Read this article to understand:
- Why multilateral development banks need urgent reform
- The role countries, investors and other parties must play to unlock finance for emerging markets’ climate transition
- The need for a new international financial architecture
Ahead of COP27, a November 2022 report of the independent high-level expert group on climate finance found that to achieve net zero by 2050, $2.4 trillion a year must flow to emerging markets, excluding China, and developing economies, by the end of the current decade (see Figure 1).1
Figure 1: Investment/spending needs for climate action per year by 2030
Source: Grantham Research Institute on Climate Change and the Environment, London School of Economics and Political Science, November 2022.2
“About 60 per cent of that should be raised from their domestic resources, which is why debt sustainability is such a big question for many of those countries,” says Thomas Tayler, head of climate finance at Aviva Investors. “Where they have national pools of assets, pension funds and stock exchanges, that domestic resource must provide the majority of financing, but mobilising domestic capital can send signals about investability to attract the private capital needed.”
The climate finance report estimates emerging markets and developing countries need to mobilise at least $1 trillion of private capital a year by 2030 from different parts of the financial system, domestic and international.3
Tayler says this is where the role of multilateral development banks (MDBs), and public banks in general, becomes so important. Investors and countries need to understand what each participant can finance and how much it leaves for private markets to cover, so they can assess the challenge (Figure 2).
Figure 2: Building a capital stack for climate finance
Note: For illustrative purposes only. This is a mock-up of the concept and is not based on a comprehensive mapping.
Source: Aviva Investors, October 2023.
However, although the World Bank recently adopted a new mission to “eradicate poverty on a liveable planet”, MDBs and other public banks are currently judged against development goals, not on leveraging private finance.4 They must be reformed, to lend more of their own capital to developing countries and maximise their ability to draw in private finance.
To this end, in June 2023 the G20 independent expert group recommended implementing a triple agenda of MDB reform: “(i) adopting a triple mandate of eliminating extreme poverty, boosting shared prosperity, and contributing to global public goods; (ii) tripling sustainable lending levels by 2030; and (iii) creating a third funding mechanism which would permit flexible and innovative arrangements for purposefully engaging with investors willing to support elements of the MDB agenda.”5
Unlocking private capital will also require countries and all players in the financial system to overcome several challenges and draw up a raft of solutions, including reform of the international financial architecture.
Barriers to investment
At the crux of the issue is the cost of capital, exacerbated by the typically high upfront investment costs of low-carbon energy projects such as wind or solar farms, batteries and electric vehicles. The climate finance report estimates that, for example, given Germany’s AAA rating, a solar project there only needs to deliver a seven per cent return to be profitable, while one in Argentina, rated CCC+, would have to deliver 52 per cent (Figure 3).6
Figure 3: Return expectations from solar projects
Source: Grantham Research Institute on Climate Change and the Environment, London School of Economics and Political Science, November 2022.7
“How can we provide financing so that if a developing country has a choice between exploiting fossil-fuel assets and going down a path of renewables, they're incentivised to go down the path of renewables? That is the multi-trillion-dollar question,” says Tayler. “They will ultimately do what makes most sense economically.”
Some of the barriers to reducing the cost of capital and making mitigation and adaptation investments more attractive for investors and developing countries are technical, including foreign exchange risk.
Others are linked to the size of many projects, which can be too small for institutional investors. Some jurisdictions’ poor basic infrastructure, political instability and lack of cooperation across borders and with non-governmental institutions also create a more difficult environment to invest in.
“Insufficient data availability and lack of expertise lead to limitations in data analysis and project preparation,” says Carmen Altenkirch, emerging markets sovereign analyst at Aviva Investors. “As well as funding, emerging markets require the technical capacity and expertise to channel funding where it is needed.”
MDBs have a clear role to play in helping to de-risk investments, but also in providing technical assistance to overcome these barriers.
Regulatory, legal and institutional frameworks exacerbate the issues. For instance, Solvency II requirements for insurance companies to hold more regulatory capital for riskier assets overwhelmingly push insurers towards developed-market sovereign debt and investment-grade credit.
“Ratings provide an important reference point for investors to assess country risk,” says Altenkirch. “This is a disadvantage for poor countries that might not have the technical expertise to engage with rating agencies.”
Not only do regulation and ratings make it more costly to invest in emerging-market assets, they send a signal to investment and risk committees that such investments are unsafe.
“There is not a huge raft of unfulfilled mandates seeking investments in emerging markets that can suddenly be achieved if the risk-return profile shifts a little,” says Tayler. “However, it is also true that shifting the risk-return profile will start to attract private capital. It is also a question of mindsets, and there is a need to shine a light on what is working well to change those, because Africa is not un-investable. Companies are happy to go and invest in the things they are familiar with there, like oil or coal.”
Platforms and collaboration are essential
MDBs have a unique role to play in reassuring investors and combining public and private financing most effectively.
MDBs should review their own risk appetite to unlock additional funds they have
To increase their own allocations to developing countries, they must update and expand their mandates to include the financing of global public goods and the protection of the global commons, alongside their development goals.8 They should also review their own risk appetite to unlock additional funds they have. However, given the sums at play, they may need an injection of fresh equity too.9
To unlock private capital, MDBs must mitigate the real and perceived risks of investing in emerging markets. The Bridgetown Initiative 2.0, a set of proposals to reform the way developed countries finance emerging economies’ transition and adaptation plans, calls for the International Monetary Fund (IMF) and MDBs to cut the excessive macro-risk premia on developing countries with $100 billion per year of foreign exchange guarantees for green investments to support a just transition. It also recommends expanding the IMF and MDBs’ provision of risk-reduction and blended-finance instruments.10
The G20 independent experts group adds “coordination between private and public sector arms of the MDBs on the use of the cascade principles, guarantees, blended finance, political risk insurance, and foreign exchange hedging should be systematic rather than episodic”.11
“MDBs can provide credit guarantees or enhancements to reduce the risk of a project or bond, which may widen the investor base,” says Altenkirch. “They should also work with credit rating agencies to expand the number of countries with ratings.”
In addition, MDBs should collaborate more with public sector authorities to help build their institutional capacity, and with the private sector to share their experience and build familiarity. They also need to shift from a project to a country approach based on economic policy analysis and advice, and strong dialogue with countries including on policy, finance and capacity building. Finally, they should provide more support to countries on investment planning, project pipeline development and preparation, including on sector investment plans consistent with decarbonisation pathways.12
Lend a hand
Countries and investors also need to play their part. Working with MDBs, governments can collaborate to aggregate investment projects into opportunities large enough for institutional investors and reduce intermediation costs and risks.
“The fight for capital is likely to intensify, so emerging countries will need to work harder to attract it,” says Emilia Matei, ESG analyst, emerging-market debt at Aviva Investors. “This means pushing ahead with growth-enhancing reforms, reducing the cost of doing business and engaging with investors.”
This can also be helped by the creation of shared, standardised datasets to minimise the cost of accessing information for risk assessments in key sectors.13
In addition, credit rating methodologies need to be rethought. Given the scale of the transformation required to shift the global economy towards climate sustainability, historical analysis will lose its predictive power and should be replaced by forward-looking assessments. And, given most institutional investors’ horizons, credit ratings should begin to give views on the probability of default to maturity – which can be decades – rather than the current three-to-five-year horizons.
“Climate change is not fully embedded into ratings methodologies,” says Matei. “However, if done properly, it could highlight the countries showing ambition and commitment to the climate transition and the laggards.”
Tayler says that can help create a financial system focused on the transition and incentivise countries to improve their plans and implementation for long-term, low-emissions development.
For their part, investors should engage with MDBs and governments to identify priorities in policy reform and improve the investment environment. They should also join and build on successful initiatives, from the GFANZ regional programmes to the Climate Finance Leadership Initiative or Africa50, which drives cooperation between the private sector, governments, international financial institutions and development finance institutions to execute large projects.14
“Doing more of that will demonstrate what’s possible and show these projects can be safe and productive investments for institutional investors,” says Tayler. “That will help change mindsets.”
Towards a new financial architecture
To ensure a green and just transition, the UN and the Bridgetown Initiative 2.0 call for a restoration of developing countries’ debt sustainability, increased official-sector development lending and broader access to the IMF’s Special Drawing Rights. That will put countries on a better footing as they embark on multi-year mitigation and adaptation investments. They also call for fairer and more inclusive global trading and tax systems, so emerging economies can reap more of the benefit from international trade.15,16
Beyond this, the climate finance report encourages MDBs to support countries in the formulation of effective development and climate strategies and plans, including nationally determined contributions (NDCs) and sector decarbonisation pathways.17 Countries must take the lead in delivering essential and urgent enhancements of NDCs, but also set a clear, whole-of-government implementation plan for the transition.
“Clear, consistent policy will help attract investor capital to fund innovation, transforming entire economic sectors. Such transformations have historically tended to be exponential,” says Tayler.18 “We need a whole-of-economy response that will create a specific, time-bound, holistic plan to transition the economy to align with the Paris Agreement goals.”
Crucially, the international financial architecture must also be reformed (see Figure 4), so regulations and supervision incentivise rather than hamper investments in the just transition.19 Tayler says a comprehensive approach is needed, encompassing regulatory and supervisory bodies and standard setters, as well as MDB reform, to change the system from looking back at the last crisis to looking ahead and setting long-term goals – in other words, a transition strategy. This should also build up the system’s resilience to short-term shocks.
“The institutions that make the international financial architecture must deliver a detailed vision to align the regulation and supervision of finance with support for the 1.5°C ambition and with national plans,” adds Tayler. “They should also produce their own transition plans to guide those they regulate and supervise, using national transition plans as their cornerstone.
“Their plans should consider, be informed by and in turn inform the plans of financial institutions as well,” he says. “Integrated feedback mechanisms can help adjust and inform government decisions, avoiding short-term mistakes and over-corrections.”
Going back to mindsets, Tayler says that in addition to the moral case to establish a just and sustainable economy for future generations these investments can also be a good use of capital.
“Possibly because of the high bar set for these projects, analysis shows their default rate tends to be low. And because there are some higher risks, there are generally better returns to be found,” he says.21
Investors should urgently call for financial architecture reform and national implementation plans for the transition, but they can also start looking for opportunities without delay.
Figure 4: Proposed reforms to the international financial architecture
Development banking
- Massively scale-up multilateral development banks
- Large volumes of finance with better terms
- Operations aligned with Sustainable Development Goals
- Allocations by need and vulnerability
- Scale up climate finance with additionality
- Leverage private finance effectively
- Increase concessional finance
International tax cooperation
- Global tax norms for digitalisation and globalisation
- Inclusive tax architecture
- Simplified rules to meet developing country needs
- Significantly higher global minimum tax rates
- Transparency instruments to benefit all
- Non-reciprocity for developing countries
Financial system rules and regulations
- Strengthen regulation of finance
- Regulate banks and non-bank financial institutions
- Address short-termism in markets
- Make business sustainable
- Mandatory sustainability reporting
- Policy and regulatory frameworks to align with the Sustainable Development Goals and climate action
Global economic governance
- Transform international financial institution governance
- Reform IMF quotas and voting rights
- Delink allocation and access; allocations be based on need and vulnerability
- Improve transparency, leadership selection
- Representative apex body for economic coordination
- Coherence of all rules and frameworks with the Sustainable Development Goals
Global financial safety net
- Strengthen liquidity and widen safety net
- Bigger role for SDRs regional arrangements
- Larger IMF, but used less
- Multilateral swap facility
- Lower capital account volatility
- Macroeconomic coordination
- Capital account management
Sovereign borrowing and debt sustainability
- Debt resolution architecture
- Workout trust to support the Common Framework
- Sovereign debt authority in the medium term
- Enhanced debt markets for the Sustainable Development Goals
- Transparency
- Sustainable Development Goal and climate-proof debt sustainability analyses
- Climate-resilient debt clauses
