While the estimates for the exact scale of required climate finance vary, there is little doubt that climate finance after 2030 will run into billions, if not trillions of dollars. Paris Agreement wants donors to report their plans to deliver climate finance every two years. Still, the situation remains complex owing to the multitude of climate finance instruments delivered through multiple channels. Different financial instruments can either be valuable or detrimental to different countries. Therefore, it is important to understand their advantages and disadvantages. This assumes particular significance, given the finance crunch resulting from the Covid-19 pandemic that has severely impacted funds available for climate finance.
Grants prioritise low-income, climate-vulnerable countries with no repayment-obligation. They are critical for countries facing financial market barriers that cannot be overcome otherwise. Adaptation projects with typically low private sector interest are funded through grants. Grants have associated risks such as stronger aid dependency being a substitute for domestic revenues. This can create problems like recipients lowering their domestic spending, facing higher levels of volatility as grants are more volatile than domestic revenues.
Concessional loans are flexible, carry low interest rates and long repayment schedules. With low ratio of debt repayment to revenue annually, established renewable energy sectors use them. A small reduction in costs or greater flexibility can enhance the financial feasibility of projects. They can provide access to finance without giving up ownership and help attract additional finance from the private sector. Loans can help investors and project-developers manage political/macroeconomic risks. Due to the burden of repayment, recipient countries may use the funds prudently and mobilise taxes to maintain current levels of revenue. Recipients of loans may be able to improve their debt management capabilities while strengthening partnership and cooperation with donors.
Loans may incentivise creditors to extend new loans to allow countries repay old ones, leading to evergreening of debt. Donors must ensure that loan finance works properly, so that projects can be implemented with the desired impact. Also, the debt sustainability of the recipient country should not be threatened.
Guarantees enable project-based investors to transfer risks they cannot easily absorb or manage and are particularly effective at mobilising investment, commonly used in infrastructure/other projects that can generate revenues and repay debts. They can help the public sector catalyse low-carbon investment in countries where access to finance is challenging and the markets are affected by non-assessable risks. Instead of taking on all risks, donors can use guarantees to undertake the minimum necessary intervention into normal market actions needed to close a transaction. Moreover, guarantees can help bridge the gap between public and private sector by bringing investors in contact with developing country borrowers. Also, the maturity of guarantees is shorter than that of loans, enabling lenders’ equity capital to be recycled more quickly than with loans.
However, there are certain drawbacks. Moral hazard issues may arise, when the guarantee allows investors to feel less obligation to undertake their own due diligence on the project and the borrower. Guarantees can also create higher transaction costs for the borrower since they have to enter contractual relationships with two separate entities (the lender and the guarantor) instead of just one, which can be significant, potentially offsetting the benefits it can bring.
Equity provides initial finance for a project to grow its operations and access other sources of finance while reducing investment risks faced by debt investors. In emerging economies with more established financial markets, direct finance like equity may be best positioned to attract private sector investors. Equity support can foster future private capital flows by demonstrating the commercial viability of a sector and its projects, thereby increasing private sector interest in similar, future transactions.
The main disadvantages of equity financing are that the leverage effect of equity is fairly low and since it requires a high degree of commitment owing to no guarantee of repayment, only few highly qualified projects are selected to receive this type of financing.
Results-based finance links the funds to independently verified pre-defined set of results from an investment or policy. It can provide financing for sectors that would typically not attract significant private sector attention. This instrument can support structural changes in markets leading to long-term climate results beyond what was initially invested. While such financing is suitable for mitigation projects where effectiveness of the projects can be directly measured, it is difficult to implement in areas where such a direct impact cannot be estimated.
Given the fragmented nature of the climate finance architecture and the constant evolution of different forms of climate finance, more guidance must be made available to poor and vulnerable countries that find it difficult to navigate this landscape.
(Dr Badri Narayanan Gopalakrishnan is founder and director, Infinite Sum Modelling. Chandreyee Namhata is a sustainability consultant and research professional based in Perth, Australia.)