India needs to develop its own paradigm of climate finance. It cannot allow itself to be boxed in by the watertight categories of ‘green’ and ‘brown’ projects being laid down by the western world as a precondition to secure green funds.

If these categories are inappropriate, there is another issue which compounds the problem here — the sheer absence of funds coming from the West, which has not kept to its commitment of raising $100 billion annually for the developing countries. Therefore, both the framework for climate finance as well as funds raised to this end will have to be homegrown.

The Climate Finance Working Group has estimated a funds requirement of ₹118 trillion, available resources of ₹64 trillion and a gap of ₹54 trillion. This gap has to be met by way of domestic and foreign debt. Indian development financial institutions (DFIs) and commercial banks have to contribute by raising domestic funds and channelling resources from abroad.

Broadly speaking, government(s) and private sector have to work in tandem. While investments for renewable power and green mobility will flow commercially, finance for climate proofing agriculture and allied sectors have to be influenced only through policy. Hence, budgetary support and credit policy assume importance.

Catalytic funding

To begin with, government(s) may consider catalytic or start-up funding and capacity building. Catalytic funding should be utilised for ‘re-purposing’ key economic activities into green activities — something that western finance and its frameworks do may not recognise as per their taxonomy.

Re-purposing, supported by a simple and inviolable classification framework, oversight and capacity building mechanisms can transform existing economic activities to green activities, crucially with smaller amounts of investments.

The RBI influenced flow of credit, since the 1970s, to sectors and population groups which did not receive adequate attention from the banking system. This is widely known as priority sector lending. RBI’s policy stance was to ensure development impact by directing credit. Climate change (CC) is the significant development issue now.

The banking system, left to itself, is unlikely to finance mitigation and adaptation investments, as they are of lower commercial appeal, compared to other lending opportunities. Shouldn’t the priority sector be sharply defined by including climate finance?

Yet given the large financing gap, long-term resources have to be raised from abroad, especially by the DFIs. In the recent past, DFIs have avoided foreign currency loans on account of competitive domestic funds and high hedging costs. Given the requirements, the government may have to step in to manage hedging costs. Can part of its budgetary resources earmarked for CC be leveraged to this end?

Investments from the private sector are equally important for financing mitigation and adaptation projects. While some of these investments that yield reasonable returns can be made on normal terms through access to bank credit, many other investments cannot meet the interest costs on account of below-par returns, long gestation periods and higher financial risks.

When the return on investment and financial rate of returns (FRR) are low, there is a need for either subsidising capital costs or the rate of interest or even both. While a small farmer investing in micro irrigation might be able to afford normal rates of interest, another farmer taking up soil remediation/enrichment may not get a return that can service the loan and sustain the investment.

The nature of funding CC investments by private sector will have to differ from activity to activity and at times based on geography. While the government will need to fund and carry out investments that are in the nature of public goods, it could also consider spending part of its budget earmarked for CC for subventions and subsidies to the private sector to compensate for the loss of income to the sector; hence the necessity of ‘blended finance’.

Blended finance

The need for ‘blended finance’ arises from investments which have a ‘development payoff’ but low/no revenue streams. While FRR is the most important determinant of investment decisions, most CC related investments will not be able to meet the FRR thresholds.

Hence economic rate of return (ERR) methodology which will take on board development payoffs is necessary to justify investments relating to mitigation and adaptation investments related to CC. Mainstream funders [read commercial banks] predominantly rely on FRR. Blended finance, through reduction of interest costs can improve FRR in the hands of the project holder.

Mainstream funders therefore, require financial and non-financial incentives for financing CC projects and their investment appraisals must be based on ERR. Suitable subventions and subsidies will nudge the bankers towards climate finance and also reduce the actual rates of interest to the borrowers. Another critical revenue stream is that of carbon credits. While some initial work on monetising carbon credits has started in India, a lot more can be done. The revenue from carbon credits can offset the low CC project revenues and make the investments feasible.

Going forward, DFIs and commercial banks must be nudged to play an active role in designing credit products for managing CC. The government has demonstrated its commitment, by successfully mobilising ₹16,000 crore through sovereign green bonds.

In sum, India’s commitments to net-zero CO2 emissions are based on a bouquet of options: shifting to renewable energy, battery storage systems, cleaner transport, climate resilient sustainable farming, optimisation of water use, afforestation to create carbon sinks and reducing fossil fuel consumption, which were well articulated in the Budget 2023.

Climate proofing investments for coastal areas through mangrove restoration, lowlands affected by floods and for rain-fed regions are priorities. Coordinated strategy between governments, the RBI and the financial sector can manage the concerns of green lending to commercial and marginalised sectors alike.We need to be atmanirbhar in climate finance.

Suryakumar is Deputy Managing Director Nabard; and Srinivasan a development consultant. The views expressed are personal