Lessons Learned from Climate Finance for Post-2015 Sustainable Development

Lessons Learned from Climate Finance for Post-2015 Sustainable Development Michael I. Westphal, World Resources Institute May 2014 (Draft) Please submit any comments to mwestphal@wri.org by June 1 st, 2014.

I. Introduction to Climate Finance What is climate finance? Climate finance can be broadly considered as finance targeting low-carbon and climate-resilient development with explicit climate change mitigation or adaptation objectives. However, there is no universally agreed upon definition of climate finance. Some organizations take a very broad view of climate finance and include all global, climate-specific upfront capital investment and grants 1, while the Copenhagen Accord, in which developed countries committed themselves to a goal of jointly mobilizing USD 100 billion a year by 2020, enshrined the principles that the climate finance should be new and additional and come from a variety of public and private sources. 2 The Overseas Development Institute has suggested five characteristics of long-term climate finance under the UNFCCC 3 : mobilized by developed countries parties; provided to developing country parties, taking into account the urgent and immediate needs of those that are particularly vulnerable to the adverse effects of climate change; balanced in allocation between adaptation and mitigation; committed in the context of transparency on implementation; scaled up, new and additional, predictable and adequate. However, there is no consensus on what is meant by new and additional, the sources of private finance that should count, nor the financial instruments or channels that should contribute to climate finance. Various definitions of new and additional have been proposed, including: only finance above the commitment made by developed countries to allocate 0.7% of Gross National Income (GNI) to aid, non- Official Development Assistance (ODA) climate finance, [or] novel sources or money channeled from new United Nations sources (e.g. Green Climate Fund). 4 Under the rubric of private sources, one could include inter alia North-South (OECD and non-oecd) investment flows, private finance leveraged by public sources, carbon market revenues and voluntary payments. There is debate as to whether climate finance should track gross flows (total amount of private finance, offset finance, and non-concessional lending) or net flows (i.e. grant-equivalent transfers and the net benefit for non-concessional public and private flows). Some have argued that only the incremental investment cost should be included, i.e. the additional capital cost of low-carbon, more climate resilient technologies. In terms of instruments, many developing countries and NGOs argue that climate finance especially adaptation finance should be delivered primarily in the form of grants, while many developed countries would like to include both concessional and non-concessional loans, as well as capital contributions, guarantees, and insurance. During the Fast Start Finance (FSF) period, a commitment under the Copenhagen Accord for developed countries to provide USD 30 billion in climate finance to developing countries, donor countries adopted widely different reporting methodologies. For example, the United Kingdom, Germany and Norway only counted concessional finance and grants. Japan included concessional loans to governments of developing countries and non-concessional loans to private companies, while the United States also included non-concessional loans to private companies as well as export credit, guarantees, and insurance. Germany applied a strict criterion of new and additional to FSF, while the United States did not. Both Japan and the United States included leveraged private finance, although the United States reported it separately from total FSF. 5 The terms leverage and mobilization are important to the understanding of climate finance, particularly with regard to the private sector. In generic financial terminology, leverage refers to the ratio of debt to 1

equity financing for an investment. 6 The Overseas Development Institute defines leveraging as the process by which private sector capital is mobilized as a consequence of the use of public sector finance and financial instruments. Leverage is usually discussed in the context of leverage factors, or ratios. There is no uniform methodology to calculate leverage ratios, and they can be expressed as the ratio of total funding to public funding, the ratio of private funding to public funding, or the ratio of specific public climate finance to broader public and private finance flows. 7 Leverage is often used interchangeably with mobilization. The OECD has sought to differentiate the two terms, whereby leveraging is a term to be used in the context of discrete financial instruments, while mobilizing is the provision of climate finance for developing countries through the use of finance and other interventions by developed countries. 8 What is the scale of the climate finance need? The World Bank has estimated that to stabilize global warming at 2 C, the developing world may need USD 140 175 billion a year by 2030 for mitigation 9, while the annual costs of adaptation in the developing world could be USD 75 100 billion a year from 2010 to 2050. 10 The World Economic Forum estimates that the incremental investment cost for infrastructure in order to stay below the 2 C limit is USD 0.7 trillion per year between 2010 and 2030. 11 Clearly there is a large finance gap: the Climate Policy Initiative estimates that climate finance totaled USD 359 billion (USD 39-62 billion in North-South flows) 2012 12, of which, 38% was contributed by the public sector and 62% by the private sector. FSF only provided USD 35 billion over three years. There has been much discussion of new sources of public finance, such as diversion of fossil fuel subsidies, carbon market revenues, carbon taxes and taxes on maritime transport. 13 However, the financing challenge is of such a magnitude that public sources alone will be inadequate; most of the climate finance will continue to originate in the private sector. Figure 1. Total estimated investment requirements under business as usual and estimated additional costs under a 2 C scenario. 14 2

What is the relationship of climate finance to ODA? There is not a clear distinction between climate finance and development finance. Members of the OECD Development Assistance Committee already track aid activities targeting the objectives of the three Rio conventions for biodiversity, desertification and climate change. Countries report whether activities target the convention as a principal or significant objective. Mitigation has been tracked since 1998, while adaptation since 2010. In 2012, DAC countries reported USD 15.6 billion and USD 10.1 billion for principal and significant mitigation and adaptation aid, respectively. Furthermore, of the USD 35 billion of FSF climate finance, 80% of it was also reported as ODA grants or ODA-eligible loans. About 25% of total ODA commitment by Japan was counted as FSF. 15 II. Major Lessons Learned from Climate Finance Based on the research of the World Resources Institute and other organizations, there are a number of lessons on climate finance that could help to inform the Post-2015 Sustainable Finance discussions. 1. Enabling conditions ( readiness ) must be in place to catalyze public and private investment in climate finance The World Resources Institute examined six case studies in low carbon energy, all of which underscored the critical importance of having an enabling environment in place to catalyze climate finance (Figure 2). 16 This includes a number of institutional and policy conditions, such as plans and targets for low carbon, climate resilient development; institutional capacity to effectively implement policies; well-designed and enforced laws; accountability systems; and regulatory instruments to support laws. Although this was not explicitly looked at in the above case studies, it is worth emphasizing that enabling activities must also address corruption, governance and transparency, especially since many low carbon development projects involve large infrastructure investments. But, these enabling conditions do not stop at government. The private sector needs support from the public sector to: create bankable projects, enhance awareness of investment opportunities, and build engineering and technical expertise. Most importantly, this extends to ensuring a stable financial market. Creating this enabling environment takes time and sustained financial support. This is very analogous to the well-understood enabling policy and institutional conditions for development, although the new insight may be the emphasis on the readiness conditions for industry and the financial sectors. The importance of enabling conditions also highlight that the climate finance challenge is not simply about addressing the sums needed to fill the finance gap, it is also about tackling the absorption deficit that countries might have in accommodating climate finance. 3

Figure 2. Public support needed to enable investments. 17 2. Strong recipient government leadership is integral to success The World Resources Institute s research on mobilizing climate finance for low-carbon energy found strong government leadership as one of the two most essential ingredients for success, along with addressing market distortions. 18 Thailand, for example, has been proactive in developing programs for energy efficiency. An energy conservation act was passed back in 1992, which established energy efficiency requirements for industry and created an Energy Conservation Promotion Fund. This has allowed Thailand to develop its own domestic source of finance for energy efficiency and provided it with a great deal of autonomy and little reliance on international support. Thailand has been strategic in using international support for very targeted measures, such as the development of energy efficiency plans, and also worked to build its own the capacity within its government offices in energy efficiency planning and program implementation. 3. Price distortions and incentives must be considered to make finance eff ective Price distortions, such as fossil fuel subsidies, impact the effectiveness of mitigation finance and reduce the competitiveness of clean energy technologies. Globally, fuel subsidies have been estimated to be USD 523 billion in 2011, 6 times greater than that for renewable energy (Figure 3). 19 When countries remove these barriers to clean energy investment, there can be significant growth in clean energy deployment. For example, in Tunisia, when the Government enacted a program that included a capital cost subsidy for solar water heaters in an environment where liquefied natural gas is heavily subsidized, the deployment of solar water heaters increased fivefold. Thailand funds its energy conservation program with a dedicated sales tax levied on petroleum products. 20 Policies, such as renewable portfolio standards (RPS) and feed-in tariffs (FiT) can incentivize private sector investment in clean energy. 21 It has been estimated that with a FiT for solar power, $1 of (annual) incremental cost financing could leverage about $8 of (upfront) private investment capital. 22 4

Figure 3. Global energy subsidies in 2011 (USD billion). 23 4. Risk mitigation is important to increase the attractiveness for private sector investment For private investors, whether to finance a project is dependent on the risk-return profile; that is the return relative to associated risks. The public sector has a number of tools at its disposal to improve the risk-reward calculus for private investors, both public support mechanisms and public financing instruments (Figure 4). 24 The public support mechanisms include policy support and project-level assistance. For low carbon development, countries may need assistance to formulate policies around FiTs, tax credit programs, renewable energy standards or to repeal fossil fuel subsidy programs. At the project-level, countries may need seed grants and subsidies to aggregate, source and evaluate projects. Public financing instruments include: loans, equity investments and de-risking instruments. Providing loan capital, such as lending to projects, investing in debt funds, purchasing bonds, or offering concessional loan terms, can attract additional private finance. Equity investments involve making a direct capital investment in project or funds that invest in projects; equity provides initial finance to help companies grow and can reduce the investment risk of debt investors. De-risking instruments can help ameliorate the perceived political, macroeconomic, policy and technology and operational risks that can inhibit private sector investment in the developing world (Figure 5 ). A number of instruments are available, such as loan guarantees, policy/risk insurance, and foreign exchange liquidity facilities (to protect against currency fluctuations) (Figure 5). 25 In the Clean Technology Fund (CTF), part of the multilateral Climate Investment Funds, there are a number of risk mitigation measures in a variety of projects to help spur private investment, such as foreign currency denominated power purchase agreements for wind energy (Egypt), blending CTF finance and commercial bank loans (Mexico), low interest credits for energy efficient appliances (Mexico) and establishing contractual mechanisms for renewable energy public-private partnerships (Morocco). 26 5

Figure 4. Public tools available to create attractive investment conditions. 27 Figure 5. Investment risks and mitigating public interventions 28 5. New and expanded use of financial instruments is critical to climate finance mobilization Given the scale of the climate finance gap, a diverse array of instruments needs to be brought to bear on the challenge. Public institutions can deploy more instruments, given the varied risks in different geographies. For example, multilateral agencies tend to focus heavily on loans, whereas they should explore a greater use of guarantees, equity products, public-private partnerships and risk-sharing financing facilities. 29 Currently, climate finance is primarily provided by multilateral development banks, bilateral finance institutions and commercial banks. New and additional sources of capital will need to be mobilized, and institutional investors represent a large potential pool. Globally, institutional investors manage about USD 76 trillion in assets. 30 However, in 2012, they contributed only USD 0.4 billion of total climate finance flows. 31 Innovative financing instruments, such as green bonds and asset-backed securities, can help to tap into this potential source. Green bonds are broadly defined as fixed-income securities issued (by governments, multinational banks or corporations) in order to raise the necessary capital for a low 6

carbon, climate resilient project. The green bond market has increased exponentially since 2008, reaching over USD 11 billion, with a potential to rise to USD 50 billion next year (Figure 6). Figure 6. The growth of the green bond market. 32 6. Public sources are indispensable to climate finance While private sector mobilization is critical, the salient role of the public sector must not be discounted. The public sector provides support for the enabling activities and risk mitigation instruments discussed above. Small, sustained amounts of finance by the public sector can have a large impact. In Mexico, international readiness support of about USD 10 million in the first five years of the wind sector s development contributed to the mobilization of over $1 billion in investments. 33 Governments play an important role in the development of complementary infrastructure, without which, private sector investments would not be possible. Most network infrastructure (e.g. roads, rail, other transportation infrastructure and transmission and distribution infrastructure for power generation) have strong monopoly and/or public goods dimensions, which require public finance and regulation. 34 Public finance serves as a fulcrum to leverage private investment. Every public dollar may leverage 3 to 5 dollars of private investment in climate-related and renewable energy investment. 35 Projects in clean energy and transportation will be the most attractive to the private sector, where the risk-return profile is favorable. However, there are areas where the private sector is unlikely to invest because of the lack of opportunity for profit. Although there are a number of adaptation-relevant areas that are likely to attract private finance namely infrastructure, agriculture, water resources management, energy and coastal zones management much adaptation finance will only be provided by the public sector. The public sector will need to provide the public goods that undergird the transformation to a low carbon, climate resilient society, such as research and development, technology diffusion, a well-educated workforce, climate and weather information, natural disaster management, and extension services. 7

7. In a fragmented climate finance landscape there is a need for harmonization and robust reporting and tracking systems There are a myriad of sources of climate finance. The Climate Policy Initiative s Global Landscape of Climate Finance report attempts to compile an inventory of all climate finance flows. For public sources alone, the report includes data from 8 multilateral development banks, 16 bilateral finance institutions, 17 national and sub-regional development banks, and 20 multilateral and national climate funds, not to mention the bilateral environment ministries or development agencies that provide ODA. 36 Clearly the landscape of climate finance is very fragmented. While it is envisaged that the Green climate Fund will become the primary vehicle for climate finance from the developed to the developing world, reducing some of this fragmentation, an array of climate sources will remain. More than 80% of the climate investment in the developing world originates domestically 37 ; this is only likely to grow, as more national development banks increase their climate finance. Thus, it is imperative that there exist robust monitoring, reporting and verification systems to ensure accountability and transparency and avoid double counting of finance. While the multilateral development banks have recently standardized their reporting on climate finance 38, there needs to be more a harmonized reporting system that also includes bilateral finance institutions, as well as the private sector. To date, private finance tracking relies on voluntarily-disclosed data or the existence of public support mechanisms that require disclosure of project details. During the FSF period, countries adopted widely different reporting methodologies. 39 There needs to be more consistent data on types of finance, intermediaries, instruments, disbursement channels, recipient countries and uses of climate finance. 40 The harmonization of reporting will require that a number of foundational issues and challenges are addressed, such as what constitutes climate finance and how to calculate leverage factors and measure causality, attribution and timing with regard to private sector mobilization. III. The Synergies of Climate Finance and Development Finance Climate finance and development finance should not be viewed through a zero-sum lens. Indeed, there is a strong mutualism and complementarity between sound development and the objectives of climate change mitigation and adaptation. Climate change threatens the goals of sustainable development. 41 Close to one quarter of all ODA currently goes to sectors that are highly vulnerable to climate change. In 2011, USD 11 billion of total ODA was for the energy sector, USD 10.7 billion for agriculture, and USD 12.6 billion for transport. 42 Finance to climate proof those sectors will provide win-wins for both development and climate change. Moreover, the fundamentals necessary for sound sustainable management of natural resources strong and capable institutions, policy and governance reforms, property rights, appropriate pricing, access to information, well-regulated markets are important building blocks for climate change adaptation. Good development builds climate resilience. Projects that increase human capital through education and health interventions or extend social protection to a range of economic shocks build adaptive capacity to climate change. 43 Likewise, there are many development co-benefits of climate change mitigation activities. In China, for example, it has been estimated that 34 161 lives are saved for each million tons of CO2 abated in the energy sector. 44 Clean cook stoves not only result in reduced emissions of black carbon and deforestation but improve indoor air quality. Indoor air pollution from the use of solid fuels leads to 4 million premature deaths each year. 45 In some areas, particularly more rural communities, distributed renewable energy may be the most viable approach to increasing energy access. Sustainable urban transport systems, such as 8

bus rapid transit systems, can reduce emissions while increasing transport services for the poor. Climatesmart agricultural practices that sequester carbon can also reduce vulnerability to natural disasters, enhance farm income and productivity, and strengthen resilience to climate change. 46 IV. Messages for Post-2015 Development Finance While the majority of development finance will likely come from the private sector, public institutions are indispensable for providing an enabling environment for investment, mitigating risk and provisioning public goods, such as information. Public finance should be focused on leveraging private finance ( crowding in not crowding out private investment) and addressing sectors where the private sector is unlikely to engage. In development, public investment will always be essential in such areas as sustainable infrastructure, social services, post-conflict assistance and peace-building, biodiversity conservation, and basic science and technology. 47 Like climate finance, sustainable development finance should concentrate on maximizing the diversity of finance sources and instruments, while being mindful of the absorptive capacity of developing countries for uptake of finance. Development finance should be recipient country-led and driven. A strong and engaged recipient government is sine qua non for effective climate/development finance. Development finance and climate finance are not zero-sum measures. They are mutually supportive and complementary. It will be impossible to meet goals of development without achieving the objectives of climate finance, and vice versa. Over time, it should be hard to distinguish between development finance and climate finance. 9

Endnotes 1 Buchner, B., Herve-Mignucci, Trabacchi, C., Wilkinson, J., Stadelmann, M., Boyd, R., Mazza, F., Falconer, A., Micale, V. 2013. The Global Landscape of Climate Finance. Climate Policy Initiative. San Francisco, CA. 2 UNFCCC. 2009. Report of the Conference of the Parties on its fifteenth session, held in Copenhagen from 7 to 19 December 2009. Addendum. Part Two: Action taken by the Conference of the Parties at its fifteenth session. Bonn, Germany. 3 Illman, J., Halonen, M., Whitley, S, Trujillo, N.C. 2014. Practical methods for assessing private climate finance flows. Gaia Consulting and Overseas Development Institute. Helsinki, London. 4 Brown, J., Bird, N. and Schalatek, L. 2010. Climate finance additionality: emerging definitions and their Implications. Climate Finance Policy Briefs 2. Overseas Development Institute, London; Stadelmann, M.J., Roberts, T.J. and Huq, S. 2010. Baseline for trust: defining new and additional climate funding. IIED Briefing Papers. International Institute for Environment and Development (IIED), London. 5 Fransen, T. Nakhooda, S., Kuramochi, T. Caravani, A., Prizzon, A., Shimizu, N., Tilley, H., Halimanjaya, A. and Welham, B. 2013. Mobilising international climate finance: lessons from the Fast-Start Finance period. Overseas Development Institute, World Resources Institute, Institute for Global Environmental Strategies, Open Climate Network. London, UK, Washington, DC, Tokyo, Japan. 6 Brown, J., Buchner, B., Wagner, G., Sierra, K. 2011. Improving the effectiveness of climate finance: a survey of leveraging methodologies. Overseas Development Institute, Climate Policy Initiative, Environmental Defense fund, Brookings Institute. London, Venice, New York, Washington, DC. 7 Brown, J. and Jacobs, M. 2011. Leveraging private investment: the role of public sector climate finance. Overseas Development Institute. London. 8 Caruso, R. & Ellis, J., 2013. Comparing definitions and methods to estimate mobilised climate finance. Organisation for Economic Co-operation and Development. Paris, France. 9 World Bank. 2009. World Development Report 2010: Development and Climate Change. Washington, DC. 10 World Bank. 2010. Economics of adaptation to climate change - Synthesis report. Washington, DC. 11 World Economic Forum. 2013. The green investment report: the ways and means to unlock private finance for green growth. Geneva, Switzerland. 12 Buchner et al. 2013. 13 United Nations. 2010. Report of the Secretary-General s High-level Advisory Group on Climate Change Financing. New York; World Bank. 2011. Mobilizing Climate Finance: A Paper prepared at the request of G20 Finance Ministers. Washington, DC. 14 World Economic Forum 2013. 15 Fransen et al. 2013. 16 Polycarp, C, Brown, L., Fu-Bertaux, X. 2013. Mobilizing climate investment: the role of international climate finance in creating readiness for scaled-up low-carbon energy. World Resources Institute, Washington, DC. 17 Polycarp et al. 2013. 18 Polycarp et al. 2013. 19 International Monetary Fund. 2013. Energy subsidy reform: lessons and implications. Washington, DC. 20 Polycarp et al. 2013. 21 A Renewable Portfolio Standard is a measure requiring that a minimum percentage of total electricity or heat sold, or generation capacity installed, be provided using renewable energy sources. A feed-in tariff is a policy that sets a fixed, guaranteed price (often structured as a USD/KWh payment) over a stated fixed-term period when renewable power can be sold and fed into the electricity network. 22 United Nations. 2010. Report of the Secretary-General s High-level Advisory Group on climate change financing. Background Work stream 7 paper: Public interventions to stimulate private investment in adaptation and mitigation. New York. 10

23 Fossil fuel subsidies data from International Energy Agency. 2012. World Energy Outlook 2012. Paris, France; renewable subsidy data from REN21. 2013. Renewables Global Futures Report. Paris, France. 24 Venugopal, S. and Srivastava, A. 2012. Moving the fulcrum: a primer on public climate financing instruments used to leverage private capital. World Resources Institute. Washington, DC. 25 Venugopal, S. and Srivastava, A. 2012. Moving the fulcrum: a primer on public climate financing instruments used to leverage private capital. World Resources Institute. Washington, DC. 26 De Nevers, M and Beppu, M. 2013. Private funding in public-led Programs of the CTF: early experience. Climate Investment Funds. Washington, DC. 27 Reprinted from Venugopal and Srivastava 2012. 28 Reprinted from Venugopal and Srivastava 2012. 29 Venugopal, S., Srivastava, A., Polycarp, C., Taylor, E. 2012. Public financing instruments to leverage private capital for climate-relevant investment: focus on multilateral agencies. World Resources Institute. Washington, DC. 30 Fulton, M., Capalino, R. 2014. Investing in the clean trillion: closing the clean energy investment gap. CERES. Boston, MA. 31 Buchner et al. 2013. 32 International Finance Corporation. 2014. Mobilizing green bond markets. http://www.ifc.org/wps/wcm/connect/topics_ext_content/ifc_external_corporate_site/cb_home/news/feature_gree nbondswebinar_april2014 33 Polycarp et al. 2013. 34 Sachs, D. and Schmidt-Traub, G. 2013. Financing for development and climate change post-2105. Draft for Discussion. Prepared by the Secretariat of the Sustainable Development Solutions Network. http://post2015.files.wordpress.com/2013/04/130316-development-and-climate-finance.pdf 35 See for example, Patel, S. and Musić, R. 2013. Leverage in IFC s climate-related investments: a review of 9 years of investment activity (Fiscal Years 2005-2013). International Finance Corporation. Washington, DC. 36 Buchner et al. 2013. 37 Ibid. 38 African Development Bank, Asian Development Bank, European Bank for Reconstruction and Development, European Investment Bank, Inter-American Development Bank, World Bank and International Finance Corporation Joint Report on MDB Climate Finance 2012. 39 Fransen et al. 2013. 40 Buchner, B., Brown, J., Corfee-Morlot, J. 2011. Monitoring and tracking long-term finance to support climate action. Organisation for Economic Cooperation and Development. Paris, France. 41 World Bank 2009. 42 OECD Development Statistics Database: http://stats.oecd.org/index.aspx?datasetcode=table5. Accessed 23 August 2013 43 World Bank 2009. 44 Vennemo, H. et al. 2006. Domestic environmental benefits of the People s Republic of China s energy-related CDM potential. Climatic Change 75: 215 39 45 World Health Organization. http://www.who.int/mediacentre/factsheets/fs292/en/ 46 World Bank 2009. 47 Sachs and Schmidt-Traub. 2013. 11