The public sector must play a major role in catalysing private climate finance
Kristalina Georgieva and Tobias Adrian
Kristalina Georgieva and Tobias Adrian
Climate change is one of the most critical macroeconomic and financial challenges that IMF members will face in the coming decades. Recent spikes in the cost of fuel and food, and the resulting risks of social unrest, highlight the importance of investing in green energy and building resilience to shocks.
This 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 of around $630 billion is only a fraction of what is really needed, and very little goes to developing countries .
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This is why we need a major change to mobilize public and, above all, private financing. With $210 trillion in financial assets in businesses, roughly double the gross domestic product worldwide, the challenge for policymakers and investors is how to direct much of those assets to mitigation projects. and adaptation to climate change.
What’s stopping more money from flowing to climate projects outside of advanced economies?
Incentives are at the heart of the problem. Investors have many alternative options for generating returns, including fossil fuels in the absence of strong carbon pricing. And currently, green projects in emerging markets and developing economies simply don’t justify the risks.
For example, 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, the risks associated with currency fluctuations, macroeconomic conditions, an unpredictable business environment and the perceived potential for political upheaval.
As a result, many climate opportunities cannot obtain sufficient funding. Those that do are more likely to attract a small group of specialist investors demanding high returns in a developing and relatively illiquid asset class, with debt being the primary instrument.
This is particularly the case for renewable energy companies, which operate in illiquid markets and have long-term financing needs. For example, there is evidence that large investors screen out companies with a market capitalization below $200 million, a threshold that relatively few renewable energy companies cross. And the return the market expects in return for owning the asset and assuming the risk of ownership, called the cost of equity, for climate investments for impact investors is on the order of 12 15% in emerging and developing frontier economies. This suggests it could be even higher for commercial investors.
Unlocking private sector financing
These obstacles are not insurmountable. But addressing this, in order 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 from country to country depending on the specific characteristics of each country and the local economic and institutional context. The combination of public and private sector financing is useful in reducing the risks of such investments to private sector capital in general, for example through first-loss investments or performance guarantees.
For example, the public sector could invest equity – which carries higher risks if the underlying asset loses value – or provide credit enhancements to improve the creditworthiness of projects. Both would reduce the cost of investment by reducing the risks for the private sector. By taking an equity stake in climate investments, the public sector would bear much of the investment risk, but they would also see upside benefits when the investments are successful.
Multilateral development banks will play an important role in this type of arrangement. They are already major providers of climate finance, particularly debt which accounts for more than two-thirds of the $32 billion disbursed in 2020.
More innovative approaches, such as equity investments, would help mobilize more private capital and would be particularly useful for the many emerging markets and developing economies that are already heavily indebted.
Other financing instruments will also have a role to play.
Consider public-private partnerships or multi-sovereign guarantees that achieve higher leverage ratios. And hedging against risks related to specific factors such as project completion or political instability can be particularly useful in mitigating the high risk premiums that inhibit private capital.
Of course, all of these tools should be deployed with care.
One of the main pitfalls is the potentially large increase in public debt due to the crystallization of contingent liabilities, so strict limits on government exposure must be judged appropriately. In Uruguay, for example, a law caps total government debt under public-private partnerships and fiscal transfers to private operators at 7% and 0.5%, respectively, of the previous year’s GDP.
The role of politics
Beyond financing, governments can use several policy tools to help attract private sector capital to climate opportunities.
A first priority is robust and predictable carbon pricing. This would help generate incentives for private investment in low-carbon projects, promote a more transparent market, and allow investors to make informed decisions in different markets.
The public sector can also play a leadership role in building a robust climate information architecture to further improve decision-making and risk pricing, as well as prevent greenwashing. “. Ideally, this would include high quality, reliable and comparable data and statistics; a globally consistent and harmonized set of climate disclosure standards; and globally agreed principles for climate finance taxonomies.
Kristalina Georgieva is Managing Director of the IMF and Tobias Adrian is Financial Counselor and Director of the IMF’s Monetary and Capital Markets Department.