the loss of preferred-creditor status this usually entails. MDBs are also tightly constrained from taking on certain assets or types of risk by the necessity of preserving triple-A credit ratings, linked to the need to minimize the risk being borne by callable capital. And MDBs may not have the underwriting skills or financial model required to undertake insurance or certain types of guarantees.
Having both full clarity on risks and the ability to design the most appropriate financial architecture to deliver a given form of finance may not matter too much when the volume of blended-finance transactions being completed is relatively small. But if the approach is to be scaled up rapidly to help close the climate finance gap, both factors will be essential to gain the confidence of the finance and development ministries overseeing MDBs.
Improving how public international finance is used
To date, most advocacy has gone into increasing the total amount of public international finance available for climate action. However, as discussed earlier, almost all new public international finance will, in one way or another, represent a call on ODA from traditional donors and is thus likely to be tightly constrained. It is therefore critical now also to think a lot more carefully about how the finance that is available is deployed. This includes considering the choice between using public international finance to mobilize private finance and using it for other objectives, and considering the relative merits of different ways of mobilizing such finance.
This is not at all easy. It means facing up to fundamental questions about the objectives and priorities for climate finance, and about the most effective institutions for delivering it. There has been a tendency to duck such questions so far. But even a modest improvement in clarity over objectives, and in the optimality with which public international finance is allocated, could make a considerable difference to the achievement of climate goals – both reducing the overall size of the climate finance gap and increasing the speed with which it can be closed.
The international policy community needs to take three main steps to deliver a more optimal allocation of public international finance:
Step 1: Conduct a comparative assessment of public international finance
The first step is to undertake a comparative assessment of the effectiveness of different ways of deploying public international finance. The assessment should look in particular at the three main areas for climate action – mitigation, adaptation, and loss and damage – and assess, for each one, the optimality of using public finance directly or as a means to mobilize private finance. In the case of the latter, making a judgment will mean weighing the relative advantages of blended finance versus measures to improve the business environment. The comparative assessment will also need to look at the relative effectiveness of deploying public capital to deliver different types of finance – whether loans, equity investment, guarantees or insurance.
The assessment should be as comprehensive as possible. It will require gathering and verifying a large amount of data on the effectiveness of different ways of deploying public international finance to achieve given outcomes. For example, at present different institutions make numerous claims about the leverage ratios achieved when they deploy public finance to mobilize private finance. However, these claims need to be assessed on a comparable basis, taking into account variables such as the cost of finance provided and the amount of risk taken on by the public sector. The assessment will also need to look carefully at differences between sectors: the optimal way to use public international finance in support of renewable energy generation, for instance, is unlikely to be the same as when funding development of grid infrastructure.
Such analysis may in turn require the introduction of a greater level of detail – setting out precisely where finance needs to be deployed – into governments’ national transition plans than is currently available through NDCs.
Step 2: Rethink institutional architectures
The second step is to look at the current choice of institutional architectures for delivering public international climate finance, and to consider what works best and whether any improvements can be made.
There is an understandable reluctance to consider institutional change because it is typically expensive and time-consuming. It also absorbs a lot of political capital, a particular problem when considering reforms to the international architecture. But to the extent that the current institutional framework is preventing the deployment of public international finance in the most effective way possible, it is critical to examine this issue.
The Brazilian G20 presidency has commissioned a study of the effectiveness of the current climate funds. It is also important to look at whether the current architecture for most MDBs – in particular a design that relies on callable capital and preferred-creditor status, must deliver on a wide range of development objectives, and allocates funds in part according to membership rather than purpose – is best suited for mobilizing private finance for climate action.
Box 1 suggests an alternative architecture which, in contrast to traditional MDB finance, genuinely leverages private finance using publicly financed capital.
