Public sector must play major role in catalyzing private climate finance

By International Monetary Fund

Public sector must play major role in catalyzing private climate finance

Climate change is one of the most critical macroeconomic and financial policy challenges that IMF members face in the coming decades. The recent spikes in the cost of fuel and food—and the resulting risks of social unrest—underline the importance of investing in green energy and boosting resilience to shocks.

It will require massive global investments to address the climate challenge and vulnerabilities to shocks. Estimates range from $3 trillion to $6 trillion per year until 2050. The current level at about $630 billion is just a fraction of what’s really needed—and very little goes to developing countries.

That’s why the world needs a major shift to harness public and, especially, private financing. With $210 trillion in financial assets across firms or roughly twice the gross domestic product of the entire world, the challenge for policymakers and investors is how to direct a big share of these holdings to climate mitigation and adaptation projects.

This is the focus of a new IMF Staff Climate Note on mobilizing private climate financing in emerging markets and developing economies. It explores the factors that limit climate finance and what policymakers can do to address them.

Constraints

What prevents money from flowing in greater volumes to climate projects outside of advanced economies?

Incentives are at the heart of the problem. Investors have plenty of alternative options to generate returns—including fossil fuels in the absence of robust carbon pricing. And currently, green projects in emerging markets and developing economies simply do not justify the risks.

For example, both mitigation and adaptation investments often come with high upfront costs, multiple technical challenges, a long time horizon, and unproven business models. Add to that poor data, risks associated with currency fluctuations, macroeconomic conditions, an unpredictable business environment, and the perceived potential for political upheaval.

As a result, many climate opportunities are unable to secure sufficient financing. Those that do 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 particularly the case for renewable energy companies, which operate in illiquid markets and have long-term financing needs. For instance, there is evidence that large investors screen out companies with a market capitalization of below $200 million, a threshold that relatively few renewable energy companies clear. And the compensation that the market expects in exchange for owning the asset and bearing the risk of ownership, termed as cost of equity, for climate investments for impact investors is in the 12-15 percent range in frontier emerging markets and developing economies. This suggests it could be even higher for commercial investors.

Unleashing private sector financing

These obstacles are not insurmountable. But addressing them—to change the incentives for domestic and foreign investors—will require coordinated and determined action across the public and private sectors.

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.

For example, the public sector could invest in equity—which brings higher risks, if the underlying asset loses value—or provide credit enhancements to improve the creditworthiness of the projects. Both 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 much of the investment risk, but it would also see upside benefits when investments succeed.

Multilateral development banks will have an important role in this type of arrangement. They are already major providers of climate finance, especially debt which makes up more than two-thirds of the $32 billion disbursed in 2020. More innovative approaches—such as equity—would help to leverage more private capital and would be particularly helpful to the many emerging markets and developing economies already carrying heavy debt burdens.

Other financing instruments will also have a role to play. Think of public-private partnerships or multi-sovereign guarantees that help achieve higher leverage ratios. And underwriting the risks from specific factors such as project completion or political instability can be particularly helpful in easing high-risk premia that serve to impede private capital. A forthcoming analytical chapter of the October Global Financial Stability Report will take a more in-depth look at financial markets and instruments in the scaling up of private climate finance in emerging markets and developing economies.

Of course, all these tools must be deployed carefully. Prominent among the pitfalls is the potentially large public debt increases through the crystallization of contingent liabilities—so hard limits on the state’s exposure should be appropriately judged. In Uruguay, for instance, a law caps the state’s total public-private-partnership liabilities and fiscal transfers to private operators to 7 percent and 0.5 percent, respectively, of the preceding year’s GDP.