The role of blended finance in funding the low-carbon transition

Where there are constraints on public funds, we must prioritise private sector capital for climate finance, write Prasad Ananthakrishnan, chief of climate finance and policy, and Charlotte Gardes-Landolfini, climate change, energy and financial stability expert, International Monetary Fund.

Mitigating climate change and achieving low-carbon and climate-resilient economies requires a sharp increase in annual investment. This investment is essential for delivering on the Paris agreement goals and enabling adapting economies to achieve sustainable development. Yet there is a burden on public finances in many of these countries, in addition to rising borrowing costs as central banks tackle high inflation. This is why scaling up private sources of climate finance has become a priority globally.

There are several supply- and demand-side constraints in doing so and those specific to mitigation and adaptation investments are magnified in emerging markets and developing economies. They include macro financial (currency, regulatory and political exchange rate fluctuations) and microeconomic obstacles (lack of bankable projects and unattractive risk-return profiles in unproven markets).

Other constraints include the absence of adequate carbon pricing, continuously high fossil fuel expansion investment, data-related constraints and a lack of standardised products that provide size, liquidity and diversification that would be attractive to institutional investors. Combined with key market failures, knowledge spillovers, high upfront costs and risk perceptions many of these economies also suffer from extensive debt vulnerabilities that could be amplified by additional borrowing.

How can the public sector best act?

Policies should play a decisive role in ‘crowding in’ private sector funds. Research shows that a combination of pricing and non-pricing policies is needed. Carbon pricing keeps the aggregate transition cost lower and preserves competitiveness, especially in energy-intensive and trade-exposed industries. Regulations and feebates are good alternatives in the power sector where technological substitution is possible. Increasing public investment in infrastructure, research and development and renewable energy technologies incentivises inflow of private sector climate capital.

A robust climate information architecture should be built around climate-related disclosures and data, with a reference framework against which to assess such non-financial and financial corporate disclosures. A [staff paper] will soon be published by the International Monetary Fund, World Bank Group, Organisation for Economic Co-operation and Development and Bank for International Settlements to address this challenge and provide technical solutions for ensuring interoperability among climate assessment methodologies.

It is now imperative to attract private sector capital. Public sector guarantees could result in privatising gains, socialising losses and creating potentially large contingent liabilities – unless there is public investment in project equity or equity tranches of securitised investment products. This is why innovative financial instruments need to be deployed. These include blended and structured financing and risk-sharing techniques (first-loss investment and collateralised guarantees), where public financial resources can partly reduce and mitigate risks for investments.

These solutions may include green or sustainability-linked bond issuance with de-risking opportunities or debt-for-climate and debt-for-nature swaps. Just Energy Transition Partnerships can also contribute to minimising the negative consequences of phasing out coal-fired power production and mining in these economies.

The IMF launched the Resilience and Sustainability Trust in autumn 2022. It complements the IMF’s lending toolkit by helping low-income and vulnerable developing economies build resilience to external shocks and ensure sustainable growth, contributing to their longer-term balance of payments stability. Ensuring that de-risking does not lead to fiscal losses requires strong state capacity and legal frameworks alongside monitoring mechanisms.

By providing greater fiscal space for climate action and supporting countries with policy reforms and capacity development, the RST contributes to alleviating private sector concerns. It aims to unlock a substantial investor base in these economies and complement the action of multilateral development banks.

The views expressed herein are those of the author and should not be attributed to the IMF, its executive board or its management.