The enduring challenges in mobilising green finance – Observer Research Foundation

The financial products conceptualised so far are not yet catering to the needs of the poor affected by climate change, especially at the critical interface of their livelihoods with the ecosystem services

This piece is part of the essay series, Towards a Low-Carbon and Climate-Resilient World: Expectations from COP26

It needs no reiteration that the planet and life on it are at their tipping point, with the forces of global warming and climate change knocking on the front doors. The key challenge that has emerged in combatting such forces is financing, referred to in this essay as “green money” or “climate cash” (or “green finance” as other analysts call it). The challenge of mobilising such “climate cash” flows becomes more acute when one considers that large parts of the developing and the underdeveloped world are still struggling to obtain the funds needed for basic developmental needs.

Opportunities on this ground were opened during the 21st Session of the Conference of Parties (COP21) to the United Nations Framework Convention on Climate Change (UNFCCC), held in Paris in 2015. The Paris Agreement ushered a new era in the domain of climate finance and markets, while treating such institutions and instruments as cornerstones to place the planet on a trajectory of limiting global warming to below 2 degrees Celsius above pre-industrial levels. Finances for climate-change mitigation and adaptation programmes were planned to be channelled through multitiered systems in the form of national, regional and international bodies. This entailed, in addition to support mechanisms for climate change, financial aid for both mitigation and adaptation activities to promote the transition towards a low-carbon growth path.

Existing Sources of Funding and Instruments

The funding sources can be broadly classified into four categories: (i) multilateral development banks and other similar international financial institutions; (ii) United Nations (UN) agencies, (iii) bilateral and multilateral government funding, and (iv) the private sector (private citizens, corporations, philanthropic organisations). However, since the nature of funding often overlaps, determining the source can turn out to be rather complicated. For example, multilateral development banks (MDBs) use their resources or specific trust funds created by their donors for climate financing. However, their resources may also include their own earnings, contributions by their board-member countries; the private sector, too, can be a contributor to the funding of such organisations. Thus, it is difficult to decipher whether the source of such funds should be attributed to the private sector or the MDBs.

In the current model, climate cash is generated through largely debt-based products (green bonds, climate-policy performance bonds, debt for climate swaps, etc.), while the fund deployment occurs through debt-based, equity-based, and often insurance-based instruments—in addition to grants and loans. Capital instruments provide funds directly to the projects, and entail a) senior debt (loans provided to projects to reduce costs, which can be given as concessional loans provided at lower rates than the ones prevailing in the market); b) subordinated debt (entailing all forms of mezzanine or quasi-equity finance, which emerges as a combination of debt-based and equity-based instruments rendering the lender the right to convert to an equity interest in case of default); and c) equity financing (buying equity stake in climate-change mitigation projects without receiving any guarantee of repayment, and acquiring ownership of the project). Financial instruments thus cater largely to the risk appetite of the investors, and ranges from fixed-income debt instruments to risky equity capital. Additionally, there is insurance-based risk management instruments, or hedging products, which include credit guarantee. These operate as insurances to the lenders in case of failure of loan repayment; partial credit guarantee that guarantees a portion of amount as insurance to cover the default risk; performance risk guarantee; revenue guarantee; and structured finance, which offers a mechanism that layers public guarantees, usually at concessional terms.

Funding Biases

The problem, however, lies elsewhere. Despite the existence of various financing sources, there has been an inherent funding bias (more than 80 percent) in favour of climate-change mitigation activities. According to a recent paper in the journal Sustainability, this heavy bias in favour of mitigation, and against adaptation, can largely be attributed to two reasons. First, results from mitigation investment are perceptible in the short run, e.g. returns on investments in energy efficiency or in renewable energy can be perceived through the financial cost savings, as well asfrom the estimable break-even periods. The same is not true for adaptation projects. For instance, returns on investment in cyclone-resistant structures might not be perceptible if cyclones do not occur.

Further still, it is difficult to find funders for adaptation modes such as the “strategic retreat” of populations to safer zones from vulnerable zones, since returns on such investments have long gestation periods and their impacts on human life and livelihoods are often difficult to predict. Second, adaptation projects find less traction amongst funding agencies because of the “public goods” nature of such projects. Large parts of the public-sector climate finance for climate-change mitigation leverages private-sector finance, and the private sector does not consider financing “public goods” as viable investments. In comparison, the private-sector financing of clean-energy technology is ever-increasing, given their clear linkage with investments and returns.

Under such circumstances, the Green Climate Fund (GCF) has emerged as a cornerstone of hope–the main financial vehicle after the Paris Climate Accord. Against the culture of large-scale promotion of mitigation projects, the GCF remains an exception and aims to deliver equal funding to mitigation and adaptation, while being guided by the UNFCCC’s principles and provisions. The GCF provides support in the form of grants (45 percent of allocated funds till date), loans (42 percent), equities (nine percent), and guarantees (two percent), and results-based payments. However, some amount of bias towards mitigation projects is evident in the workings of the GCF as well. Data as late as 7 October 2021 suggests that of the 190 approved projects, 43 percent are adaptation projects, 32 percent are mitigation projects, and the remaining 25 percent are cross-cutting. However, the fund allocation towards mitigation has been as higher, at 62 percent, revealing the tacit dominance of the mitigation projects.

The low level of funding to climate-change adaptation projects may partly be driven by its status as a new activity, for which there is no real pre-existing “expertise” available. However, also part of the reason is the mindset that adaptation provides primarily local benefits. Biases against funding adaptation projects by the GCF have been criticised by adaptation experts, particularly those from least developed countries (LDCs) and small island developing states (SIDs). They contend that the GCF has failed to channel funding to the most vulnerable communities in the most vulnerable countries, because it has approached its mandate as a “bank” seeking returns on its investments in terms of repayment of loans. Moreover, the GCF’s emphasis on fiduciary and fund-management capacities of both recipient country governments and implementing entities have made accessing large-scale funding difficult. The GCF also insists on genuine adaptation projects and not development proposals dressed up as adaptation.

Can Market-based Instruments Play a Role in Adaptation?

Over time, various financial instruments have emerged that can help in combating the risks of climate change through financial compensations to the affected nations and communities. These are offered in the form of weather derivatives, weather insurances, water futures, and other climate-linked financial products that monetarily compensate for losses caused by climate variability. While these instruments can help the adaptation process, such financial products are more popular in the developed world than in the developing or the underdeveloped world, since the latter do not have the wherewithal to customise, design and strategically market a product of such nature that can cater to their specific needs.

To be sure, the financial products conceptualised so far are not yet catering to the needs of the poor affected by climate change, especially at the critical interface of their livelihoods with the ecosystem services (services provided free of cost to the human community by the natural ecosystem). In his 2009 paper published in Nature, Pavan Sukhdev interpreted the monetary values of the ecosystem services as the “GDP of the Poor,” with 57 percent of their incomes in India being sourced from nature.

The egregious impacts of climate change on ecosystem services have neither been sufficiently acknowledged at the negotiation tables, nor have they featured in the government’s financing programmes. Thus, due to the expected failures of market-based instruments, no financial institution has endeavoured to create products catering to the needs of the poor, whether directly or indirectly, as it is not expected that they will participate in such markets. This remains a critical gap in product conceptualisation in the context of the climate crisis. Even when such products are conceptualised, newer forms of institutions will be required to act as aggregators and help communities to access their benefits. The question that must now be addressed is this: Can governments and the private sector come together to compensate with green money?

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