Emerging Economies Need Much More Private Financing for Climate Transition

IMF Blog, October 2, 2023

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Authors: Prasad Ananthakrishnan, Torsten Ehlers, Charlotte Gardes-Landolfini, Fabio Natalucci
Published: October 2, 2023

Investment needs and scale

Achieving the transition to net-zero emissions by 2050 requires substantial climate mitigation investment in emerging market and developing economies, which currently emit around two-thirds of greenhouse gases.
These countries will need about $2 trillion annually by 2030 to reach that ambitious goal, according to the International Energy Agency.
This $2 trillion annual need is a fivefold increase from the current $400 billion of climate investments planned over the next seven years.
The majority of that funding is expected to flow into the energy industry.

Role of the private sector and projected shares

Growth in public investment is projected to be limited; the private sector will therefore need to make a major contribution.
The private sector will need to supply about 80 percent of the required investment.
When China is excluded, the private sector share rises to 90 percent (as shown in an analytical chapter of the Global Financial Stability Report).

Key barriers to private climate finance in emerging markets and developing economies

Domestic financial market underdevelopment in many countries limits the ability to deliver large amounts of private finance.
Lack of investment-grade credit ratings in most major emerging market economies and almost all developing countries deters institutional investors that often require such ratings.
Few investors have experience in these countries and are able to take the higher risk.
Phasing out coal power plants is a major challenge:
- Coal is the single largest source of global greenhouse gas emissions (about 20 percent).
- Most power plants in emerging market and developing economies are relatively young, so retiring or re-purposing them requires large amounts of private investment and public support.
- Some countries are highly dependent on coal and would need to develop alternative sources of energy relatively quickly.
Climate policies and commitments at most major banks are still not aligned with net-zero climate targets, even when they have policies intended to reduce emissions.
Sustainability-focused investment funds are growing, but:
- Only a small portion of such funds explicitly aim to create a positive climate impact.
- The much larger number of funds that make investment decisions based on environmental, social, and corporate governance (ESG) factors don’t necessarily focus on climate issues.
- ESG scores used in portfolio allocations aren’t necessarily designed to reflect climate impact.
Lower-middle-income and low-income countries are generally not rewarded for good environmental and climate policies:
- Credit rating agencies' assessments fall short of fully reflecting these countries’ preparedness for a low-carbon transition or their exposure to stranded asset risks because of high levels of hydrocarbons.
- The financial industry lacks clarity on what constitutes good sovereign performance on environmental issues.

Policy mix to unlock private finance

Carbon pricing can provide an important pricing signal for investors but faces political hurdles when implemented on a broad-enough scale.
Structural financial sector policies are necessary, including:
- Strengthening macroeconomic fundamentals.
- Deepening capital markets.
- Improving governance.
- These policies can help improve credit ratings, lower the cost of capital, and increase domestic financial resources.
Investors require better climate-related data to make investment decisions.
Innovative financing solutions to initiate a managed phase out of coal power production should be employed, such as blended finance and securitization instruments.
More extensive public–private risk sharing is critical while longer-term reforms take effect:
- Multilateral development banks and donors can play an important role in supporting blended finance, including through a more extensive use of guarantees.
Transition taxonomies should:
- Consider activities with potential for significant improvements in emissions over time and across sectors, including carbon-intensive sectors such as steel, cement, chemicals, and heavy transportation.
- Connect emission reduction targets and criteria to a country’s nationally determined contributions, long-term strategies, and decarbonization targets for specific industries.
Use of sustainability labels:
- Current use is still lax.
- Regulators and supervisors should set clear rules, tighten enforcement, ensure disclosures and labels for sustainable investment funds effectively enhance market transparency and market integrity, and ensure better alignment with climate objectives.

Policy focus and timing

Many recommended policies will take time to implement and achieve intended effects.
In the interim, public–private risk sharing and blended finance mechanisms are critical to foster private climate investments in emerging markets and developing economies.

Role of IMF tools

The IMF Resilience and Sustainability Facility can help by bringing together governments, multilateral development banks, and the private sector to foster the financing of climate investments.
The facility’s total size is $40 billion.
Though $40 billion is small relative to global climate investment needs, reforms supported by the facility can help attract more private climate finance.

This blog is based on Chapter 3 of the October 2023 Global Financial Stability Report. Chapter authors are Torsten Ehlers (co-lead), Charlotte Gardes-Landolfini (co-lead), Ekaterina Gratcheva, Shivani Singh, Hamid Tabarraei, and Yanzhe Xiao, with guidance from Prasad Ananthakrishnan and Fabio Natalucci. Markus Brunnermeier was an expert advisor.