Closing the climate finance gap

A substantial gap exists between the amount of finance needed to achieve net zero in order to avert catastrophic impacts from climate change and the amount of finance available. The bulk of the finance to close this gap will need to come from the private sector, and substantial progress is being made in increasing the proportion of overall private finance that is going to green investment. But the process needs to happen much faster, and support from governments, central banks, multilateral development banks and other public (or publicly backed) institutions is critical. This research paper focuses on the options for addressing the particularly challenging part of the finance gap that affects emerging markets and developing economies (EMDEs) excluding China. Public international finance1 has a unique and critical role to play in supporting efforts to achieve climate goals, including through accelerating mobilization of greater amounts of private finance and building trust between advanced and developing economies. But public international finance is in short supply relative to the demand for it. The paper’s analysis focuses both on how best to increase public international finance for climate action and on how to use the limited finance available, or likely to become available, more effectively. In particular, the paper looks at the relative merits of mobilizing private finance through conventional use of public finance to improve the business environment versus deploying public finance alongside private finance in risk-bearing arrangements. Many think-tanks and academics have proposed sharp increases in public international finance for climate action. So far, however, such proposals have failed to make a significant difference to the amount of funding available, in large part because they imply a current or future call on official development assistance (ODA) provided by traditional donors. Notwithstanding strong practical, political and moral arguments for financing more climate action, many donor governments are constrained by severe pressures on public finances. Similarly, efforts to use public international finance to mobilize private finance on a larger scale have had only limited success. In addition to the above-mentioned fiscal constraints, key issues include fundamental differences in objectives between the private sector and the public sector, and the fact that the public finance potentially available to catalyse private investment is not being used optimally. Lack of progress in this area has added to the distrust between advanced and developing economies. While efforts to increase the overall amount of public international finance available for climate action need to continue, this paper argues that significant progress in closing the climate finance gap will depend on the international policy community2 paying much closer attention to how currently available flows of public international finance are used, and how such flows can be made more effective. Addressing these twin issues will involve difficult choices: on how much public international finance to devote to climate action vs other high-priority non-climate objectives; on the absolute amounts of finance to be allocated to different climate objectives; and on the different ways of mobilizing private finance. Critical to improving the effectiveness of available public international finance will be to increase the proportion used to facilitate genuine risk-bearing in conjunction with the private sector. A mechanism needs to be developed under which this can happen without imposing contingent risks on advanced-country donors. Such risks arise, for example, if those donating funds to capitalize climate finance operations are liable for losses over and above the initial funds they provide – a situation likely to deter donors from providing capital for riskier operations. The international policy community also needs to understand better why so much private finance is still going to hydrocarbon-intensive investment. This is likely in substantial part to reflect ‘moral hazard’ and other perverse incentives such as hydrocarbon subsidies; urgent steps must be taken by central banks, financial regulators and finance ministries to remove such incentives and, where possible, to repurpose the subsidies. A carefully calibrated political process is needed to deliver this fundamental change of approach, and it will not happen overnight. But the ongoing negotiations around a New Collective Quantified Goal (NCQG)3 – the priority agenda item at the UN’s COP29 climate summit, being held in Azerbaijan between 11 and 22 November 2024 – provide an important opportunity to agree a mandate on initial steps. Such a mandate could then be followed up at the Finance for Development Conference and COP30 climate summit in 2025. The election of Donald Trump to a second term as president of the United States only reinforces the need for the approach proposed in this paper. While Trump has yet to define his detailed policies in this area, the next president may repeat his previous action in withdrawing the US from the Paris Agreement on climate change. He is unlikely to increase US contributions to public international finance, particularly in the area of climate action. He may also use the US’s vote at the World Bank and other multilateral development banks to try to constrain such institutions from increasing their conventional climate lending. Meanwhile, his domestic policies are likely to slow, or even reverse, the US economy’s shift away from hydrocarbon-intensive investment. In these circumstances it will be critical for other countries to make the best possible use of the public international finance they provide for climate action, and to redouble their efforts to eliminate perverse incentives for carbon-intensive investment. Public international finance includes: official development assistance (ODA); finance provided by multilateral development banks (MDBs) fully guaranteed by public shareholders; finance provided by the IMF fully underwritten by member states; and finance provided by bilateral development finance institutions fully guaranteed by the sponsoring government shareholder. Such finance may take the form of loans, equity investment, guarantees, insurance or outright grants. The ‘international policy community’ is defined here as consisting of the following groups: policymakers in advanced and developing countries; international financial institutions (IFIs); and researchers in think-tanks and universities. Agreeing a New Collective Quantified Goal (NCQG) on Climate Finance is at the top of the agenda at COP29 in Azerbaijan. At the COP21 climate summit in Paris, in 2015, parties agreed that before 2025 the ‘Conference of the Parties’ (COP) to the United Nations Framework Convention on Climate Change (UNFCCC) would set a new and more ambitious climate finance goal with a floor of $100 billion a year, and that this goal would take into account the needs and priorities of developing countries.