An Introduction to Climate Finance

19 October 2016 - // Features

Defining climate finance

“Climate finance” is an elusive term. At its narrowest, climate finance is understood to refer to those public financial resources that are allocated by developed countries to developing countries for the purposes of climate change mitigation and adaptation. In a broader designation, climate finance is meant to encompass all financial flows aimed at climate change mitigation and adaptation, whether those flows are from public or private sources, and regardless of the degree of development of their origin or destination.

With no internationally agreed upon definition, the measurement and monitoring of climate finance is unsurprisingly elusive, too. A methodological discussion of the aggregate size of climate finance is beyond the scope of this article, but it is worth mentioning a few numbers to set the context: through the United Nations Framework Convention on Climate Change (UNFCCC), developed countries have pledged to contribute US$100 billion per year of climate finance by 2020, from public and private sources. According to the OECD, such flows amounted to US$62 billion in 2014. This may sound like a lot, but it is not: the International Energy Agency (IEA) estimates that approximately US$1 trillion a year is required between now and 2030 to fund the energy transition – and yet more than that is required for us to limit the temperature increase to 2°C.

As a result, climate finance is hotly debated. Not only do we not have enough climate finance, the climate finance we do have is often not the right kind: the vast majority of existing climate finance goes into mitigation projects, which tend to have reasonable returns on investment, while very little is left for adaptation projects that are less obviously profitable, but arguably more pressing for developing nations. Undeniably, blind profit maximization and excessive bureaucracy are legitimate plagues. At the same time, increasing the scale of climate finance is not as straightforward a task as it seems. Climate finance, as indeed all of development finance, suffers from a capacity-allocation issue.

Routinely referred to as the greatest challenge of our time, climate change mitigation and adaptation require the allocation of appropriate amounts of financial resources. The response, so far, has been mixed. In this article, we look at the current state of “climate finance”, as well as what hope there can be about its future

The development finance paradox

No one knows exactly how much development finance the UN’s Sustainable Development Goals (SDGs)will require, but on one point everybody agrees: it will be trillions of US dollars. The current ambitions are such that only a minority of the required finance can come from the public sector. The reason is capacity: there is nowhere near enough public finance for the SDGs. There is, on the other hand, enough private finance.

The paradox at play is that while development and climate finance has traditionally been a public agenda, it is the private sector that must step up to represent the brunt of it. Because development and climate finance is not always good business by private sector standards, the way forward requires a new kind of cooperation between the public sector, international institutions, the private sector and even the civil society

The public sector

To say that the public sector does not have the financial muscle necessary to finance all climate change mitigation and adaptation efforts is not to say that the public sector is powerless – quite the contrary. The public sector has a privileged position and commanding tools at its disposal. Laws, regulations, tax incentives and subsidies all have profound impacts on how private money flows. In practice then, the public sector’s role is one of a catalyst, and the focus is on finding the best use for limited public resources (financial or otherwise) in order to crowd in the private sector.

The UK’s Green Investment Bank (GIB)is a good example of how this can work. The GIB was created in 2012 by Her Majesty’s Government, with funding of GBP3 billion and expecting to leverage an additional GBP15 billion in private investments in green infrastructure in the UK. The GIB’s mission is not to finance all of the UK’s green infrastructure requirements, but rather to “invest in a way which demonstrates the attractiveness of the opportunity to others. […] We must show that it is possible to invest in projects which are green and profitable – this is our double bottom line.”3 In the GIB case, it worked so well in fact that they are currently in the middle of a privatization process, freeing up public funds to be reused somewhere else.4 The Green Bank phenomenon is recent, but growing. The Green Bank Network, an organization aimed at sharing data and best practices between the green banks in the US, the UK, Australia, Malaysia and Japan, was created at the twenty-first Conference of Parties to the UNFCCC (COP21) in Paris last year.

International Institutions

International institutions have long had climate finance as part of their development agenda. In fact, there are so many initiatives that it is exceedingly difficult to keep track of them, or indeed understand how they differ from one another. At the center of the efforts lies the United Nation Framework Convention on Climate Change (UNFCCC), the financial mechanism of which are the Global Environmental Facility (set up as an independent body at the Rio Earth Summit in 1992) and the Green Climate Fund (set up at COP15 in Copenhagen in 2009). The UN’s Adaptation Fund (COP7 in Marrakech in 2001) focuses solely on adaptation projects in developing countries that are Parties to the Kyoto Protocol. The Climate Investment Funds are multilateral funds not directly under the UNFCCC, but seemingly working to achieve similar objectives. The World Bank serves as trustee to all of these funds, and is also an agency through which monies are disbursed. And if this is not complicated enough, those entities have further sub-funds and there are yet other side projects both in the UN (the UN Environment Programme Finance Initiative) and in the World Bank Groupand other multilateral development banks.

Hopefuls and cynics alike have, legitimately, decried the unnecessarily complicated and bureaucratic nature of the institutions. The fact remains though, that billions in climate finance are being channelled through them. In addition, they bring political and technical expertise which private sector operators do not always possess in-house. By encouraging the private sector to invest alongside them in projects they have rubberstamped, they are ideally situated to play a role of “honest broker” between the public and the private sector. As a result, they are instrumental in the quest of going “from billions to trillions”, as the World Bank Group famously put it.

The private sector

Traditional banking operates a model of risk/reward optimization. In this model, risk is bad and financial reward is good. Green infrastructures do not do well under this model: they typically carry higher uncertainty (risk) than traditional infrastructures do, and their environmental benefits are not always directly quantifiable in financial terms. Tragically, the banking regulations that emerged after the recent global financial crisis have made this problem worse: aimed at reining in the banking sector’s excessive risk taking practices, the regulations also compel banks to reduce their exposures to borrowers in developing nations and infrastructure projects.

With banks genuinely hamstrung, it has become clear that the surge in private climate finance has to come from other sources. Capital markets, where trillions of dollars can be accessed from a diverse institutional investor base (asset managers, mutual funds, pension funds, sovereign wealth funds, etc) are the obvious alternative. The shift is not happening painlessly, but there are interesting developments.

“Green Bonds” are debt securities issued to finance projects with environmental benefits. What started about a decade ago as isolated bond issuances by supranational agencies to finance climate change related policy goals, has more recently morphed into a market-wide initiative, with an increasing number of private sector borrowers issuing Green Bonds to fund various kinds of projects and assets. A catalyst in the development of the Green Bond market was the establishment by the International Capital Market Association (ICMA)of the Green Bond Principles, 5 industry wide standards which issuers voluntarily follow to earn the right to call their bonds “green”. The benefits for issuers include access to new pockets of investors. For the environmentally conscious investors, Green Bonds increase their investment universe. The Green Bond market is growing rapidly, with 2016 year to date issuances (US$43 billion) already higher than last year’s total issuances (US$42 billion), and multiples of what it was just three years ago in 2013 (US$11 billion).

Socially Responsible Investing (SRI) is another phenomenon on the rise, with an interesting history. Seemingly for centuries investors of various religious traditions have been known to avoid investing in companies active in what they saw as “sin industries”, such as alcohol, tobacco, firearms or gambling. Such was the preaching of Methodism’s John Wesley in the 18th Century, and such are the rules still applicable today to Shariah compliant finance. But SRI is evolving beyond “negative screening” and emerging today as a significantly more complete discipline. It includes, among others: investing according to environmental, social and governance considerations (“ESG Integration”), using shareholder rights to compel companies to behave sustainably (“Shareholder Engagement”), and channelling investments towards traditionally underserved individuals or communities or in a manner that solves environmental or social issues (“Community / Impact Investing” – microfinance is, in this classification, a form of Community / Impact Investing). The Global Sustainable Investment Alliance estimates in their latest report that SRI has grown 61% between 2012 and 2014, and that at US$21.4 trillion it currently represents 30.2% of all professionally managed investments in the developed world. The SRI definition used by the report is debatably wide, but the rise of SRI is real and it is good news for climate finance.

One of the most inspiring examples of climate-related SRI is the Breakthrough Energy Coalition. Ironically, the Coalition comprises industrialists and businessmen mostly from outside the finance industry: Bill Gates, Mark Zuckerberg, Richard Branson, Jack Ma, Mukesh Ambani – and twenty odd other business household names. The project was born out of the view that technology is the answer to the world’s energy issues, and that the world cannot afford to wait for the normal cycles of research and investment to transform the energy landscape. Current government-backed research is insufficient, and in today’s business environment transformative energy projects are unlikely to attract early-stage financing from traditional private investors. What is required is scaled up government-backed research together with a different kind of private investor, one with a long-term commitment and who is willing to put truly patient flexible risk capital to work. The Coalition wants to fill the shoes of this different kind of private investor and is committing capital in those countries that have agreed to increase government-backed research on clean energy innovation.

More participation

Climate change mitigation and adaptation is a colossal task. Colossal too, is the financing required for it. But for those of us who believe that climate change is real and who want to leave a planet behind for the next generations, there is no choice but to try and mobilize the necessary resources. “Too little, too late” is a valid criticism, one that we need to collectively take on board and address. The funds exist – the challenge is to get them to where we want them. The roles of public and private sectors are complementary, and public-private partnerships can form unique combinations to address unique problems. Initiatives to date by the public and private sectors are encouraging.

What is perhaps still missing from the picture is a more active involvement of the civil society. True, individuals do not directly command trillions of dollars, and it is easy for an individual to feel powerless in the international finance sphere dominated by big business and government. But individuals do have power. For one, individuals have investment power. Crowd-funding initiatives and peer-to-peer platforms allow anyone with an internet connection to contribute small amounts of funding to climate change related projects. Perhaps more importantly though, we individuals are consumers and constituents, and as such have power over the private and public sectors. Individually we may be negligible, but our collective action is meaningful. With other initiatives gaining ground, the time seems ripe for our civil societies to realize this potential.

Bruno Rauis is a finance professional with more than a decade of experience in the private sector in Europe and Asia-Pacific. Specialized in the structuring of complex credit transactions, he is currently spending a mid-career break completing a master’s degree in environmental economics and climate change at the London School of Economics and Political Science.

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