Climate finance: Need fresh approaches to expand lending capacity

climate finance
The requirement of climate finance is significantly higher than what the current institutional mechanisms can provide.

Climate change is the biggest challenge faced by humanity as it reels under the impact of extreme weather events triggered by global warming. The world needs huge investments to reduce the emissions of heat-trapping greenhouse gases. Climate finance is also needed for adaptation to the adverse effects and of the changing climate. Estimates of the funds required every year vary between $1.8 trillion and $2.3 trillion in energy, cities, food and land use, water, and industry.

Accessing climate finance can be challenging for both nations and businesses due to a number of reasons such as lack of awareness and information, stringent eligibility criteria, limited availability of funds, as well as political and regulatory barriers. Experts who participated in a webinar organised by EGROW Foundation touched upon the challenges faced by governments and businesses in finding adequate funds.

Montek Singh Ahluwalia, Former Deputy Chairman of the Planning Commission.

Climate finance seeks to address several issues related specifically to India or the developing world as a whole. It must address both mitigation and adaptation. Mitigation benefits everyone globally, while adaptation is a local public good that only benefits the region where it is implemented. Thus, provision of national financial support for both mitigation and adaptation remains a requirement. It is also important that some moral standards should be utilized to determine it. It is estimated that the funding requirement is significantly higher than what the current institutional mechanisms can provide. Jeffrey Sachs proposes that developing countries, except for China, would require one trillion dollars each year.

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There is a need for financial assistance to combat climate change in terms of mitigating its effects and adapting to the changing climate. The lack of progress in climate finance is due to funds, as India needs more than $100 billion per year, while the developing world needs trillions of dollars in funding. Thus, there is a need for a comprehensive plan from the international community that includes both public and private financing to tackle the issue.

The significance of determining a trustworthy magnitude of international assistance, which should include both public and private funds, is immense. A revenue model is also crucial in order to attract private investment in the energy sector. There is a need to evaluate whether the steps taken to combat climate change are adequate to tackle the magnitude of the problem.

The World Bank is required to alter its operational model, an idea supported by Janet Yellen and others. Larry Summers proposes that the World Bank should fund global public goods instead of traditional development, a notion that may be contentious for India as it may result in the bank ceasing to finance development while providing broader support for the energy transition. Further, in these processes, the credit rating of the MDBs must not be jeopardised, implying that the pace of lending expansion will be based on the availability of capital.

The World Bank should explore alternative approaches to expand its lending capabilities. Additionally, G7 countries must be engaged in a fair Energy Partnership, which would be funded by both the World Bank and bilateral assistance. Although developed nations are inclined towards bilateral lending associated with their national identities, influence can be exerted over the stipulations of the lending and promote competitive bidding for the projects. Moreover, the fact that certain countries may restrict bids from other countries to develop renewable energy shall be also detrimental to competitive bidding. The most extreme form of bilateral lending entails linking the funds to purchases made by the lending nation.

There are rising concerns about private investment in renewable energy due to financial instability in distribution companies and politicisation of electricity tariffs. The World Bank may aid in private investment with risk mitigation measures. Innovative financing is required to address risks related to projects, sectors, and countries. However, de-risking such risks remains a huge challenge.

The difficulties associated with financing climate change initiatives are huge. For example, rising interest rates and high-risk countries are impediments to securing adequate funding. Further, there is uncertainty about the efficacy of green financing, questioning its ability to significantly reduce costs. Apart from that, institutional challenges also restrict funds from being directed towards environmentally friendly projects. Nevertheless, progress can be made within the constraints of the current situation only if the complexity of the issue is acknowledged and addressed too.

Architesh Panda, Senior Research Associate, United Nations University – Institute for Environment and Human Security

The implications of fiscal and military policy in climate finance are vast in nature. The issue of climate finance in dealing with climate change remains important, and thus, there is a requirement for substantial investment. In order to achieve net zero by 2050, present levels of investment are inadequate. Thus, the need for fiscal and monetary policies of countries, especially with low and middle-income levels, requires attention.

The need for environmental tax reforms can be a method to achieve climate objectives and create sufficient climate finance. The global carbon budget or carbon tax is largely inadequate, and thus environmental tax reforms can be used to mitigate and adapt to climate change. Climate is a public good, and with the existence of externalities, there is also a considerable tax gap for fossil fuels in most low-income countries.

In order to limit global climate change to 1.5 degrees, there is a necessity to increase carbon prices to around £18 to £22 per tonne of CO2 by 2030, given the current global carbon price of only £1. There is a need to consider distributional impacts when increasing carbon taxes affect the countries e.g. the tax gap for coal in India is huge. These taxes can play a major role in climate finance and fiscal policies.

Two primary topics need attention here. Firstly, the limitations of the voluntary carbon market. While China is more active in this area, India has recently introduced a mandatory Energy Efficiency scheme. A carbon tax rate of £18 per tonne of CO2 is required to achieve the goal of reducing greenhouse gas emissions and reaching net zero by 2050. However, currently, there is no such initiative.

Secondly, the fiscal sustainability concerning climate change should be taken into account. Also, finance is necessary to address climate change, but using funds from other sectors can have negative consequences for long-term fiscal sustainability. Furthermore, many highly vulnerable and indebted countries, who are already in high debt, find it challenging to adapt to the effects of climate change and manage post-disaster reconstruction. Therefore, it is essential to consider the intersection of climate change and long-term fiscal sustainability.

The importance of considering the financial impacts of the transport industry at the budgetary level also needs attention e.g. some Indian states that have begun factoring in the Sustainable Development Goals, including climate change, in their budget allocation. However, the expenditure on environmental protection constitutes less than 1% of subnational government spending in India, indicating a need for increased spending on climate change. Thus, incentivising subnational governments to invest more in carbon reduction through intergovernmental fiscal transfers remains a way out.

Additionally, the significance of monetary policy in addressing physical risks such as floods, droughts, and cyclones, as well as transition risks in the process of achieving a decarbonised society cannot be ignored. It is important to consider both physical and transition risks when designing monetary policy. Studies demonstrate a definite correlation between climate change and inflation, particularly during hot summer weather that reduces food supply in both high and low-income countries. Thus, Indian monetary policy should address climate change at the policy level and introduce a graph outlining potential monetary policy that can be implemented in India to increase awareness and take proactive measures in mitigating climate change, as per the ongoing global discourse.

Three major accomplishments have been made in the last five years, including the establishment of a financial system network, a task force on climate-related disclosures for private companies, and an ESG policy. They emphasise the significance of the central bank in managing climate risks and disseminating information to the public about monetary policies. It is important to raise awareness of climate risks and communicate information at the central and state levels.

The concept of climate change stress testing, which assesses the ability of banks and central banks to handle the impacts of climate change, has been implemented in various countries, and India is preparing for it. The Reserve Bank of India has issued guidelines for stress testing at the submission level. However, only a few Indian banks have evaluated their exposure to climate change, and only one-third of them have assigned board-level responsibility for climate initiatives. India is expected to provide due attention to the impact of climate change on monetary policy in the upcoming years and maintain bank stability while handling the stress of climate change. 

Frannie Leautier, Partner and CEO SouthBridge Investment.

Climate finance for nations with low and middle-income economies is of great significance because the problems associated with climate risk are intertwined with development issues, and addressing these can contribute to global public goods. Therefore, there is a requirement to delve into the matter of funding climate finance by examining both the financial and risk aspects.

There is a relation between development issues faced by nations with low and middle-income economies, particularly in the context of forests, floods, and droughts. There remains a need to address the intersection between global public goods and local development needs. The nexus of these two areas can be considered as a means of promoting the availability of development financing. Additionally, insurance instruments also have the potential to transform a local climate risk issue into a matter of global significance.

The financing sources for climate finance and development agendas also require attention. Three possible funding sources are domestic resources and development finance institutions, private sector investments, and capital replenishments. In the recent past, organizations with private sector investments, such as EBRD, have earned returns from private transactions, while other MDBs with less significant private sector portfolios depended on capital replenishments.

There are various methods for financing development agendas while effectively managing climate risks. One approach involves optimizing the utilization of existing capital and attracting private investment through risk transfers, securitized assets, and hybrid capital. The second approach includes redefining the risk appetite of multilateral development banks (MDBs) and modifying the way credit rating agencies perceive their preferred creditor status and callable capital, which could significantly increase the available financing.

In addition, philanthropic capital and grant financing can be utilised to reduce the cost of capital for borrowers, and national development banks can partner with other MDBs and regional development banks to fill the financing gap for development, climate-related risk, and global public goods or bads like the Covid-19 pandemic. There are certain successful partnerships between MDBs and national development banks to support the energy transition and encourage more private sector participation.

The development finance institutions can generate funds without necessitating additional capital by enhancing efficiency and effectively utilising risk transfers. They can attract private investments through non-voting capital, including hybrid capital, e.g. the African Development Bank’s successfully risk transfer transactions through a program called “Room to Run,” which allowed institutional investors and others to take risks in African portfolios, thus freeing up capital for the bank to undertake further endeavors. This approach can be followed by other MDBs, offering a prospect to amplify their initiatives.

The other instances of risk transfer that go beyond the portfolio level, involving innovative approaches such as callable capital, insurance products and securitised assets to entice private investors. Some suggestions that could impact the amount of capital accessible to the MDBs are redefining their risk tolerance and addressing the way credit rating agencies view the preferred creditor status and callable capital employed by the MDBs.

The Inter-American Development Bank’s utilisation of callable capital to elevate its risk tolerance and lending capacity and IDB Invest’s redefinition of its risk tolerance and adoption of a risk-sensitive capital adequacy framework to expand the amount of financing available for lending to client nations are leading examples which can be replicated in other MDBs.

The expense of capital borne by borrowers can also be reduced by employing innovations such as utilising philanthropic capital and grant financing to lower the cost of capital. Illustratively, The Gates Foundation collaborated with the Islamic Development Bank to procure a considerable amount of capital for Pakistan to eliminate polio. This approach can allow for an expansion of the borrowing capacity of the country and reduce the cost of capital for the country while also reducing MDB risk concentration and the ability to extend capital to additional countries. This strategy can also be applied to climate-related risks, such as flooding, forest fires, and droughts.

There is a need to emphasise blending of mitigation and adaptation measures to achieve both development and climate goals because of its immense potential. National development banks can be combined with regional and MDBs for better outcomes for countries, as well as to attract bilateral financing. The MDBs can expand their capabilities by redefining their risk appetite and increasing their capacity without requiring new capital.

The potential for combining mitigation and adaptation solutions to achieve both development and climate objectives is immense. It is recommended that MDBs use their AAA rating strategically rather than solely as an objective to access cheaper financing. 

Neha Kumar, Head South Asia Programme, Climate Bond Initiative.

A key aspect of a sustainable finance ecosystem is transparency on spending. Thematic debt capital instruments such as green bonds offer a huge opportunity to governments. Sovereign green bond issuance can provide long-dated funding, particularly well-suited to long-term capital investments needed for transition. Governments can use this new source of finance to mobilise private capital and help plug the substantial finance gap for climate action and SDGs. The proceeds fund the expenditures linked to grants, subsidies, and activities that clearly fall within ‘green’ definitions. It also involves budget tagging of such eligible expenditures, hence increasing transparency.

Earmarking the use of proceeds versus fungibility: In the case of sovereign green bonds, the purposes for which such proceeds can be used are restricted. If such bonds are issued by a sovereign, this can be perceived as a limiting feature. But this specificity of expenditure associated with GBs enhances their ability to ensure that money is spent for the purposes intended, and helps quantify the sovereign fiscal commitment to green and sustainable activities.

Sovereign Green Bonds deepen and broaden the market for sovereign debt. As the recent Indian issuance shows that INR denominated green bonds are attractive to foreign investors and the issuances signalled ample appetite for GOI to scale up issuance. These features, rather than the ‘greenium’, make such products attractive from a fiscal policy point of view.

The other aspect concerns reorienting capital flows where subsidies and taxes can play a significant role. The loss of revenues in one sector and the raising of subsidies for another will require deft fiscal management and an understanding of the inevitable trade-offs that will emerge. States with coal-dependent economies will be impacted more than others, necessitating deft fiscal management. The government can also provide subsidies to green bond issuers. Interest rate subsidies or stamp duty exemptions could be applied to green bond issuance. Subsidies can also cover the cost of verification and external review.

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Carbon pricing needs to be well thought through. Carbon price volatility will discourage green investment, particularly for emerging economies where carbon pricing may not be appropriate as the main element of the policy package. Non-price instruments such as standards, regulations, and subsidies may be more effective in overcoming market failures.

Developed countries are likely to introduce measures like the CBAM, which could impact developing countries’ exports (specifically to the EU) and can also be perceived as a protectionist measure. The proceeds of such taxes should/could be redistributed to support the transition in developing countries.

Equity transition will cause disruptions and dislocation in multiple sectors simultaneously. Efforts to decarbonise will have to accommodate the rising consumption needs of people in developing and emerging economies, create job opportunities, enhance affordable access to goods and services, and ensure that prosperity gains are equitably and widely shared. Equity can be looked at from the point of view of at least three stakeholder groups: consumers, workers, and communities. Demands for new skills and even income support may become important considerations and demand deft fiscal management.