That there are significant shortfalls in meeting climate finance commitments by developed countries is no breaking news. But given the urgency of the need vis-à-vis the delays on the other, there is a need to explore creative but tested solutions to bridge the gap. One category that may hold promise is credit enhancement instruments such as guarantees, subordinated debt, grants, and equities.
The key sources of international climate finance are multilateral development banks (MDBs) such as World Bank and Asian Development Bank; international development financial institutions such as International Finance Corporation (IFC) and UN-backed international climate funds (Green Climate Fund, Climate Investment Fund), and bilateral funding. Typically, climate financiers use four categories of instruments to fund green projects — equity, loan, risk management instruments, and grants/technical assistance. The last category is a small amount, and all others are direct financial support for large infrastructure and other development projects.
There is a need for large capital by poor countries to combat climate change — estimated by economists Nicholas Stern and Vera Songwe at over $2 trillion per year by 2030.
By comparison, the total disbursement of capital by World Bank Group in 2022 was only $88 billion. There is hence a clear need to unlock private capital, given the staggering need.
However, there are a few issues that discourage private investments. First is the need for risk reduction through long-term and patient capital without which many projects become too risky for private investors to consider. Second, given the capital-intensive nature of clean-tech investments and the higher cost of capital in poor countries, there is a need for subsidising the cost of finance to make projects viable.
This however makes the returns not commensurate with the project risks, for a private investor.
A study by Kenny, Kalow, and Ramachandran suggests that IFC’s portfolio has become less risky over time, which is slowing down capital flows to sectors that need public financial support.
Credit enhancements
Rather than provide loans and, lately equity, use of credit enhancement instruments such as guarantees or subordinate debt, can help crowd-in private capital. Let us illustrate the leverage one can get from simple default guarantees. Consider a debt portfolio of $1 billion with an expected default rate of 10 per cent. A partial guarantee of 50 per cent by MDB needs a credit guarantee fund of $50 million. So, we can get a leverage of 20x to unlock $1 billion by setting up a credit guarantee of $50 million.
Despite the large power of leverage, guarantees represent only a small portion of the total investment portfolio of MDBs. Since MDBs treat guarantees on the same basis as a loan in their book, there is no financial benefit for using guarantees instead of a loan from the shareholder perspective. Remarkably, the IBRD was envisaged as a guarantee institution, not a lending institution.
Similarly, a subordinate bond, junior than senior bond in the capital structure, can attract private financiers as well. For example, a subordinate debt from MDBs that contributes 30 per cent of debt in the capital structure can give enough comfort to private senior debt-holders to invest in the project as the later have the first rights over the assets. The public capital leverage will be 2x.
However, data shows that DFIs currently take the less risky senior debt positions in the capital structure of the project. A study by ODI on blended finance suggests that senior debt accounts for 72 per cent of blended concessional investment by MDBs and DFIs.
If MDBs continue to be conservative in lending and equity investment and have an investment strategy that is similar to a private investment, it will miss out on its important role — attracting private capital.
Labanya is a climate finance specialist, and Meera works on early-stage venture investments