Summary

Global investment to achieve the Paris Agreement’s temperature and adaptation goals requires immediate actions—first and foremost—on climate policies. Policies should be accompanied by commensurate financing flows to close the large financing gap globally, and in emerging market and developing economies (EMDEs) in particular. This note discusses potential ways to mobilize domestic and foreign private sector capital in climate finance, as a complement to climate-related policies, by mitigating relevant risks and constraints through public-private partnerships involving multilateral, regional, and national development banks. It also overviews the role the IMF can play in the process.

Introduction

Even with the rapid increase in private sector investments in recent years, climate finance needs remain large, notwithstanding considerable uncertainty around the size of mitigation and adaptation needs. Estimates of global investments required to achieve the Paris Agreement’s temperature and adaptation goals range between US$3 to $6 trillion per year until 2050. Global climate finance currently adds to about US$630 billion annually (Annex 1, Annex Figure 1),² with debt being the main source of funding for these investments. Green bonds represent less than 3 percent of global bond markets, and most of them are issued in developed markets and China.³ Estimates of financing needs vary because of large data gaps in the tracking of climate finance data, especially in sectors other than renewable energy, energy efficiency, and transport. In addition, data on climate finance are partial, as data collection and disclosures at present are not required in several countries.

This note discusses ways and policies for attracting domestic and foreign private sector capital in climate-related products by overcoming existing constraints. Starting from first principles, the note first draws attention to existing constraints and risks, including absence of carbon pricing and business models for infrastructure projects. Although there is no consensus that public policies would necessarily “crowd-in” private sector funds, the public funding and policies influence private sector investments. Such policies include carbon taxation, emissions trading, feebates, clean technology subsidies, and command-and-control regulations, not to mention direct government investments in green projects, all of which should lead to a change in incentives and a shift in public and private spending toward climate goals.

Climate finance policies can complement mitigation and adaptation policies. Such policy options include (1) adopting carbon pricing paths to ensure well-functioning market and prices; (2) increasing public investment in infrastructure, R&D, and renewable energy technologies that will support and incentivize inflow of private sector climate capital; (3) implementing policies to complement carbon pricing (sectoral policies; feebates, where political support for adequate carbon pricing is lacking); (4) addressing climate data gaps, data disclosure standards, and developing taxonomies for sustainable financing; (5) elevating commitments and coordination of all participants; (6) enhancing regulations for sustainable finance; and (7) creating clear transition pathways. Regulations may encompass three areas: prudential regulation, reallocation of capital across industries, and enhancing market practices through transparency. In Europe, Asia, and parts of Latin America, all three areas are covered. Transition in this note covers mitigation and adaptation, or simply stated, the move toward a low-carbon, climate-resilient economy.

The transformation needed to limit global warming to 1.5°C requires enabling conditions that reflect links, synergies, and trade-offs among mitigation, adaptation, and sustainable development.⁴ Several constraints stand out: (1) currently, climate projects in EMDEs do not justify the risks for private sector investment flows, and (2) public sector guarantees could result in privatizing gains and socializing losses, creating moral hazard, unless the public sector could invest in project equity or equity tranches of securitized investment products. In addition, EMDEs need to reduce fossil fuel use, avoid the exploration and development of new fossil energy sources, and scale up renewable energy at high speed. These issues should be viewed in a holistic manner instead of looking at them separately, also taking into consideration the heterogeneity among EMDEs, in terms of being oil exporters vs importers, capital exporters vs importers, etc.

This note explores several solutions for attracting private sector climate finance by involving collectively multilateral and national development banks (MDBs and NDBs) and international financial institutions (IFIs), including the IMF. The desirable role of the public and private sectors in financing mitigation and adaptation investments is context specific. The role of public and private sector financing varies across countries depending on country-specific characteristics and the local economic and institutional context. Blending public and private sector finance is useful to de-risk these investments for private sector capital in general, through for example, first-loss investments or performance guarantees. The solutions are based on structuring innovative products consisting of at least two tranches, with junior/equity tranche going to the public sector and the mezzanine/senior tranches to the private sector. By doing so, the public sector can help internalize the social benefits of climate investment. The public sector needs to avoid or minimize the moral hazard and potentially large contingent liabilities associated with taking on first losses or junior/equity tranches. Strong state capacity and legal frameworks, together with mechanisms to monitor investment projects, will be helpful to ensure that de-risking does not lead to fiscal losses. This is particularly the case in smaller low-income countries (LICs), given their generally weaker state capacity.

The IMF can play a catalytic role in climate finance through its policy advice, surveillance, program lending, and capacity development. The IMF can mitigate macroeconomic risk by providing advice through bilateral and multilateral surveillance, conducting Article IV consultations, performing risk assessments in FSAPs, providing climate macro-financial country assessments, and enhancing capacity development in countries. Where countries, particularly EMDEs, have limited fiscal space, the IMF Resilience and Sustainability Trust (RST) financing could help, as it focuses on longer-term structural changes, including climate change, that entail macroeconomic risks and where policy solutions have a strong global public good nature.⁵ The RST could play a catalytic role by helping to develop a conducive investment climate through reforms that address hurdles to private sector investment and improve the regulatory environment and infrastructure-resilience policies. The IMF is also playing a leading part in advocating carbon pricing and in identifying data gaps, promoting climate-related disclosures, and developing guidelines for taxonomies of sustainable finance. The measures discussed in this note are complements to carbon pricing, as they can help internalize public benefits of low-carbon climate-resilient investment—measures in addition to carbon pricing can increase societal welfare.⁶ The need for private climate financing, however, is to some extent conditional on the degree to which climate mitigation and adaptation policies are implemented.

The global macroeconomic context plays a determining role in climate finance. Higher energy prices have sparked energy security concerns, delaying efforts to spur the low-carbon transition in some countries, and exposed many EMDEs to high fossil fuel prices, and some to energy rationing. Several minerals that are critical for the transition have seen further sharp price increases since the onset of the war in Ukraine. In the context of monetary policy tightening in advanced economies (AEs), high sovereign bond yields in some EMDEs can raise hurdle rates in project finance to very high levels, jeopardizing projects with high upfront capital costs, such as solar and wind projects.

It is also important to monitor balance of payments vulnerabilities that could arise from large capital inflows associated with climate finance. If the de-risking of climate-friendly infrastructure assets is not accompanied by increased domestic capabilities in low-carbon manufacturing (for example, renewable energy technology) or large critical minerals endowments, capital inflows could drive current account deterioration, and could lead to financial imbalances if future returns are overestimated, generating macroeconomic vulnerabilities.

The note proceeds as follows. The next section discusses constraints and risks for climate finance investments. The following section focuses on the role of private sector capital⁷ in climate finance, followed by a section on MDB climate finance. The next section explores public-private risk sharing in scaling up climate finance. The fifth section discusses and proposes policy considerations. Finally, the last section highlights follow-up issues that could be explored in future policy work and analysis.

Constraints for Climate Finance

A well-designed carbon price is an indispensable part of a strategy for reducing emissions in an efficient way. Carbon prices are intended to incentivize the changes needed in investment, production, and consumption patterns, and to induce the kind of technological progress that can bring down future abatement costs.⁸ It is not the only way, and even if implemented forcefully carbon pricing needs to be complemented with other supporting sectoral policies such as regulations, standards, financial sector policies, and climate financing. Put differently, climate goals face externalities that cannot be resolved quickly and simultaneously. This justifies a complementary role for financial policies to address urgent climate goals. Such policies would help EMDEs to attract and scale up financing for mitigation and adaptation projects.

Multiple constraints preclude attracting and scaling up private sector climate finance. These include supply and demand factors, macro-financial and microeconomic impediments, unattractive risk-return profiles in unproven markets, high fossil fuel investments, and data-related constraints. Key market failures include knowledge spillovers, high risk perceptions because of uncertainties about future climate policies, technological costs, and the economic effects of climate impacts; and high upfront costs and risks associated with mitigation and adaptation investment projects, which imply insufficient returns given risks.⁹

High upfront costs and risks related to mitigation and adaptation investments play a major role in deterring such investments in EMDEs. The costs are related to large upfront capital expenditure, the longtime horizon of infrastructure projects, development of profitable business models, among others. Risks include: (1) currency; (2) regulatory and political (contract renegotiation, change in taxation or regulatory environment); (3) macroeconomic and business-related (volatility of demand, exchange rate fluctuations); and (4) technical (construction delays and cost overruns, technology and obsolescence, force majeure).¹⁰ As a result, climate investments could fail long before high carbon prices and associated competitiveness benefits arise—even when a government’s commitment to a path of rising carbon prices is credible, as shorter-term costs and risks can deter climate investment decisions. This underscores the role of second-best measures to further incentivize climate investments.

Several supply and demand factors affect both sustainable finance and climate finance; they can be addressed through reducing externalities. Supply-side factors include changes in energy supply, production technologies, and deployment of carbon dioxide-removal technologies that would keep demand end-user invariant. Demand-side factors revolve around modifying the demand for goods and services toward more sustainable options in consumption, behavior, lifestyle, etc.¹¹ Supply and demand factors translate into financial constraints and various risks, which are important on macro- and microeconomic levels, for countries and private sector investors.

There are significant macro-financial constraints to mobilizing private capital, particularly in EMDEs. A key constraint is the absence of adequate carbon pricing, notably in EMDEs.¹² Such pricing would help generate incentives for private investment in low-carbon projects. It would promote a more transparent market and the ability to make clear and informed investment decisions in different markets and economies. Another macroeconomic constraint is country risk, which may be difficult to price for some EMDEs, specifically for climate-related products. In addition, many EMDEs and LICs have considerable pre-existing debt vulnerabilities that could be magnified by additional borrowing, including the transfer of currency and liquidity risks from private to public sector balance sheets (Annexes 2 and 3).

Microeconomic constraints are primarily related to mitigation and adaptation investments and are specifically high in EMDEs. These include long timeframes, lack of large investment grade investments and liquid markets, high upfront capital and transaction costs, and significant project risks.

As a result of these and other constraints, difficulty remains in attracting financing to many mitigation and adaptation projects. These types of projects are most likely to attract a small pool of specialized investors demanding high returns in a developing and relatively illiquid asset class, with debt being the main instrument. This is the case for renewable energy companies, which have low liquidity and long-term financing needs. For instance, there is evidence that mainstream investors screen companies with a market capitalization of at least US$200 million, a threshold that relatively few renewable energy companies clear.¹³ Discussions with large development finance institutions (DFIs) suggest that the cost of equity for climate investments for impact investors and DFIs was 12–15 percent as of June 2022 in small frontier EMDEs, suggesting that it could be even higher for commercial investors. Adaptation finance is often built into capital and operating expenditures, making it difficult to track. However, emerging sources of private adaptation financing include green, social impact and resilience bonds (although there are concerns about these instruments’ additionality), dedicated investment vehicles (that is, equity funds), balance sheet finance, and insurance.¹⁴ It is not always clear how such projects generate returns, however.

Some other important impediments include unattractive risk-return profiles in unproven markets and lack of scalable quality projects. This suggests that pooling projects through structured financial instruments could help in some cases. Pooling several projects in a structured fund and creating ABS-type instruments would attract more institutional investors and large investment funds into less developed economies, which may not even have an investment grade, as well as diversify risks. This would raise global climate financial flows and bring them closer to required levels, as currently only about a half of such flows come from the private sector and only about a half goes to developing countries (Annex Figure 1). However, it is critical to address risks associated with scaling up cross-border climate finance (Annex 2), including through risk management practices (Annex 4).

An important constraint for enhancing climate finance is high fossil fuel investments, which need to be scaled down. Phasing out fossil fuel assets to replace them with low-carbon energy sources requires managing the macro-financial consequences of asset stranding, including the reallocation of capital and labor.¹⁵ However, some international investment treaties, such as the Investor State Dispute Settlement system and the Energy Charter Treaty (ECT), which are legally binding, protect fossil fuel investments which can lock in large amounts of emissions, or alternatively expose authorities to legal action for breach of that protection when seeking to adopt regulatory measures to curtail fossil fuel activity. The European Commission is negotiating a modernization of the ECT to better enable regulatory action to be taken to address climate change, and similar steps are needed in relation to other international investment treaties. However, even under the European Commission’s proposal, protection of foreign investment in certain natural gas investments is to be kept until as late as 2040. Aligning climate finance with the Paris Agreement entails a major reallocation of investments to avoid those that are inconsistent with climate goals. This includes the exploration and development of new fossil energy sources and the building of unprotected critical infrastructure in areas that are subject to climate risks.¹⁶

Beyond climate-related externalities, there are others. These include information asymmetries related to taxonomies and large data gaps, absence of common taxonomies, inadequate classifications for sustainable investment, home bias considerations, and an overlay of other risk factors and externalities.¹⁷ Among data gaps, developing weather monitoring and forecasting systems is important especially for LICs, which are heavily reliant on agriculture. Such externalities create significant barriers for private sector climate investment and effective capital reallocation. The introduction of carbon border adjustments in some countries can boost other countries’ incentives to adopt similar policies and tax carbon domestically, which could accelerate the transition.

Data provision processes remain manual, cumbersome, and costly. Data quality needs to be addressed to improve transparency, verification, and reporting process. Technology could be a game changer in collecting new data in a more efficient way.¹⁸ Some examples include: (1) Application Programming Interfaces to connect directly to infrastructure systems to retrieve directly relevant data on environmental impact and energy consumption; (2) Internet of Things (IoT) devices to measure carbon emissions and pollution levels at the source and in real time, although this may bring broader concerns about potential emission and environmental impact of IoT development; (3) blockchain platforms to ensure provenance of ESG certifications; and (4) natural language processing to analyze relevant sustainability-related information.¹⁹

There are also issues related to scaling up private sector finance. These include the size of global fixed-income and ABS markets, diversity in investor types and risk profiles, differences in investment time horizon, various climate strategies in the asset management industry, and the lack of investable projects. Institutional investors face difficulties in identifying investments in EMDEs that are relatively safe and liquid. This limits private sector exposures to only 12 to 15 investment-grade EMDEs that have large and relatively liquid bond markets, making it difficult to build diversified bond portfolios and leaving many other EMDEs without needed private sector climate funding. There is evidence that development institutions that channel subsidized public resources to private sector projects face challenges related to absorption capacity and development finance saturation, particularly in LICs and small states, including Small Island Developing States.²⁰ This points to the need to increase the supply of investable projects to avoid generating competition for a scarce pipeline of projects. Indeed, the latter could increase the cost of financing if a lack of investable projects leads to more marginal investment opportunities being financed.²¹

Pooling of projects is needed for ABS-type products to attract institutional investors. Mitigation and adaptation investment projects are often too small with respect to institutional investors’ requirement of diversified asset pools. Devices that pool projects, notably those that facilitate project bundling, can help address this constraint.

Unlike fossil fuels, at present low carbon energy sources in EMDEs may not be considered attractive to private sector investors. Political, regulatory, and macroeconomic instability increase investment risks and lead investors to apply a higher premium.²² In addition, there are other constraints, including less transparent financial reporting, difficulties in evaluating projects, and other local impediments. This makes many theoretically attractive projects economically unviable and creates additional constraints and risks.

As part of the transition, adaptation finance faces larger hurdles compared with investment in mitigation (Figure 1). A major constraint is uncertainty about the economic consequences of climate impacts and the efficiency of adaptation technologies, which can hinder project-level investment.²³ Adaptation projects in particular are often unattractive to the private sector as a result of underpriced risks, a general lack of access to finance in EMDEs, and a lack of economies of scale (Box 1). Weather and climate extremes are generating cross-border economic and societal impacts through markets, natural resource flows, and supply chains that depend on key commodities and infrastructure. Changes in precipitation patterns and water availability could affect hydropower, and for countries that share river basins it can reduce productivity in the food and energy sectors. Almost all adaptation finance is currently provided by the public sector, even though there are opportunities for private sector capital, especially in early warning systems, global mangrove protection, and climate-resilient infrastructure.²⁴

Biannual Average Climate Finance by Uses (Billions of US dollars)

Citation: Staff Climate Notes 2022, 007; 10.5089/9798400216428.066.A001

Source: Climate Policy Initiative.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

Biannual Average Climate Finance by Uses (Billions of US dollars)

Citation: Staff Climate Notes 2022, 007; 10.5089/9798400216428.066.A001

Source: Climate Policy Initiative.

• Download Figure
• Download figure as PowerPoint slide

Biannual Average Climate Finance by Uses (Billions of US dollars)

Citation: Staff Climate Notes 2022, 007; 10.5089/9798400216428.066.A001

Source: Climate Policy Initiative.

• Download Figure
• Download figure as PowerPoint slide

Countries’ exposure to physical impacts of climate change and the costs of transition (mitigation and adaptation) impedes climate finance. The economic costs of physical impacts are very uncertain, and with the acceleration of climate change, the frequency and strength of physical impacts are growing. Although central banks and financial regulators are trying to sensitize various agents to these risks and developing tools to address them, climate-related financial risks remain underestimated, limiting the reallocation of capital to climate transition. This challenge is exacerbated by countries’ general economic vulnerability and indebtedness. Growing fiscal costs of mitigation and adaptation also affect many developing countries, worsening their public debt levels and credit ratings and, in some cases, level of debt distress, while impacting the investment climate.

High financial project risks could be addressed. Low-carbon projects face high upfront transaction and other risks, especially in LICs and EMDEs, reflecting uncertainty about environmental regulations. Such risks include cost overruns, delays, transaction costs, permit risks, and contract renegotiation, particularly for less mature technologies.²⁵ These risks are higher for smaller projects and compounded by limited familiarity with specific geographies and markets and an uncertain governance landscape. Investments in climate projects tend to be bespoke, one-off projects, and therefore costly, time consuming, uncertain and hard to diversify.²⁶ These factors tend to limit the supply of high-quality, transparent low-carbon climate-resilient investment projects and make the cost of capital higher in LICs and EMDEs. Transparency is particularly important, as highlighted by the case of reported secret electricity power purchase agreement contracts, which can hinder the low-carbon transition, create contingent liabilities for the state, and undermine democratic accountability.²⁷

There are also important challenges for the green bond market. For example, as demand for green products is increasing fast, issuers may tend to “greenwash” projects that produce few real climate benefits. Thus, there is a need for independent third-party evaluation to ensure that this type of investments indeed go into green projects. Therefore, some countries and regions, such as the EU and China, are putting in place specific standards for green bonds—hence the role of taxonomies.

Because of the transformation of illiquid low-carbon assets into tradable financial securities and the development of deep and liquid local bond markets, there could be a large increase in intermediation of portfolio flows to EMDEs and the amount and share of intermediation of capital flows to EMDEs that are originated from benchmark-driven investors. In turn, this could lead to the transmission of cross-border stress and to capital outflows from EMDEs.

Private Sector Capital in Climate Finance

Private sector capital for climate finance includes the funding provided by private financial institutions, investors, and companies in climate-friendly projects and financial assets. These investments are often priced on a market basis, with financial returns measured against risks. Scaling up private sector climate finance can be enhanced if the social benefit of carbon emission reduction were internalized in the financial returns and risks were reduced. At the same time, the large uncertainties surrounding the development of climate-related technologies, the financial returns of climate projects, and future carbon policies and emission pathways, often make climate-related investments risky, which underscores bigger role of large global investment funds. Thus, to attract private sector capital in climate mitigation and adaptation investment, there is a need for innovative financial instruments in addition to those that already exist, including blended and structured financing and risk sharing, where public financial resources can partly reduce and mitigate risks for investments.²⁸ The appropriateness of such tools depends on countries’ public debt and balance sheet sustainability, given the risk of potential contingent losses and liabilities.

While it has grown rapidly in recent years, private sector climate finance remains a small share of total assets under management (AUM) globally (Figures 2 and 3). In the absence of effective carbon pricing frameworks, the social cost of carbon emissions is not directly incorporated in private investment decisions, resulting in a less attractive risk-reward profile for low-carbon relative to carbon-intensive investments. The longer payback period of low-carbon options with high upfront capital costs raises these investments’ sensitivity to uncertainty relative to energy technologies where fuel costs dominate. The high policy and technology uncertainties surrounding the low-carbon transition can further disincentivize private sector investment. It is estimated to be about US$300 billion per year in new climate financing, still very small compared to the US$210 trillion total private AUM.²⁹ In a large sample, analyzed by the IMF, the global total AUM for climate-labeled investment funds grew more than tenfold to US$133 billion in 2010–20. However, the AUM for climate-labeled private investment funds in the sample represented only less than 0.3 percent of the total AUM.³⁰ Moreover, some assessments find that the 30 largest financial institutions in the world collectively provide more than US$740 billion in primary financing of fossil fuels.³¹ This reflects the significant limitations of private capital as well as potential room for growth in climate finance. De-risking by public financial resources is likely needed to fully scale up private capital participation.

Assets Under Management, by Fund Label, 2010:Q1–2020:Q4

Citation: Staff Climate Notes 2022, 007; 10.5089/9798400216428.066.A001

Sources: Bloomberg Finance L.P.; Lipper; Morningstar; United Nations Principles Investment; and IMF staff calculations.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

Assets Under Management, by Fund Label, 2010:Q1–2020:Q4

Citation: Staff Climate Notes 2022, 007; 10.5089/9798400216428.066.A001

Sources: Bloomberg Finance L.P.; Lipper; Morningstar; United Nations Principles Investment; and IMF staff calculations.

• Download Figure
• Download figure as PowerPoint slide

Assets Under Management, by Fund Label, 2010:Q1–2020:Q4

Citation: Staff Climate Notes 2022, 007; 10.5089/9798400216428.066.A001

Sources: Bloomberg Finance L.P.; Lipper; Morningstar; United Nations Principles Investment; and IMF staff calculations.

• Download Figure
• Download figure as PowerPoint slide

Net Flows into Funds, by Fund Label, 2010:Q1–2020:Q4

Citation: Staff Climate Notes 2022, 007; 10.5089/9798400216428.066.A001

Sources: Bloomberg Finance L.P.; Lipper; Morningstar; United Nations Principles Investment; and IMF staff calculations.Note: This figure shows mutually exclusive fund labels.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

Net Flows into Funds, by Fund Label, 2010:Q1–2020:Q4

Citation: Staff Climate Notes 2022, 007; 10.5089/9798400216428.066.A001

Sources: Bloomberg Finance L.P.; Lipper; Morningstar; United Nations Principles Investment; and IMF staff calculations.Note: This figure shows mutually exclusive fund labels.

• Download Figure
• Download figure as PowerPoint slide

Net Flows into Funds, by Fund Label, 2010:Q1–2020:Q4

Citation: Staff Climate Notes 2022, 007; 10.5089/9798400216428.066.A001

Sources: Bloomberg Finance L.P.; Lipper; Morningstar; United Nations Principles Investment; and IMF staff calculations.Note: This figure shows mutually exclusive fund labels.

• Download Figure
• Download figure as PowerPoint slide

Private sector capital may and should play a bigger role in climate finance, including with innovative financial instruments. A growing number of institutional investors, investment funds, and credit institutions have already been paying attention to climate change and sustainability. Several financial tools have been increasingly used in climate finance in recent years (Table 1). This trend provided a good incentive to private sector financial institutions to search for climate-related products and liaise with the public sector and MDBs to develop joint products and partnerships. Large global investment funds can start investing a small percentage of their capital in climate financial products in EMDEs and diversify their risk. These funds can partner with MDBs and the national public sector, by investing a small share of their portfolio in climate EMDE products/projects, thereby fulfilling their climate commitments and investors’ mandate. While private sector investors can provide a large share of financing, the public sector can underwrite more risks, take on equity/junior tranches, provide guarantees and credit enhancements, as well as help with project selection and assessment, capacity development, and diversification for the private sector. Public-private synergies in this area would provide a multiplicative effect.

^{Table 1.}

Examples of Private Sector Climate Finance Tools

Sources: World Bank, OECD, Climate Bonds Initiative, and IMF.

^{Table 1.}

Examples of Private Sector Climate Finance Tools

Commercial bank lending with climate considerations	Conventional commercial bank lending with climate considerations is growing, driven by both commercial banks’ voluntary climate strategy and financial regulations.
Green bonds and green loans	Green bonds and loans are used to exclusively finance projects that have positive climate and environmental impacts. Some may qualify for a “green” label. Green Sukuk are also being explored in Islamic finance.
Sustainability-linked bonds and sustainability-linked loans	Sustainability-linked bonds and loans are used by corporates and sovereigns to raise capital often at lower costs, by committing to achieve predefined key performance indicators (KPIs) on sustainability.
Sustainability bonds and social bonds	Sustainability and social bonds are financing tools where the proceeds are used to finance projects that achieve positive climate and social impacts.
Green asset-backed securities (ABSs)	Green securitization can transform illiquid climate-friendly assets into tradable financial securities.
Other financial instruments	Other financial instruments are used in private climate finance, including through certain environmental, social, and governance funds (with climate considerations), as well as private equity and venture capital investments in climate-related firms. Shareholder engagement is also used to encourage companies’ green investment decisions.

Sources: World Bank, OECD, Climate Bonds Initiative, and IMF.

View Table

^{Table 1.}

Examples of Private Sector Climate Finance Tools

Commercial bank lending with climate considerations	Conventional commercial bank lending with climate considerations is growing, driven by both commercial banks’ voluntary climate strategy and financial regulations.
Green bonds and green loans	Green bonds and loans are used to exclusively finance projects that have positive climate and environmental impacts. Some may qualify for a “green” label. Green Sukuk are also being explored in Islamic finance.
Sustainability-linked bonds and sustainability-linked loans	Sustainability-linked bonds and loans are used by corporates and sovereigns to raise capital often at lower costs, by committing to achieve predefined key performance indicators (KPIs) on sustainability.
Sustainability bonds and social bonds	Sustainability and social bonds are financing tools where the proceeds are used to finance projects that achieve positive climate and social impacts.
Green asset-backed securities (ABSs)	Green securitization can transform illiquid climate-friendly assets into tradable financial securities.
Other financial instruments	Other financial instruments are used in private climate finance, including through certain environmental, social, and governance funds (with climate considerations), as well as private equity and venture capital investments in climate-related firms. Shareholder engagement is also used to encourage companies’ green investment decisions.

Sources: World Bank, OECD, Climate Bonds Initiative, and IMF.

These are several market instruments that private sector climate finance can utilize:

• Climate considerations in conventional commercial bank lending. Commercial bank lending can play a significant role in climate finance. Total bank loans to the private nonfinancial sector amount to about 100 percent of the 2020 world’s annual GDP.³² However, climate-related considerations are not among the key factors that currently determine bank lending decisions. With physical and transition risks becoming more prominent, some banks are starting to gain awareness of climate-related risks. Some banks are augmenting their internal credit risk models to capture climate physical risks in the credit risk assessment as well as the quality of collaterals, although it is not currently a requirement in many countries. Some banks are incorporating GHG emissions considerations in their companies’ environmental, social, and governance (ESG) frameworks. However, the social benefits of climate mitigation are typically not reflected in the terms and conditions of conventional loan contracts, which continue to constitute a significant limitation of conventional bank financing. The role of ESG considerations in institutional investors’ allocation strategies may also divert capital flows from EMDEs, as the latter tend to lack data or score poorly on ESG metrics.

• Green bonds and green loans. Green bonds are a form of financing wherein the proceeds are used to exclusively fund projects that have positive climate and environmental impacts via a use-of-proceeds approach. The Green Bond Principles introduced by the International Capital Market Association (ICMA) in 2014 provided a set of voluntary principles that promote transparent and standardized climate objectives and impacts that qualify for a green label. Increasingly originated by financial institutions, sovereigns, and nonfinancial corporates, green bond issuances have grown rapidly over the last decade, reaching more than US$600 billion in 2021. Green bonds are one of the most important types of climate-related bonds, representing one-half of the global total issuances of climate-related bonds and about 80 percent of climate-related bond issuances in EMDEs. Despite the recent growth, green bonds constitute only 3.8 percent of all bond issuances in EMDEs (excluding China), leaving significant room for future growth.³³ Green Sukuk, Islamic bonds, that were first launched by Malaysia in 2017 and were used to exclusively finance green projects, have seen issuances in a few countries over the past few years, including Indonesia and the UAE. In addition, similar to green bonds, green loans, which are typically conducted via private transactions and are often smaller in size for each transaction than a green bond, are used to raise capital for green eligible projects. International Financial Corporation (IFC) and some other MDBs also use green loans to provide support to the low-carbon transition of developing countries. The Green Loan Principles of ICMA and other similar principles provide guidelines for the green loan market.

• Sustainability-linked bonds (SLBs) and sustainability-linked loans (SLLs). SLBs are used by corporates and sovereigns to raise capital often at lower costs by committing to achieve predefined key performance indicators (KPIs) on sustainability. For example, an energy company may raise capital by issuing an SLB and committing to reduce the usage of fossil fuel by a certain percentage in its power generation fleet over the next five years. A country can issue an SLB and commit to reach certain national carbon emission targets by a predefined timeline. These bonds commonly enjoy lower interest rates but will incur a jump in the coupon rates if the issuer fails to meet their sustainability targets at predefined observation dates. An important characteristic of SLBs is that the proceeds from the bonds can be used for general purposes by the issuer. SLLs are capital intermediated through banks and are similar in concept to SLBs. The markets for SLBs are still very modest, while SLLs have grown to US$400 billion in annual issuances in 2016–21. About two-fifths of SLB issuers are in EMDE countries.³⁴ While these financial instruments are highly innovative and have gained growth momentum, their total market size remains small compared to the entire bond market and to global climate finance needs.

• Social bonds and sustainability bonds. Social bonds are a financing tool where proceeds are used to finance projects that achieve positive social impact. The social impact can include addressing poverty, gender, environmental issues, and racial inequalities, as well as challenges for underprivileged groups. Recently, some COVID-related social bonds have emerged with goals to address COVID-related social issues. Sustainability bonds are a financing option where proceeds are used to finance a combination of social and green projects. Both types of bonds are useful financial instruments that can leverage private capital to address climate change. The global issuance of these bonds surpassed US$200 billion in 2020.

• Green asset-backed securities (ABSs). Securitization is a tool that makes illiquid assets into tradable financial securities and is increasingly used in the green investment area. For example, loans to small and medium enterprises to invest in climate-friendly projects could be structured as collaterals for green ABSs. In some countries, home mortgages that finance energy-efficient homes could be structured into green mortgage-backed securities. Green securitization is a useful tool to increase the demand and liquidity in the secondary market, which in turn can stimulate direct financial investments in the primary market. However, despite the fact that the China, EU, and the United States, and a few other countries and regions have seen growing issuances in recent years, the overall market size for green ABSs is still small. Given the uneven regulatory landscape and data limitations, climate-related ABS would need to be closely monitored and regulated.

• ESG funds, venture capital, and other forms of private finance. ESG funds especially climate-labeled funds have experienced strong inflows in recent years. These funds typically have investment screening processes that account for ESG and climate considerations, although screen criteria can vary widely across funds. The rise in inflows to these funds can potentially lower the financing costs for the issuing companies that have high ESG and climate scores. Venture capital is also increasingly involved in climate finance, with estimations of more than US$200 billion being invested in climate-related technology firms between 2013 and the first half of 2021.³⁵ Compared to other forms of private sector capital, venture capital’s high appetite for risk can have an advantage in climate financing, considering potential high financial risk of climate-related projects and technologies. The limitation of venture capital is that it is mostly restricted to small-sized private companies that potentially have large commercial values but not necessarily projects that mostly have significant social and climate benefits.

• A potential benefit for green bond issuers is to enjoy a green premium (or “greenium”) in pricing, although empirical evidence on the actual size of the pricing benefit remains mixed.³⁶ While the greenium is still small reaching around 50 basis points at best, the margin could widen with increasing demand and credibility of green and ES-linked bonds.³⁷ Thus, ESG investors should be willing to have lower return investing in this type of products, but at the same time meeting their mandate.

MDB Climate Finance³⁸

MDBs and NDBs can play a crucial role in channeling funds to support climate issues. These banks can provide countercyclical intervention in the credit market through direct lending, provision of credit guarantees, or buying loans and securitized products. They can provide long-term or concessional resources and promote private-sector involvement (for example, on-lending scheme). Because of their financial model, MDBs’ ability to leverage their capital through bond issuances is determined in part by their capital adequacy frameworks. To safeguard their ratings, MDBs have traditionally been conservative in managing their finances. Equity stakes allow the public sector to share in the upside, but they also help to leverage private capital in the largest way, and they would be particularly helpful given that most EMDEs already have too much debt. Therefore, MDBs can play an additional role to help countries structure financial products in such a way to take equity stakes and thus attract private sector capital. Public equity investments are important to help delivering on the annual $100 billion commitment by developed countries in support of climate action in EMDEs.

MDBs have made significant climate finance commitments (Figure 4). As of 2020, overall commitments of the five major MDBs reached US$32 billion (Table 2). Adaptation finance and co-financing were increased to US$18 billion and US$110 billion, respectively, including private direct climate finance mobilization of US$40 billion.³⁹ However, in 2020 MDBs’ climate finance for developing countries fell well short of these commitments, at US$38 billion (57 percent) most likely because of the global COVID-19 pandemic.⁴⁰ Mitigation finance dominated adaptation finance at 76 percent of the total.

MDB’s Climate Commitments (Billions of U.S. dollars)

Citation: Staff Climate Notes 2022, 007; 10.5089/9798400216428.066.A001

Source: Joint Report on Multilateral Development Banks. Note: 2015–18: Climate finance in emerging and developing economies; 2019–20: Climate finance in all economies where the MDBs operate.

• Download Figure
• Download figure as PowerPoint slide

View Full Size

MDB’s Climate Commitments (Billions of U.S. dollars)

Citation: Staff Climate Notes 2022, 007; 10.5089/9798400216428.066.A001

Source: Joint Report on Multilateral Development Banks. Note: 2015–18: Climate finance in emerging and developing economies; 2019–20: Climate finance in all economies where the MDBs operate.

• Download Figure
• Download figure as PowerPoint slide

MDB’s Climate Commitments (Billions of U.S. dollars)

Citation: Staff Climate Notes 2022, 007; 10.5089/9798400216428.066.A001

Source: Joint Report on Multilateral Development Banks. Note: 2015–18: Climate finance in emerging and developing economies; 2019–20: Climate finance in all economies where the MDBs operate.

• Download Figure
• Download figure as PowerPoint slide

^{Table 2.}

MDB’s Climate Finance Commitments, 2015–20

Source: MDBs (2021).Note: Climate finance resources for the International Financial Corporation (IFC), Multilateral Investment Guarantee Agency (MIGA), and the World Bank (WB) stood at US$3.5 billion, US$23 million, and US$17.7 billion, correspondingly, with shares of climate finance in the total financing reaching up to 30 percent.

^{Table 2.}

MDB’s Climate Finance Commitments, 2015–20

	World Bank Group	European Investment Bank	Inter-American Development Bank	European Bank for Reconstruction and Development	African Development Bank
Climate finance commitment for LICs/EMDES as of 2020 (USD billions)	22	3.2	2.5	2.3	2
Climate finance commitments in LICs/EMDEs as share of total financing	96	N/A	73	59	N/A
Climate finance in LICs/EMDEs as share of total climate finance commitments	N/A	N/A	15	11	34
Co-finance for LICs/EMDEs as of 2020 (USD billions)	17.9	1.3	3	N/A	7.2
Climate finance goals	In 2021–25, the IFC aims to reach 35 percent of climate finance in the total portfolio. Moreover, the IFC has committed to align 85 percent of its real sector operations with the goals of the Paris Agreement starting in mid-2023, reaching 100 percent in mid-2025.	The EIB plans to gradually raise the share of financing allocated to climate and environmental sustainability to over 50 percent of its operations in 2025. The EIB has also announced that it will restrict almost all oil and gas finance from 2022 onward. From 2021, the bank aims to have a target that comprises both climate finance and environmental sustainability finance, with the former expected to account for 85 percent of the total.	The IDB aims for climate finance in total financing to be at least 30 percent for 2020–23.	The EBRD aims for green finance to account for over 50 percent of it total annual investment by 2025, and to set a date when all projects must be aligned with the Paris Agreement. Under the “Green Economy Transition” approach, the bank uses many instruments, including direct finance (debt, equity, and quasi-equity), intermediated finance through local financial institutions or through no n-financial intermediaries (e.g., utilities, energy service companies, and supply chains), large-scale PPPs, and performance-based finance.	The bank planned to double its climate finance to US$25 billion in 2020–25, prioritizing adaptation finance.
Other climate finance initiatives	In addition to green loans and green bonds, the IFC is developing sustainable finance products, including blue bonds and blue loans, sustainability-linked finance, and climate transition products. It is also developing debt products aligned with the ICMA Climate Transition Finance Handbook to assist carbon-intensive companies with the low-carbon transition.	In 2021, the EIB developed a product that links the loan’s interest rate to emission reductions, rewarding the company, if it reduces its emissions to a specified level and penalizing it if it fails to do so.	N/A	N/A	N/A

Source: MDBs (2021).Note: Climate finance resources for the International Financial Corporation (IFC), Multilateral Investment Guarantee Agency (MIGA), and the World Bank (WB) stood at US$3.5 billion, US$23 million, and US$17.7 billion, correspondingly, with shares of climate finance in the total financing reaching up to 30 percent.

View Table

^{Table 2.}

MDB’s Climate Finance Commitments, 2015–20

	World Bank Group	European Investment Bank	Inter-American Development Bank	European Bank for Reconstruction and Development	African Development Bank
Climate finance commitment for LICs/EMDES as of 2020 (USD billions)	22	3.2	2.5	2.3	2
Climate finance commitments in LICs/EMDEs as share of total financing	96	N/A	73	59	N/A
Climate finance in LICs/EMDEs as share of total climate finance commitments	N/A	N/A	15	11	34
Co-finance for LICs/EMDEs as of 2020 (USD billions)	17.9	1.3	3	N/A	7.2
Climate finance goals	In 2021–25, the IFC aims to reach 35 percent of climate finance in the total portfolio. Moreover, the IFC has committed to align 85 percent of its real sector operations with the goals of the Paris Agreement starting in mid-2023, reaching 100 percent in mid-2025.	The EIB plans to gradually raise the share of financing allocated to climate and environmental sustainability to over 50 percent of its operations in 2025. The EIB has also announced that it will restrict almost all oil and gas finance from 2022 onward. From 2021, the bank aims to have a target that comprises both climate finance and environmental sustainability finance, with the former expected to account for 85 percent of the total.	The IDB aims for climate finance in total financing to be at least 30 percent for 2020–23.	The EBRD aims for green finance to account for over 50 percent of it total annual investment by 2025, and to set a date when all projects must be aligned with the Paris Agreement. Under the “Green Economy Transition” approach, the bank uses many instruments, including direct finance (debt, equity, and quasi-equity), intermediated finance through local financial institutions or through no n-financial intermediaries (e.g., utilities, energy service companies, and supply chains), large-scale PPPs, and performance-based finance.	The bank planned to double its climate finance to US$25 billion in 2020–25, prioritizing adaptation finance.
Other climate finance initiatives	In addition to green loans and green bonds, the IFC is developing sustainable finance products, including blue bonds and blue loans, sustainability-linked finance, and climate transition products. It is also developing debt products aligned with the ICMA Climate Transition Finance Handbook to assist carbon-intensive companies with the low-carbon transition.	In 2021, the EIB developed a product that links the loan’s interest rate to emission reductions, rewarding the company, if it reduces its emissions to a specified level and penalizing it if it fails to do so.	N/A	N/A	N/A

Source: MDBs (2021).Note: Climate finance resources for the International Financial Corporation (IFC), Multilateral Investment Guarantee Agency (MIGA), and the World Bank (WB) stood at US$3.5 billion, US$23 million, and US$17.7 billion, correspondingly, with shares of climate finance in the total financing reaching up to 30 percent.

MDBs have announced climate finance targets and actions for the several years ahead (Table 2). They are working together to develop the joint MDB long-term strategies (LTSs) for low-carbon and climate-resilient development. This involves providing a tailored approach to country needs through (1) partnerships and capacity building, (2) engagement and policy support (including the preparation of an LTS), and (3) support for the operationalization of an LTS.

Debt climate finance is the main type of instrument used for MDB financing, at an estimated 68 percent of the total in 2020 (US$26 billion), of which only 12 percent is low-cost or concessional financing. It is followed by policy-based financing, grants, and guarantees at about 11.5 percent (US$4.4 billion), 9 percent (US$3.3 billion), and 4 percent (US$1.5 billion), respectively (Table 2, Annex 5). Solar and onshore wind technologies attract more than 90 percent of financing, and low-carbon transportation is the fastest-growing recipient sector (Annex Figure 2). As of 2020, more than three-quarters of tracked climate finance flows were domestic.⁴¹

MDBs have agreed on “enhanced principles” to govern the allocation of blended concessional finance. These principles include not crowding out the private sector, minimizing the subsidies, having a goal of commercial viability, addressing market failures, avoiding market distortions, and promoting higher standards.⁴² In addition, MDBs have preferred creditor status in some cases, which can affect underlying credit risk.⁴³ In some cases, this can have a powerful effect, as syndicated lending by MDBs has been shown to attract 7 dollars of private sector credit for every dollar of public sector credit.⁴⁴ Discussions with DFIs suggest that EMDEs face a high cost of capital for climate investments in the private sector. MDBs, by contrast, require much lower financial returns—on the order of 1 to 2 percent. This suggests that MDBs could play an important role in filling the investment gap.⁴⁵

MDBs and other IFIs can play an important role in supporting the mobilization of climate finance. Their expertise can contribute to selecting projects, monitoring, and ensuring adequate progress towards meeting the Paris Agreement objectives. In addition, IFIs, donors, and domestic financial institutions could support national development banks (NDBs) by strengthening their capacity, easing access to climate finance funds, channeling most international climate finance directly through national institutions, and helping climate funds understand how NDBs operate to facilitate access to more funding sources.⁴⁶ MDBs can help stabilize financing through policy consultations and direct financing when volatility and uncertainty in financial markets are high, as in the current context of monetary policy tightening in AEs. More climate financing resources could be channeled through MDBs by increasing their capital base and reconsidering their approaches to risk appetite through partnerships with the private sector supported by governance and management oversight.

MDBs can facilitate to tailor debt issuance to local contexts, ensure country ownership, and support development of local bond markets.⁴⁷ In assisting countries to issue green, social, and sustainability (GSS) bonds and SLBs, MDBs should explore the opportunity to align them with local climate transition paths. SLBs can contribute to enhance the role debt markets play in encouraging companies to participate in sustainability investments. Sovereign issuers can also issue green, social, sustainability, and sustainability-linked (GSSS) bonds partnering with MDBs. In addition, MDBs can support the development of local bond market infrastructure to provide a foundation for capital market depth and liquidity, and thus encourage further issuance of GSSS bonds and other debt instruments.⁴⁸

The low-carbon transition requires the transformation of urban, transport, and infrastructure systems. Such large-scale transformations would likely involve a variety of financial instruments, including equity investment, policy-based financing, early-stage risk capital, and guarantees, as well as capacity development. The World Bank has identified some levers to deploy climate finance, including financial sector reform to “green” capital allocation (for example, regulations for green bonds and loans), sectoral policies (such as energy efficiency standards, building codes), and innovation and technology transfer (for example, R&D support).⁴⁹ These levers require managing political economy challenges, with an emphasis on just-transition issues, such as mitigating adverse distributional consequences of the net-zero transition.

MDB support for NDBs could play an important role in scaling up climate finance. In many EMDEs, insurance and capital markets are thin or do not exist, making the coverage of key risks expensive. Hedging instruments typically have short tenors in many EMDEs, making hedging of a project over its lifetime difficult and costly during crises, in part because of procyclicality in the financial system. MDBs could help manage domestic systemic risks that are likely idiosyncratic from a global perspective, including political, currency, and natural disaster risks. This approach should in principle enable the diversification and thus risk insurance.

MDBs could also help to address governance and fiscal risks associated with the provision of financing by NDBs. For instance, to address fiscal risks from the allocation of excessive subsidies, MDBs could require that NDBs use auctions in which quantities are set and contracts awarded to the lowest bidder and strengthen governance by benchmarking financing to projects in similar countries and industries. In addition, MDBs could create portfolios of short-maturity projects from a range of countries, which could be securitized and sold to international investors to diversify risk internationally. MDBs could provide insurance, as they have a greater ability to diversify risks. Finally, increased provision of funds from MDBs to NDBs could increase NDBs’ ability to use a wider range of instruments and lend to sectors that are considered riskier.⁵⁰

Public-Private Risk Sharing in Scaling up Climate Finance

The public sector could play a powerful role in reducing constraints and catalyzing private sector climate financing. The public sector can align incentives with climate objectives through regulations, taxations, guarantees, subsidies, and disclosure requirements, thereby helping induce collective action, including from other stakeholders. Addressing climate change requires many changes in the economy, requiring close coordination across stakeholders and sectors, especially in EMDEs, with a wide range of market failures beyond the climate externalities. Without pricing mechanisms for climate externalities, under-investment in climate infrastructure would likely persist, placing achievement of the Paris Agreement temperature objectives at risk.

Project-based funding channeling public and private financial resources to infrastructure projects can bring positive climate impacts. Often, blending public finance with private sector capital, as discussed above, is useful to de-risk these investments for the private sector investors. By doing so, investments that benefit from public sector support essentially help internalize the social benefits of climate investment. Project-based financing can also target investments that are especially under-provided or have important positive spillover effects. However, limited public financial resources together with the financial constraints faced by many private sector investors may limit rapid scaling up globally for project-based financing.⁵¹

Potential ways for the public sector to reduce investment costs include the following:

• Providing public equity capital in combination with private sector debt investment can reduce the total cost of borrowing and give the public sector control over investment decisions, although this would not necessarily be the case if the public sector holds an equity stake in a private asset. The MDBs have a potential role to play as intermediaries for providing public equity.

• Establishing public-private partnership investment can take down the total cost of borrowing to allow the private sector to make better investment decisions and avoid loss-making projects, taking advantage of public sector expertise in project selection, monitoring, evaluation, and capacity development.

• Improving information asymmetry can allow the private sector to have better project evaluation and thus improve project selection and monitoring costs. The public sector and MDBs could leverage their expertise in these areas, as well as provide capacity development.

• Underwriting specific risks, such as project completion or political instability can ease high-risk premiums for the private sector.

• Providing multi-sovereign guarantees can help achieve higher leverage ratios, for example, through multi-country sovereign-backed guarantee funds.⁵²

• Public investment management and procurement policies for supporting private sector climate finance can help to attract additional capital. Wind and solar technologies benefited from early public investments and technology diffusion that enhanced technology maturity. Frontloaded public finance can help minimize risks for future private investment.

Public equity capital provision and public-private partnership investment imply potentially large public debt increases through the crystallization of contingent liabilities. To address this risk, hard limits on the state’s contingent exposure could be considered. For instance, Uruguay’s public-private partnership (PPP) law caps the state’s total PPP liabilities and fiscal transfers to private operators to 7 percent and 0.5 percent, respectively, of the preceding year’s GDP.

Several specialized facilities have been established to provide funding for climate-related projects in EMDEs. These financing facilities often receive funding resources from governments and provide financing options at concessional terms. A few prominent examples include the Climate Investment Funds (CIF), the Green Growth Equity Fund, the Green Climate Fund (GCF), and IFC’s Managed Co-Lending Portfolio Program (Box 2).

The public sector could take equity tranches, which may result in first-loss positions, or provide credit enhancements that would lower the cost of investment by reducing risk to the private sector. By taking an equity position in climate investments, the public sector would bear most of the investment risk, but it would realize gains if investments were successful. A good example of such an arrangement is the Amundi Planet Emerging Green One (EGO) Fund (Box 3). The public sector could choose to accept below-market returns for the risk it takes in return for positive climate outcomes, thereby significantly lowering the cost of capital to potential borrowers. This in turn would allow investments to rise closer to an efficient level. Such an arrangement might also attract additional private sector capital with a lower risk appetite. This would obviate the need for direct private sector subsidies if risks were priced appropriately, and if funds were managed by well-equipped fund managers who are able to avoid credit defaults thereby preserving the first-loss protection provided by the public sector.

A fund structured with public sector equity and private sector debt provides further scale and diversification benefits.⁵³ The riskiest first loss (or equity) tranche would typically be held by public sector investors, junior debt (mezzanine tranche) by public and private sector investors, while the lower-risk senior (investment grade) and super-senior (AAA-rated) debt tranches would be targeted at private sector investors. It is this risk transfer that would allow the fund to attract private sector participants who are seeking high credit quality investments. A pooled structure allows investments at scale by eliminating the need for costly risk-sharing arrangements in individual investments (as may be seen in typical public-private partnerships arranged at individual debt transaction levels). Another good example of this arrangement is the Green Credit Continuum (GRECO) program (Box 4), which focuses on channeling capital to underdeveloped segments in the European green fixed-income market. How sensible an equity tranche held by the public sector is and how much risk the public sector would accept again depends critically on the degree of carbon pricing and other mitigation policies. If these variables are not in place, the “public tranche” would be the equivalent on a nontransparent, inefficient public transfer—the type of fiscal transfer that we advise against elsewhere.⁵⁴

In addition, public development banks could invest more and help mobilize private sector capital into climate finance. These institutions collectively disburse about US$2 trillion per year—about 10 percent of global public and private investment, according to some estimates.⁵⁵ NDBs’ comparative advantages include knowledge of the local investment landscape, long-term relationships with the local private and public sectors, sectoral and project expertise, knowledge of domestic development needs, and in some cases the ability to fund non-transformative projects.⁵⁶ Thus, NDBs and MDBs could take on the role of catalyzing private sector finance through strengthening five mutually reinforcing capacities: (1) financing low-carbon and climate-resilient development, (2) mobilizing external finance, (3) blending international climate and public development finance with their own resources to scale up private sector investment, (4) influencing policies to help shape policy frameworks to attract green private investment, (5) developing pipelines of projects and new technologies to demonstrate commercial viability, and (6) providing capacity development and project monitoring. A concrete example of how NDBs and MDBs could take on the role of catalyzing private sector finance for low-carbon development is provided in a case study offering economic justifications for and quantitative estimates of the climate financing needed to replace the most polluting fossil fuel, coal, with renewables (Box 5).⁵⁷

Existing initiatives need to be scaled up to significantly shift capital allocation towards green projects. Specialized funds using public money in high-risk positions, including Amundi EGO Fund, the Climate Investment Funds, and the Green Climate Fund added up to less than US$20 billion in investments in 2021. Although somewhat larger in scope, green bond issuance at US$100 billion in EMDEs in 2021 remains particularly small compared to investment needs. Moreover, most financial flows are not “green,” implying an overall inconsistency between financial flows and the goals of the Paris Agreement and thereby contradicting Article 2 of the Paris Agreement, which calls for “making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.” As the market size for climate and sustainable finance remains small, recent growth in green finance may largely reflect the green labeling of existing projects. Therefore, the link between the development of climate and sustainable finance and growth in activities that are actually aligned with the temperature and adaptation goals of the Paris Agreement should become stronger if financial flows become consistent with a pathway towards low-carbon, climate-resilient development.

Debt relief could create policy space for climate related investments, and thus enhance the credibility of EMDEs’ mitigation plans, but must focus on restoring a sustainable position. Debt distress can indirectly lead to the entrenchment of extractive growth models and the lock-in of emissions. For instance, some Latin American economies faced with external debt pressures and large hard currency needs have resorted to opening foreign direct investment inflows into extractive sectors, undermining their mitigation efforts. With about 60 percent of the 73 countries eligible for the G20 Debt Service Suspension Initiative (DSSI) in 2020–21 at high risk of or already in debt distress,⁵⁸ linking fiscal space to carbon lock-in poses a risk to the credibility of climate finance ambitions in these countries. However, debt relief should focus on restoring a sustainable public debt position. The Intergovernmental Panel on Climate Change (IPCC) has noted that to ensure fiscal space for climate action and reduce dependency on capital markets, debt relief, deferrals of liabilities, new solidarity structures and higher levels of bilateral and multilateral lending need to be considered.⁵⁹ The possibility to link the extent of debt relief to climate achievements or commitments of indebted countries could be explored.

Where countries, particularly EMDEs, have limited fiscal space, the IMF Resilience and Sustainability Trust (RST) financing could help play a catalytic role to attract private investments. The IMF’s engagement could help improve countries’ policy frameworks and allow them to access other sources of climate finance in equity and debt. The RST extends the IMF’s existing lending toolkit to longer-term lending programs associated with climate change. There is potential to leverage the RST loans to catalyze private sector investments for climate-related finance.

The public sector can play other meaningful roles.

• Through regulation of the sustainable finance bond market, the public sector can help better standardize the public debt market. Well-crafted standardization will enable lowering sustainable bond transaction costs for issuers and investors and facilitate the creation of specialized data bases, which can guide investors through better quality publicly available information dissemination.

• The public sector can disseminate sustainable finance best market practices through case studies, release research as a public good, and provide training curriculum adapted to EMDEs’ needs.

• Large global institutions like the World Bank and the IMF can partner with global data base providers to supply them with regularly updated macroeconomic and climate-related data, adapting the data and make them accessible by the public in a well-packaged manner. The IMF already started publishing the Climate Change Indicators Dashboard that includes some indicators related to climate financing.

• The public sector can play a role in sustainable finance information quality verification, for example by supervising second opinion providers on GSS bonds use of proceeds (as is already being done in China) and monitoring of impact indicators on the step up/stop down of SLBs.

• MDBs could design and monitor KPIs in collaboration with national authorities and/or civil society. For instance, a proposal from Finance for Biodiversity Initiative (F4B) is to develop a Nature and Climate Sovereign Bond Facility hosted by international institutions.

Policy Considerations

There are several climate finance policy levers that government can use to help attract private sector capital in climate investment. The IMF can play an important role in this regard through its instruments, including surveillance, capacity development, risk assessments, and climate diagnostic tools. In addition, the RST can act as a catalyst in leveraging private sector financing, although its implementation will be gradual with a few pilot cases to begin with. For example, advanced economies can underscore the importance of public equity investments as a way of delivering on their annual US$100 billion commitment to EMDEs. Equity stakes allow the public sector to share in the upside, but they also help to leverage private capital in the largest way. This would be particularly helpful given that most EMDEs already have too much debt.

Announcing and implementing policies, including carbon pricing paths, can be important government objectives. First-order policy objectives can include closing climate-related data gaps, improving data disclosures, overcoming various externalities, incentivizing R&D, and addressing carbon pricing gaps. Many sectors are characterized by a low responsiveness of emissions to carbon prices. In these cases, carbon pricing needs to be complemented by other policies, for example supporting sectoral policies (for example, building standards), as well as large-scale public investments.

An important role for the public sector is to invest in infrastructure that will support and incentivize low-carbon private sector investments. There are widespread coordination failures associated with multiple complex systems from the part of the private sector, especially in LICs and EMDEs.⁶⁰ Public investment in infrastructure could support the integration of new technologies, including in electricity grids, charging stations, public transport, broadband, and urban planning, as in many countries utilities are mostly public-sector owned, emphasizing the importance of public investment in low-carbon infrastructure.

The public sector could provide leadership in improving data quality, closing data gaps, fostering data disclosure standards, and developing relevant taxonomies. A strong climate information architecture should comprise of high-quality, reliable, and comparable data; a globally harmonized and consistent set of climate disclosure standards; and globally agreed principles for climate finance taxonomies and other taxonomy approaches to align investments with climate goals. This could facilitate more accurate market pricing of risks, enable more informed investment decisions, and foster the growth of climate finance.⁶¹ In the absence of harmonized data, based on internationally accepted methodologies, information asymmetries among investors would continue to impede the allocation of risks. However, better disclosures may not be sufficient to ensure that financial flows are consistent with climate goals.⁶²

Developing a robust greenhouse gas (GHG) accounting methodology based on gross emissions is critical to ensure the environmental integrity of impact reporting. Accounting methodology and standards can be developed by financial reporting standard setting bodies, such as for example International Accounting Standards Board or its equivalent, in collaboration with the IFIs. The ICMA Climate Finance Transition Handbook is an important reference for climate finance for MDBs to help carbon-intensive companies with their low-carbon transition.⁶³ To generate globally consistent climate disclosure standards, it will be desirable to develop a standardized GHG accounting methodology based on gross (absolute) emissions, as what matters from a climate and tipping point perspective is absolute emissions, rather than avoided emissions.⁶⁴

The public sector could elevate commitments and coordination with the private sector. Immediate, credible, and verifiable commitments, as underlined in proposals from the Framework for Sustainable Finance Integrity, are essential to the achievement of real economy impacts.⁶⁵ Coordination across public and private financial institutions could help ensure coherence and impact on mitigation and adaptation goals and alignment with the science. Government collaboration with other stakeholders could help by setting roadmaps, developing strategies, and convening stakeholders.⁶⁶

EMDEs need to achieve high-quality, low-carbon, and climate-resilient economic development through mitigation and adaptation transition. The next decade will be crucial for EMDEs investment in urban, energy, transport and other systems.⁶⁷ Even if private sector climate finance flows rose rapidly and reached desirable levels, political economy factors could translate into an increase in rent-seeking and “white elephant” projects, rather than climate-compatible investments.⁶⁸ Redirecting spending and foreign investment to climate-compatible solutions would require governments to reform policies and regulations in all sectors.⁶⁹ Therefore, political economy considerations could be considered in policy strategies and the climate finance agenda to reach desired climate goals. Depending on a country’s political and institutional context, building new institutions, creating bespoke institutions, or revamping existing ones could be required.⁷⁰

To make climate finance effective, country authorities could pay attention to social implications. The transition from business-as-usual pathways to deep decarbonization pathways would most likely generate localized costs, which can be large, and which could disproportionately impact some segments of society, industries, workers, communities, and regions. These impacts underscore the importance of “just transition” policies. Climate finance can help create an enabling environment for smoothing the transition and supporting essential policies. For instance, data on localized climate impacts and opportunities can help compensate adversely affected segments and population groups.⁷¹ It is also important to design redistribution measures to address the social and labor market impacts of mitigation policies and strengthen financial regulations to contain risks from stranded assets.⁷²

Thoughts on Future Policy Work and Analysis

As noted above, there are several constraints to private sector climate finance for mitigation and adaptation. It would benefit policymakers, researchers, and financial sector participants to focus on key constraints and reasons for high investment risks and risk premiums identified for mitigation and adaptation projects, as well as overall scarcity of investable projects with a view to finding solutions to overcoming them. These include (1) long investment time frames; (2) high upfront capital and transaction costs; (3) significant project and/or country risk; (4) limited familiarity with specific geographies; (5) lack of formalized and specialized investment channels because of political, regulatory, and macroeconomic instability; (6) physical climate-related financial risks; and (7) an uncertain governance landscape.

There are also multiple economic and non-economic risks highlighted in the note whose materialization could significantly hinder the scaling up of private climate financing. Policymakers and financial industry practitioners should discuss such risks and come up with a mutually beneficial strategy to mitigate and reduce them. Solid and scalable investment ideas are as important as important as de-risking. In this regard, a program of proven investment ideas could be one of the potential answers.

Private sector involvement in adaptation finance has been low. Granularity in identifying specific constraints to mobilizing private sector finance for adaptation would help evolve specific solutions. It would be good to identify and segregate specific adaptation projects that are suitable for large-scale private sector investments, and those projects of public good nature meant largely to be financed by the public sector.

The private sector could help the public sector make the politically difficult case for carbon pricing. For example, the transparency, accountability, and credibility of net zero commitments by the financial sector could be strengthened by the clear articulation of their commitments with regard to, for example, portfolio objectives, specific financing goals, interim target, and how they are planning to operationalize and meet their commitments.

ESG investing may become more effective in supporting decarbonization, but significant hurdles remain. However, we should ensure mechanisms to avoid “greenwashing” and make a significant shift in investment and financing allocation towards the substantial reduction of greenhouse gas emissions. A question that remains open is whether the mixing of E, S, and G criteria poses structural and/or insurmountable issues for effectively driving decarbonization. The E component is central to the deployment of ESG strategies in a world facing planetary boundaries. ESG scores—overall, as well as on the environment components—do not reflect differences in firms’ contributions to climate change.⁷³ High-quality data, disclosures, and interoperable taxonomies can play a crucial role.

Public-private risk sharing can become more attractive to the private sector, possibly including through an ABS-type vehicle. An important question is what mechanisms to use—credit enhancements versus coinvesting versus specific risk guarantees. Public-private sector synergy should develop the best way to structure risk sharing in an ABS-type instrument. For example, a public co-investor in the equity tranche could improve private sector confidence and potentially investment outcomes. A question here is whether there would be significant market demand for private sector mezzanine/senior tranches if the public sector provided only equity/junior funding. In addition, it would be important to develop pricing mechanisms for first loss guarantees by the public sector.

Expectations of the size of availability of private sector funding need to be managed, given the nonlinearities in size among private investors. There could be risks that scaling up private sector funding at a global level may not be possible to operationalize. Therefore, it is possible that, to be more realistic, the scaling up of private sector funding should be managed at the country or sub-country specific project or portfolio of projects-level through pilot programs.

Public sector governance structure and policies need to be strong to get the private sector to participate in climate finance more actively. In particular, the private sector would need to have confidence in risk management, particularly in complex financial structures. Specific public policies should be developed to generate the needed trust and confidence for the scaling up of private sector climate financing.

MBDs can support NDBs in scaling up climate financing in EMDEs and LICs, in addition to country authorities. Given the lack of investable projects, it would be important to develop pipelines of projects, demonstration projects, and new technologies to demonstrate commercial viability.

Several financial issues remain relevant: (1) What is the appropriate duration for public sector funding? Will the long-term capital lockups that may be necessary to match project duration deter private investment at scale? (2) While public credit enhancements might be necessary to overcome externalities, are they necessary to attract private sector investors? (3) How can liquidity be built in this space, and is it important and/or does liquidity generate its own set of risks, such as volatility and capital flight? Would ratings be challenging to conduct given the desire for untested scale? Are multiple vehicles necessary? (4) What are policymakers and financial practitioners’ views on the “greenium?” Can a “greenium” enhance investment returns? What should be done to make it happen?