Climate finance is the means to achieve climate action

Finance is needed to turn climate ambition into action, to transform the energy system to eliminate greenhouse gas emissions and to make our infrastructure more resilient to climate-related events. The need for finance is especially acute in the developing world. Host Samantha Gross talks with Amar Bhattacharya of Brookings and David Victor of UC San Diego about how to get important climate projects financed.

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BHATTACHARYA: Climate finance is the means by which we deliver on climate action.

GROSS: We hear the phrase “climate finance” all the time, and about the need for huge sums of money to deal with climate change. But it’s not often clear what all this money is for or where it’s supposed to come from—what does the term “climate finance” mean”? Is it paying for the energy transition? Helping people adapt to our changing climate?

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I’m Samantha Gross. I’m the director of the Energy Security and Climate Initiative at the Brookings Institution and have spent my career focused on energy and environmental issues. I’ve been in Washington for 20 years, working on energy policy in government and private industry before I came to Brookings. But I started my career as an engineer, designing technical solutions to environmental problems. My work now focuses on how to transition to a clean, zero-carbon energy system—the technical, political, and social challenges in getting from here to there. ​

Joining us to talk about climate finance, especially in the developing world, is one of my Brookings colleagues.

[1:19]

BHATTACHARYA: I’m Amar Bhattacharya. I’m a senior fellow at the Center for Sustainable Development. My field of research is climate change and within that climate finance. I’ve been working on the international agenda on climate finance now for a few years.

When we think about climate finance, it’s extremely important to think about climate finance for what? And the ultimate purpose of finance is to support investment, investment that allows us to, in some sense, make sure that the structure of the economy is consistent with the global temperatures that we are trying to achieve and that we are investing in adaptation and resilience so that we are able to respond to the impacts of climate change.

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GROSS: Climate finance includes mitigating global climate change through investing to reduce greenhouse gas emissions, like building more wind and solar power generation or investing in industrial facilities that use low emissions processes. Climate finance also includes investments to adapt to our changing climate. Even if the world stopped emitting greenhouse gases today, we are already feeling the effects of climate change through more energetic weather—dryer droughts, more intense and wetter storms, more frequent and fiercer wildfires. Adaptation investments reduce financial losses and human suffering caused by the changes we’re already seeing and those likely to happen in the future.

This is a tall order and requires a lot of money. And thinking about where to invest brings up the foundational injustice of climate change that we discussed last season—that the developed, wealthy countries put the world in the position it’s in today. The lion’s share of greenhouse gases in the atmosphere came from wealthy countries, with the United States in the lead.

But the worst consequences of climate change often happen to those who can least afford to deal with them and who contributed the least to the problem—people in the world’s poorest countries. People and governments in these countries don’t have the resources to protect themselves from the changing climate, and thus endure the lion’s share of climate-related suffering.

[4:03]

BHATTACHARYA: There is a major equity issue in climate action. And it arises from the fact that there is what we call historical responsibility—developed countries are indeed responsible for the bulk of the carbon that’s out there. And the impact of that carbon falls disproportionately on the developing world, and especially the poor and vulnerable in the developing world. So, the issues of equity and climate justice are indeed very powerful.

Let me turn to the role and obligations of the developed countries. So, at one level you could look at it and you say, look, you put the carbon out there, that carbon is causing lot of damage. You, therefore, must compensate the developing world that is being hit with the sums of money that are necessary, including for loss and damage. That has some moral legitimacy to it, but it is absolutely politically unacceptable to the rich countries.

So, most analysts, therefore, do not try to equate the monies that are necessary to compensation, because that leads you into very, very difficult waters. It’s much more constructive to say, look, developing countries will need financing. What’s the best way to give it? And you, the developed countries, should be providing some of that yourself.

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GROSS: I need to jump in to describe a very important phrase Amar used: “loss and damage.” The reason why climate change is such a problem is that it changes our environment in ways we’re not used to, in ways our infrastructure isn’t set up for. Like most things, these changes are most difficult to deal with in the developing world, where people don’t have homeowners’ insurance or crop insurance to protect their homes and livelihoods. It’s harder for them to pack up and leave if an area floods frequently or if droughts make their land unproductive. Climate losses there mean real suffering.

These changes aren’t just in the future—they are happening now. The most extreme example is the small island nations in the Pacific whose very existence is threatened by rising sea level.

Loss and damage is the idea that somebody needs to pay for these damages—and wealthy countries are responsible for the emissions that brought these damages about. The moral responsibility is clear but describing payments in terms of “liability” and “compensation” opens a can of worms that tends to scare off wealthy countries. A fund for loss and damage compensation was agreed to in late 2022 at that year’s global climate summit in Egypt, but funding commitments have been coming in very slowly so far.

Discussions of climate finance have to include who is responsible for funding and where that funding should go. Wealthy, developed countries have well developed systems for financing projects and lots of money looking for financial returns. The money is there. The challenge in countries like the United States is directing that money toward the right kinds of projects.

Developing countries face the challenge of funding necessary investments without the advantage of wealth.

[7:36]

BHATTACHARYA: Let me begin by talking about the magnitude and nature of finance that is necessary. So, the analysis that we have done—and that analysis is now used worldwide—is that we need around $2.4 trillion a year for climate and climate related action in emerging markets and developing countries other than China by 2030. $2.4 trillion. That is four to five times more than what we are spending today. And in a very short span of time, less than a decade, we need to get to that if we are serious about the climate goals.

The bulk of that money will come from countries’ own resources, public as well as private. And the public part is extremely important because a lot of the investments we are talking about has required complimentary public infrastructure.

One of the really important features of the clean energy transition is that most of the investments have to be made by the private sector, and most of the investments can be financed by the private sector. And let me break it down.

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The bulk of the investments that are necessary on the generation side is the financing of renewables. And that’s quintessentially private sector. Second, we do need to make complementary investments in the grid, which is typically mostly a public sector activity.

So, strengthening the ability of countries for domestic resource mobilization and strengthening their ability to spend the money wisely is absolutely crucial.

GROSS: When you hear the words “climate finance,” many people’s thoughts immediately jump to government spending and the loss and damage funds I described. But the overwhelming majority of the money that will finance the energy transition is private investment. I asked another of my Brookings colleagues to talk about the private sector’s role.

[9:59]

VICTOR: I’m David Victor. I’m a professor of innovation and public policy at UC San Diego, and I’m a nonresident fellow at Brookings.

Well, the private sector is essential. We’re not gonna solve the climate problem, with the public sector alone. There are some countries, China most notably, that have a large public sector, but that’s pretty rare. Most countries don’t have those capabilities.

And so, the private sector is going to be crucial, especially for scaling up technologies as they become more mature. And really the entire mission of controlling the gases that cause climate change sinks or swims on the success in engaging the private sector.

GROSS: We’ve brought up the moral imperative of government investment in climate finance, especially for adaptation and loss and damage. What brings in private sector investment?

[10:45]

VICTOR: What brings the private sector in is the opportunity for financial return. It’s thinking about these things from the perspective of the individual firm and its investors. Can we go deploy money in a new technology or infrastructure or something like that and get a plausible return on that?

It doesn’t mean it’s risk free, but it means you have to be attentive to risk. It means the private sector, all else equal, is going to be much more engaged with mature technologies, mature business models, mature policy environments than things that are kind of flaky.

And I think one of the challenges that a lot of private investors see right now around the climate, is that there are a few areas, solar, wind, some conventional power plants with emissions controls, investing in grids, electric vehicles, electric two wheelers in India and other places, where the economics are already there. And you can build businesses, and indeed people are building businesses. And that’s true in the emerging economies as well as the mature economies.

One of the things that I find is most striking is solar. Solar power 20 years ago, was still kind of a science project. It made sense in some places but needed a lot of policy support. The policy support was disproportionate in the western countries. Now, solar is one of the lower cost forms of energy everywhere in the world, thanks partly to globalization and the manufacturing revolution in China. But therefore, you see private investors backing solar projects, sometimes with policy support, sometimes without policy support.

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A lot of the most innovative solar projects in the world are off grid projects, whether it’s in remote Africa, whether it’s in India, in firms that are building their own power supplies. These are almost entirely backed by private capital. And so, it’s happening, just not happening everywhere. And it’s super sensitive to risk.

GROSS: Risk as a word that comes up over and over in this episode. Financing in the developing world is expensive because investments there are considered more risky. It’s a sad fact that the countries most in need of money for climate-related investments can least afford the high interest rates they have to pay. A key part of climate finance is finding ways to get money to projects in developing countries at interest rates that they can afford. Amar tells us more.

[13:04]

BHATTACHARYA: The cost of capital of the developing world is twice that of the developed world, therefore, it’s extremely important to bring down the cost of capital and to ensure that developing countries have indeed the finance that is necessary to build this clean energy out. When we look at now the financing costs associated with renewables in developing countries, it’s 10, 15, 20 percent in terms of cost. And at those kinds of rates, we cannot finance the clean energy transition.

Developing countries face higher financing costs. They are considered more risky in macroeconomic terms, and that translates itself into foreign exchange risk premium. And there’s a lot of focus right now on how we can deal with this risk premium, because the actual risk is typically much less than the perceived risk.

At the microeconomic level, this gap between actual and perceived risk is even greater. In Africa, which is the most frontier of the markets, the rate of default on renewables is less than 1%. That is better than U.S. corporates or EU corporates. Yet, the cost of finance for renewables in Africa is as I said prohibitively expensive.

So, again, development finance institutions, development aid providers, and the private sector can team up particularly in reducing the cost of capital by reducing this gap between actual and perceived risks.

On the financing side, the private sector will provide financing if there’s certitude of revenues and if the risks are considered reasonable.

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So, in order to do that we need de risking structures, both at the macroeconomic level, but also at the microeconomic level.

GROSS: Interest rates in developing countries are so high because investments there are perceived as riskier than those in wealthy countries. You can bring those high interest rates down by mitigating the risks that lenders are concerned about and that they want to charge extra for.

A number of different mechanisms are possible to de-risk investments in the developing world. On the macroeconomic, or economy-wide level, insurance-like products to protect projects against changing exchange rates or from government expropriation can reduce risks to lenders.

On the microeconomic, or project level, mechanisms like power purchase agreements with external guarantees can help. This means that there is guaranteed payment for power generated by a green energy project, and thus a guaranteed stream of revenues to pay off a loan.

Products like these make investments more attractive to private capital and bring in investment at affordable interest rates.

The multilateral development banks, or MDBs, like the World Bank or Inter-American Development Bank, are international financial institutions that exist to fund development in poorer nations. They have a key role to play in directing finance to climate mitigation and adaptation projects.

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They prioritize social goals set by the countries that contribute to them, rather than maximizing profits for shareholders like a commercial bank.

[17:04]

BHATTACHARYA: The role of development finance institutions is twofold. They can work with governments in creating the enabling environment for acceleration of the investments. And second, they can both provide their own financing for things that the private sector cannot finance, but very important, they can partner with the private sector to reduce risks and to improve the affordability of capital.

So, a lot of focus right now on the role of development finance institutions as this enabler and as the partner to the private sector.

GROSS: A key role of the multilateral development banks is to act as a stimulus to bring in other sources of finance. They generally don’t fund all of a project, but act in concert with private sector lenders to make investment possible. They do this through mechanisms like guaranteeing that they will take on a first amount of loss if a project fails, making it less risky for the private partner.

The ability to offer lower interest rates is a key feature of the MDBs, since they are not trying to make a profit on their lending.

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Back to David Victor for further thoughts on de-risking.

[18:29]

VICTOR: This is an age-old question around how do you de-risk things that are risky, and to some degree is you make them less risky. So, some of that’s technological change. Solar is a great example. Because of the enormous decline in the cost of solar, a lot of projects that used to seem risky, had long payback times, required a complicated policy to support, they weren’t in the money.

And so, one thing you do is you lower outright risks in the business model and the technologies. That’s not going to work all the time everywhere. It’s not going to work in particular for the hard to abate sectors.

Then there’s a lot of instruments that people are excited about that involve in one way or another removing or managing currency risk or political risks. And blended finance in one way or another is, offers examples of that where you provide, again, a bunch of different policy instruments that help in one way or another lower risks and then bring in private capital.

I expect all, all else equal, this is going to happen in places that have relative.y stable government policy support, places where you can do long-term projects, And we see a lot of that in the world: Namibia, China, parts of the Indian market, especially the parts that are less exposed to government intervention. And one of the most interesting solar markets for decades has been the Kenyan solar market, off grid in particular.

So, it’s happening in a lot of places. So, I think that’s what’s interesting here, and it’s going to happen in places where you can create this kind of policy environment or create something that looks like a normal investment environment for investors.

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And recognize that we have to have a long-term perspective here around how do you crowd in capital from the private sector because it’s going to be multiples of whatever’s available in the public sector.

GROSS: The private sector is where the big money is, but wealthy countries still need to fund the multilateral development banks and help in areas that just aren’t amenable to private funding.

[20:17]

BHATTACHARYA: So, how much are the developed countries providing right now and what would be reasonable targets for the future? This is the discussion of this year in the UNFCCC because this is the year that we will set a new climate finance goal.

So, we argue that developed countries need to do more. We have argued that they should double that amount of finance between now and 2030. But even if they did, that would not be enough.

It’s essentially to invest massively in the clean energy transition. And the clean energy transition in developed countries is about ensuring that you are moving away from dirty fuels to clean fuels. But in developing countries, the clean energy transition is primarily about investing so that new energy comes from clean energy, because there the developing countries are the source of all of the incremental demand for energy in the world.

So, the story between developed and developing countries in what we are trying to achieve is different, but both require a massive tick up in investment. Now the financing constraints in the developed world is more around ensuring that we can have low-cost finance, particularly for ensuring that the cost of capital is kept reasonable.

But in the developing countries, this is a much, much bigger challenge because the finance is often not accessible, and the finance is certainly not affordable.

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So, in some sense, the developing country challenge right now is how do we mobilize this very large pool of finance that will be necessary, but also ensure that it is made available at reasonable cost.

GROSS: In terms of financing, not all investments are created equal. Renewable energy projects mitigate the effects of climate change by providing energy without greenhouse gas emissions. They create revenue streams when they are finished—people paying for the clean electricity that they generate. But investments in adaptation and resilience to climate change are about avoiding future costs and suffering. They don’t have revenue associated with them. This lack of revenue makes adaptation and resilience investments much harder to finance than mitigation, especially for those that need them the most.

[23:06]

BHATTACHARYA: Adaptation and resilience is about avoided costs. Investing in the clean energy transition is about utilizing the possibilities of lower cost and cleaner energy. And so, it’s much easier, therefore, to finance clean energy than it is to finance adaptation and resilience.

And you can break out the adaptation and resilience into different buckets. So, if you’re a company and you have to put up a plant, it is in your interest to ensure that that plant is resilient to earthquakes or climate change or whatever else. And it is easier to finance avoided costs because the company knows that if it doesn’t, it will have to pay those costs. So, for a company, it’s the easiest in some sense of thinking about financing adaptation and resilience.

When you get to the level of governments, you still have a rational basis. Governments can say, I’m putting up a building and I need to make sure it’s earthquake proof or it is hurricane proof or whatever it makes sense. But it becomes challenging because of the pressures always of short-term savings versus these long-term benefits. So, it is difficult, but it can be done.

It is most difficult for individuals in poor and developing countries because they are so cash constrained, they can barely make ends meet. And when you tell them, you know, you’re building a house or you’re building this, we need you to spend another 25% doing this or doing that, it’s very, very difficult for them.

So, adaptation and resilience, you find even here in the United States is something where local communities, individuals find very, very difficult. There’s also not only financing is difficult, but, you know, regulations often also are not set in a way that they disincentivize investments in area of high vulnerability.

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So, this is an area which I feel there’s a big imbalance between the adaptation and resilience agenda and the mitigation agenda. And it is in the rich countries, but it is especially and powerfully so, for example, in the floods in Bangladesh, some of that is inevitable, but some of it could have been avoided if there had been the massive kinds of investments that are necessary.

So, you need strategy, you need a plan, but you also will need very, very long-term, low-cost finance in the adaptation and resilience space.

GROSS: Climate offsets are another key, but controversial form of climate finance. The idea of an offset is instead of spending money to reduce your own emissions, you pay someone else who can reduce their emissions at a lower cost. Sounds great, right? We want to do the lowest-cost emissions reductions first, to keep the overall cost of dealing with climate change down and to accelerate action. We’re in a hurry here.

But talking about climate offsets is a good way to start a fight among folks concerned about climate change. Offsets raise some very important questions.

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A first question is practical: is the reduction in emissions that the offset is paying for additional? That is, would the emissions reduction have happened anyway, even without the offset payment?

As an example, using an offset payment to build solar electricity generation in Africa sounds like a great idea. But given that parts of Africa desperately need electricity, and that solar generation is usually the cheapest form of new generation around, would that project have been built anyway? Likely yes. This isn’t to say that the project was a bad idea, only that the offset payment may not have made a difference in overall greenhouse gas emissions. These are not the kind of offsets we want.

A second big question about offsets is moral: is it fair for wealthy people to pay others to reduce their emissions instead of biting the bullet and doing it themselves? It’s hard to give a practical answer to a moral question. But suffice it to say that if we are going to go this route, we need to make darn sure that we’re paying for something real. I asked Amar to elaborate on the practicalities of offsets.

[27:57]

BHATTACHARYA: Carbon offsets probably are amongst the most controversial aspects of climate finance. And the reason for that is there is issues of integrity, both with regard to are you really financing something that leads to real impact in terms of reduction in carbon emissions? And on the demand side, is it really avoidance or are we really adding in some sense to global collective action? So, ensuring integrity both on the supply and the demand side is a very challenging aspect.

In the UNFCCC, this all relates to Article Six, which says that, yes, we think that you can use offsets to finance the most low hanging-fruit in terms of cutting emissions. But it has to be in some sense according to certain rules and disclosure and the like. And, on the other side, are the companies that are buying these offsets are you giving them an easy way out? That’s the issue.

GROSS: Offsets are challenging, and “integrity” is a fuzzy word and difficult to prove on the ground. But that doesn’t mean that offsets are useless. There are times when the cash flow created by an offset funds a real difference in emissions that wouldn’t have happened otherwise. I don’t think we should eliminate a whole potential source of money just to eliminate the bad apples. So, I asked Amar where he thought offsets worked best.

[29:38]

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BHATTACHARYA: So, there are two areas right now, which have featured very prominently as where in the developing world, you could get accelerated action and where the financing would in some sense produce much higher results than could be done by the companies themselves.

The first is the accelerated phaseout of coal. Coal is the most polluting source of energy in the world, and if every unit of coal you get rid of, even by other types of fossil fuel like gas, you are really helping to bring down carbon emissions.

So, if countries are committing to accelerated phaseout of coal, and there are really well structured, well monitored programs for doing that, then using offsets to finance that, in my personal view, makes sense. And that’s something that Secretary Kerry was very, very focused on last year to help create, in some sense, contributions from U.S. companies, including fossil fuel companies, to help with the financing of the phaseout of coal.

And the other area where offsets can make a difference is in large scale preservation and restoration of forests, including the three critical basins: The Amazon, the Congo, and the Papua Indonesian forest basins. And again, there you could say that we have monitorable means, satellite data, other ways to track this to show that actually this is leading to reversal of deforestation or restoration.

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The satellite part of it right now is really quite powerful. And on the other side, you could say, yes, we have means to ensure that these offsets are really being used.

GROSS: There are so many numbers and trends in this episode. Climate finance is a big topic with a lot of information to absorb. So, I asked Amar to give us a summary of where we are today and positive signs we should look for in the future. Climate finance will be a focus at the next global climate summit, in Azerbaijan in November, so it’s good to know what to watch for.

[32:02]

BHATTACHARYA: Climate finance is absolutely central to raising the ambition on investment and investment is the means by which we deliver on climate action.

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We have been stuck on the climate finance agenda for more than a decade, but we are at a point in time where the world is coming together around potential solutions, especially for emerging markets and developing countries. We must not lose that opportunity. The setting of the new collective quantified goal is a tremendous opportunity to shift from a blame game of developed and developing countries to now putting in place a system of finance that is fit for purpose.

And a system of finance that is fit for purpose means utilizing all pools of finance in a way that the whole is more than the sum of the parts. Private finance will have to play the most important role, and we have a tremendous opportunity to do that, but we must create this new highway for private finance, which is essentially about tackling impediments, de-risking, and bringing down cost of capital.

Second, we have to ramp up the role and the finance of the development finance institutions, multilateral, regional, national. Even here in the U.S., we are talking about the role of development finance because of this catalytic role that they can play both with regard to driving action, but also with regard to mobilizing finance. So, ramping that up will be of central importance.

And third, very importantly, rich countries have to live up to their commitments. They have to go further than where they have in terms of delivery of finance. But we are not going to be able to get the scale of concessional, low-cost finance that we need, so we have to find innovative ways to mobilize that finance, and we have to have the political will to go in that space.

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And I think in all of these areas, there is now much, much more willingness to do so. Our biggest enemy is time.

GROSS: As Amar points out, the money to deal with climate change is there. The savings that many of us have in our retirement accounts, for example, is out there looking for returns on investment. The challenge is finding innovative ways to direct that money to investments where it can do the most good for the most people, creating a new energy system and resilient infrastructure that keeps people safe. Climate finance aims to do just that.

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Many thanks to the experts I talked to in this episode. 

Climate Sense is brought to you by the Brookings Podcast Network. Fred Dews is the producer; Gastón Reboredo the audio engineer. Thanks also to Kuwilileni Hauwanga, Daniel Morales, and Louison Sall, and to the communications teams in Brookings Foreign Policy and the Office of Communications. Show art was designed by Shavanthi Mendis.  

You can find episodes of Climate Sense wherever you get your podcasts and learn more about this show at Brookings dot edu slash Climate Sense Podcast. You’ll also find my work on climate change and research from the Brookings Initiative on Climate Research and Action on the Brookings website. 

I’m Samantha Gross, and this is Climate Sense.