Climate Finance: Where Does the Money Come From and Who Gets It?

Reaching climate goals means rich countries must invest in sustainable technologies in developing countries with huge energy needs.

As you can probably attest, it’s a hot summer on a warming planet. With temperatures toppling records and climate-driven havoc unleashed around the world, humans are reminded that the climate crisis is a global problem — and the clock is ticking. Experts warn that unless countries can come together to find real solutions, climate goals will remain out of reach. Yet the common good for humanity is often elusive on the world stage, and the climate crisis is no exception despite widespread calls for international financial cooperation.

Questions about investments in sustainable technologies have surfaced in recent climate meetings, and it’s clear that wealthy countries like the U.S. and China will have to play a major role in financing climate mitigation and adaptation. They are already the largest investors in sustainable energy. Unfortunately, they are also the world’s biggest greenhouse gas emitters. So there’s that.

Nadia Ameli, an Associate Professor at University College London, studies the economic, financial, and policy aspects of climate change and related energy issues. She looks at how funds flow to programs and projects meant to address climate change across the globe, homing in on how monies from developed countries reach poorer ones so that they can meet the daunting costs of confronting climate change in the face of massive energy needs. Ameli and her colleagues point to the urgent need to direct more investment towards those less affluent nations, especially the very poorest with little access to capital and debts already piled sky-high. She stresses that rich countries can’t assume that the path to sustainability in developing ones will look like theirs. It’s time for a new understanding.

Ameli spoke to the Institute of New Economic Thinking about the financial challenges of the climate crisis, the chances of getting collective action, and a bright spot on the global climate stage emanating from a small Caribbean nation.

Lynn Parramore: This summer, people everywhere are experiencing the climate crisis in real time – from intense heat to raging forest fires to devastating crop failures. You point out that reaching climate goals depends on developing countries making investments in sustainable technologies to aid developing countries with growing economies and big energy needs. These technologies are expensive; many are capital-intensive at the start. Which types of technologies are most critical to sustainable development?

Nadia Ameli: I do believe that the investment challenge is going to be in developing countries in the future. If we look at the last estimates of current levels of investments going towards vulnerable economies, we would need to increase them by a factor of between 4 and 8 in order to reach goals by 2050. This is a huge feat. Most of those investments need to go towards low-carbon technologies.

I believe the most needed are solar and wind energy investments because they are the most available resources, and also because compared to other technologies, these have attracted major investments in terms of scale as well as a favorable policy environment. There’s a history of innovation and fantastic learning curves. Costs are coming down. Developing countries are really well-placed when we look at factors like solar radiation or wind speed. For example, Africa is a perfect place for solar radiation. Historically, hydropower has been one of the major renewable resources in developing countries, and it still plays a major role in many of them because it produces very stable energy over time, reducing fossil fuels and creating some job opportunities. But large hydropower dams have been controversial in terms of their environmental impact, the impact on biodiversity, and the resettlement of local communities. I really think the future is solar and wind.

LP: You also show that climate-related finance to developing countries is far from adequate, and of course, they are often too poor themselves to finance much. Where is the shortfall the most concerning?

NA: When we think about investments and the distribution of climate finance globally, there is a huge disparity between the developed world and the developing one. Also, when we zoom in on developing countries, most of the monies go to the upper-middle-income countries over the most vulnerable ones, which see just a few percentage points of investment compared to the others. It’s really those upper-middle-income economies, like Brazil, South Africa, and Morocco, that are getting most of the investment. This relates to the investment risks associated with a given country – the local financial environment, the macroeconomic conditions, the business confidence, policy uncertainty, and so on. When we compare, on average, developing countries across income groups, we see that they score very differently. For example, Brazil or Chile will have much stronger policy support compared to the Congo or some nations in Africa.

Generally, equity investors or financial lenders ask for higher rates of return to compensate when they perceive high investment risk in a given country. It impacts their willingness to lend. Also, when we look at the most vulnerable economies, they lack capital stock, so there is not really enough capital in these countries, as you say. The financial markets and bond markets are not well-developed, so the money can’t easily flow. Domestic finance is really constrained, and with international finance, it’s very difficult because of these high risk premiums. The result is disabling: If you want to invest in a project in the Congo, the cost of capital is 30% compared to 10% in other countries. It’s also linked to the high debt associated with these countries. International money just doesn’t land there. Some of my research shows that this applies to private capital, which we could expect, but also to public finance. Some of the public finance we examined was much more concentrated in those upper-middle-income countries compared to the more vulnerable ones. So the investment risk is also reflected in the public financial flows, unfortunately.

LP: How do you view remedies to this problem in relation to the financial sector? How should multilateral institutions and richer countries help, especially given that so many people in these countries are stressed by inflation, flat or declining incomes, and, of course, climate change?

NA: We have many overlapping challenges and there’s little fiscal space to take on new debt. I would say that’s an additional challenge on top of inflation and the other issues you mentioned. Multilateral development banks, international agencies — the World Bank, the IMF — must play a huge role. We need to reframe international financial markets, and one way to do this is by improving the financing and lending conditions. Multinational development banks need to expand their lending capacity. They need to create risk mechanisms so that they are able to target developing countries. I’m thinking, for instance, of the IMF, which recently launched the Resilience and Sustainability Trust [which provides long-term financing to countries aiming to reduce risks to prospective balance of payments stability, including those related to climate change]. These instruments need to be deployed more widely to developing countries to promote climate targets.

We could also use some reform of the macro-financial system. Among the international organizations, the IMF is the one that has the power and is well-placed to act. There’s been much talk about the IMF’s Special Drawing Rights. The Special Drawing Rights are basically international currencies based on major currencies like the U.S. dollar, the euro, the yen, the pound. The idea is to use the special drawing rights to mitigate currency risk. This way, at least you reduce the currency risk when developing countries are lending money for local investments. Currency risk is one of the major sources of risk for investment in developing countries because the currency is very volatile. That’s another way of using the macro-financial system to help.

Along these lines, we also need to promote additional capital flows that really specifically target the most vulnerable economies, especially those that are more hit by inflation and don’t have fiscal space for new debt. That means clear new mechanisms that can be deployed, for instance, when there is construction needed after a climate disaster or new instruments targeting adaptation. There are some new instruments called debt-for-climate swaps. For instance, if the U.S. is a creditor to the Congo or another vulnerable country, that country could be allowed to invest in an adaption project in the country itself instead of paying back the debt. We also need long-term loans that are fully backed by international development banks. These should help in terms of sustainable energy and improving economic resilience, and they should be able to target sustainable development.

Those are the main instruments. I think overall, it’s critical to create confidence in some countries. What I noticed in my research is that countries that have been historically able to attract more money are also those that are in a much better position to attract future funds. So we have path-dependent effects. On the other hand, those that have not been receiving money are locked into this cycle. You need to build the critical mass so that investors can say, ok, there is enough investment in the country that I can then jump in and leverage this critical mass. We need better leverage between public and private money to build this critical mass, after which investment can be mobilized at scale.

LP: What are some of the political hurdles that must be addressed to unlock flows of investment from the financial sector? Unless we get political buy-in in developed countries like the U.S., for example, we’re not going to get far on climate goals.

NA: I completely agree. Unfortunately, what I’m seeing in the U.S. and also in Europe is that the initiatives are mainly designed for the developed world. The European Union has really been developing an amazing set of tools to promote sustainable finance in terms of taxonomies and disclosure, but they’re designed for developed markets. If we think about taxonomies and disclosure, it’s hard for developing countries because they’re not really in a position to produce good data to meet those requirements. It has not been a priority to target initiatives for developing countries, but rather to redirect capital flows already in established markets, perhaps moving from one asset class to a different asset class. We have to start thinking of climate change as a global challenge with developing countries as a critical part of the story.

Sometimes it’s a problem of economic interest. We need to reprioritize what is needed for everyone and try to combine different goals at the same time and think about how we can achieve system-wide development. We might need to change narratives. Often the narrative is that the developed countries are going to teach developing countries what to do, but I don’t think that will work. Developing countries are at different stages and they can have a very different path on climate goals. If we look at the history of developing nations like the U.K. where the Industrial Revolution started, you might say, ok, now we have to decarbonize the economy. But developing countries have different resources, different needs, and different challenges. Some of those you have mentioned. In countries where much of the population doesn’t have access to energy, or face other challenges, we need to find a compromise in terms of meeting their needs and achieving sustainable development. We can’t expect them to follow the same path that the richer countries went down, say, for the last two decades. It’s a different narrative.

LP: An important aspect of the problem is the need for international coordination to attack it. If two or three large countries stay out, they can potentially wipe out the gains made by all the rest. For example, heavy users of coal or oil could just keep using them. How do we deal with this “collective good” aspect of the problem in your view?

NA: I think it’s very hard because international cooperation is really the only way through. It requires persistent efforts that can be achieved, I would say, in several ways. We need to pursue, of course, global agreements and treaties, like the Paris Agreement. That’s one way. We make sure countries are not left out and don’t feel penalized. And we need to look at the compromises. In the last COP meeting [Convention on Climate Change], we achieved some things for example the loss and damage fund, but then we let go of emissions targets or reduction of fossil fuel. There was a big fossil fuel debate.

We still need to deploy incentives and support towards financial aid through public authorities. We need capacity-building initiatives to spur economic growth. A strong incentive for international coordination is to have more trade and economic measures. So you try to incorporate climate concerns into trade agreements and economic policy because that would be an incentive for everyone to change behavior. It could be a win-win solution if we were able to implement good trade agreements and economic policies.

Another thing I see that can be very valuable are regional collaborations. If we boost or target specific countries in a region, it will promote some regional collaboration. We could try to promote best practices among these countries, but we might face the challenges that we were discussing earlier because every part of the world is quite different and regions are at different stages of economic development and might face distinct challenges. I would also say that climate diplomacy and leadership are very important.

LP: Do you see any hopeful signs on that last point? Is there anybody out there leading the way?

NA: I’m struck by what has been happening in Barbados. There you have strong leadership. through Prime Minister Mia Mottley. I would say that Barbados is bringing the debate on developing countries to another level. Barbados is a very small country at the global level, but Mia Mottley and her team are really pushing the needs of developing countries and the need to reform the global financial architecture to meet their needs. I’ve been impressed with this kind of leadership and how she is able to shift the discourse and the narrative. A couple of weeks ago at the end of June, she was at the Paris climate summit and was able to gain quite a bit of momentum in terms of injecting some of those ideas into the discussion. She’s really calling for reform of the financial system at these big events and it’s getting incorporated into the larger agenda. That’s a hopeful sign.

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