To finance the investments needed to achieve net-zero emissions by 2050, the private sector needs to step up – particularly in emerging market and developing economies. By 2030, climate change mitigation investment needs are projected to increase to $2tn in EMDEs. These countries, however, are projected to have limited fiscal space and face challenging market conditions, which increase their financing costs. As a result, the private sector will most likely have to cover about 80% of climate mitigation investment needs in EMDEs (90%, if excluding China).
Boosting private climate finance in EMDEs is particularly difficult – both in attracting private capital more generally and achieving a speedy energy transition specifically. A barrier to catalysing this level of funding is the (actual and perceived) high risk of EMDE investments. This is due to a lack of investment-grade sovereign credit ratings for most EMDEs, high foreign exchange and policy risks.
Underdeveloped domestic capital markets constrain domestic resource mobilisation as well. Investors who are willing and able to take the inherent risks face a lack of well-structured, investable project pipelines that meet their risk-return requirements. The transition to renewable energy and the phasing out of fossil fuels is slowed down by elevated costs of capital as well as the sheer number, concentration and still young age of coal-fired power plants in EMDEs. In some countries, economic dependency on coal can be high, while forecasts of capital expenditure point to a continued expansion of new oil and gas capacity.
Meanwhile, climate policies of major banks and insurance companies are not yet aligned with net-zero emission targets, curtailing the alignment of private financial flows with the climate transition. Despite the continued growth in environmental, social and governance investment funds, funds focused on creating climate impact remain small.
Varied policy mix needed in EMDEs
In light of these challenges, the International Monetary Fund’s ‘Global financial stability report’ calls for a broad mix of policies to create an attractive investment environment and engage private climate finance in EMDEs.
While carbon pricing can be highly effective in pricing climate externalities, creating transition opportunities and providing a strong and credible price signal to investors, it may be politically challenging. To mitigate this, carbon pricing needs to be supplemented with other policies to address market failures and catalyse private financing and investment in low-carbon technologies. These involve the reform of fossil fuel subsidies, sectoral policies such as environmental regulations (for example, clean energy standards), green subsidies and green public investment in infrastructure.
However, these policy options may not be feasible in all EMDEs, especially in low-income countries and small developing states. Internationally coordinated efforts are therefore indispensable to minimise the cost of decarbonisation. In addition, structural reforms and policies should aim to overcome the fundamental barriers to investment in EMDEs, and boost domestic resource mobilisation by reducing capital costs and improving credit ratings. This will strengthen macroeconomic fundamentals, deepen financial markets, improve policy predictability and foster institutional and governance frameworks.
Refocusing financial sector policies on climate impact
Financial sector policies, such as climate-related disclosure requirements, taxonomies, standards for sustainable financial instruments and products should incentivise the transition to and financing of a low-carbon economy. Doing so will need to reflect the local context and purpose in EMDEs. Transition taxonomies – and planning frameworks – should be standardised and connected to a country’s nationally determined contributions, long-term strategies and supporting sectoral decarbonisation targets and plans. They should also integrate measures for a managed coal phase out.
It’s crucial that investment fund labels credibly signal an alignment with greenhouse gas emissions objectives, and ESG data providers should offer climate impact-orientated scores as a tool for fund managers and investors. Credit rating agencies’ and sovereign ESG methodologies need to be realigned to better reflect climate factors and cover material differences across EMDEs in terms of exposure and opportunities related to climate change. In this context, reforms supported by the IMF Resilience and Sustainability Facility can help attract private climate finance. All these considerations serve to make private climate finance not just an attractive opportunity for investors, but an opportunity that is logistically possible to aid EMDEs in their climate change mitigation costs.
Charlotte Gardes-Landolfini is Financial Sector Expert, and Torsten Ehlers is Senior Financial Sector Expert, Climate Finance Policy Unit, Monetary and Capital Markets, International Monetary Fund.
This article was published in the Sustainable Policy Institute Journal, Autumn 2023 edition.
The views expressed in this paper are those of the authors and do not necessarily represent the views of the IMF, its executive board, or IMF management.