Public Sector Must Play Major Role in Catalyzing Private Climate Finance

IMF Blog, August 18, 2022

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Climate change is "one of the most critical macroeconomic and financial policy challenges that IMF members face in coming decades."
Investment needs:
- Estimates range from $3 trillion to $6 trillion per year until 2050.
- Current level at about $630 billion is "just a fraction" of what’s needed, with "very little" going to developing countries.
Financial resources available:
- $210 trillion in financial assets across firms, or roughly twice the gross domestic product of the entire world—implying potential to redirect large shares to climate mitigation and adaptation.
Recent shocks (spikes in the cost of fuel and food) underline the urgency of investing in green energy and resilience to shocks.

Core problem: incentives. Investors have alternative return opportunities, including fossil fuels in the absence of robust carbon pricing.
Specific barriers for climate projects, especially in emerging market and developing economies:
- High upfront costs.
- Multiple technical challenges and unproven business models.
- Long time horizons.
- Poor data and climate information gaps.
- Currency fluctuation risks and adverse macroeconomic conditions.
- Unpredictable business environments and perceived political instability.
Market structure and investor behavior:
- Many climate opportunities cannot secure sufficient financing; those that do tend to attract a small pool of specialized investors demanding high returns in a relatively illiquid asset class.
- Debt is the main instrument for financed climate projects.
- Evidence that large investors screen out companies with a market capitalization of below $200 million, a threshold few renewable energy companies clear.
- Cost of equity for climate investments for impact investors is in the 12-15 percent range in frontier emerging market and developing economies—likely higher for commercial investors.

Principle: change incentives for domestic and foreign investors through coordinated action across public and private sectors.
Public sector roles and instruments:
- Blending public and private finance to de-risk investments (examples: first loss investments, performance guarantees).
- Public equity investments to absorb downside risk and share upside when projects succeed.
- Credit enhancements to improve project creditworthiness and lower private costs.
Role of multilateral development banks:
- Already major providers of climate finance, especially debt which makes up more than two-thirds of the $32 billion disbursed in 2020.
- More innovative use of equity could help leverage additional private capital and assist heavily indebted emerging markets and developing economies.
Other instruments and mechanisms:
- Public-private partnerships.
- Multi-sovereign guarantees to achieve higher leverage ratios.
- Underwriting specific risks (project completion, political instability) to reduce high-risk premia that impede private capital.
Caution and limits:
- Risks of large public debt increases through crystallization of contingent liabilities.
- Suggestion: hard limits on state exposure should be appropriately judged.
- Example: Uruguay 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.

Implement robust and predictable carbon pricing to:
- Generate incentives for private investment in low-carbon projects.
- Promote a more transparent market and enable informed investor decisions.
Build a strong climate information architecture to improve decision-making and risk pricing and to prevent "greenwashing":
- High-quality, reliable, and comparable data and statistics.
- A globally harmonized and consistent set of climate disclosure standards.
- Globally agreed principles for climate finance taxonomies.
The IMF engaged in discussions and co-authored a report for the Network for Greening the Financial System on urgent steps to bridge climate finance data gaps.

Modes of IMF contribution:
- Surveillance.
- Capacity development.
- Financial sector risk assessments.
- Climate data and diagnostic tools.
Programs to promote climate-friendly management of public finances and public investments:
- Promote accountability, transparency, and more effective spending.
- Increase domestic revenues and mobilize external funding from donors and the private sector.
Support for fiscally constrained countries:
- The new IMF Resilience and Sustainability Trust could help, with a focus on longer-term structural changes such as climate change, and is expected to play a catalytic role to create a conducive investment environment.
Analytical work:
- A forthcoming analytical chapter of the October Global Financial Stability Report will examine financial markets and instruments for scaling up private climate finance in emerging market and developing economies.

Source: Kristalina Georgieva and Tobias Adrian, August 18, 2022. Public Sector Must Play Major Role in Catalyzing Private Climate Finance, IMFBlog.

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