How blended finance can support climate transition in merging and developing economies

Many also have high debt and constrained budgets because of the pandemic and face higher government borrowing costs amid rising interest rates around the world, making it especially difficult for public finance to meet pressing climate financing needs.

These factors mean mobilizing private capital on a large scale will be key to achieving their climate objectives. Financial markets alone can’t do the job, but combining public and private capital offers unique advantages by reducing investment risk and attracting greater funding. Multilateral development banks and international financial institutions can provide support through creating blended financing structures to alter the risk-return profile for the climate transition in emerging economies.

It’s important to start by establishing an attractive investment climate and policies to incentivize private participation. Climate policies and finance are complementary because better policies attract private investment, in turn helping meet policy objectives. Carbon pricing is the most effective tool to make high emitters pay for the climate costs they impose and thereby channel private investment toward projects that emit less.

More generally, climate policies and commitments like the Paris Agreement’s Nationally Determined Contributions can signal to investors to direct investment to a low-carbon economy. Establishing a strong climate information architecture for data, taxonomies, and disclosures also will help.

Opportunity for impact

Unfortunately, private climate finance faces multiple constraints, from future policy uncertainty and technological costs that raise the cost of capital to other barriers such as data limitations and unattractive risk-return profiles. Despite these challenges, private climate finance can help emerging economies meet Paris Agreement goals.

Innovative financing instruments can attract investors with different risk profiles and investment horizons, as we noted in our October Global Financial Stability Report. In larger emerging markets with functioning bond markets, investment vehicles such as green bond funds can help broaden the investor base by drawing in institutional participants like insurance companies and pension funds.

Multilateral development banks and international financial institutions have a crucial role to play to attract much larger sums of private capital. They can provide technical assistance, helping develop projects, improve governments’ institutional capacity, and build the local currency bond markets to broaden the set of domestic investors.

By agreeing to be first to endure losses in green funding vehicles and securitizations, development banks can increase the expected risk-adjusted return for private investors. With appropriate governance, public backing can help avoid moral hazard associated with guarantees, which involve risk that gains are privatized while losses socialized. Advanced economies could back public equity as a way of delivering on their annual $100 billion commitment to emerging and developing economies.

In addition, equity investment can effectively leverage public money. Commitments by development banks are matched by less than a third of the amount from private sources, for emerging and developing economies, on average. That contrasts with smaller deals by the World Bank Group’s International Finance Corporation and Amundi SA, Europe’s largest asset manager. The IFC-Amundi structured fund attracted 16 times as much private investment.