With the IPCC’s Fifth Assessment Report (2014) showing that resources to address climate change must be significantly scaled up, the issue of climate finance had a significant role in shaping up the outcome of the UN Climate Talks in Paris 2015.

At the 2009 UN climate change conference in Copenhagen (COP15), developing countries were promised US$30 billion. in ‘fast-start financing’ to invest in low-carbon infrastructure and adaptation measures by 2012. This commitment was largely met – but by 2020 these climate finance flows are due to reach a minimum of US$100 billion. per annum.

Although this US$100 billion. target may sound a lot, it is less, for example, than the cost of bailing out the UK banks in the wake of the 2008 banking crisis (at its peak, government support for the banking sector totalled £1,162 billion.). What is more, according to UNEP, “investment in development that is climate compatible must be in the trillions – not millions – of dollars.”

The United Nations Financing for Development Conference, held in Addis Ababa in July 2015, and the summit to adopt the post-2015 development agenda (the SDGs), in New York in September 2015, both reaffirmed the commitment by developed-country parties to the UNFCCC to a goal of mobilising jointly $100 billion annually by 2020 from all sources to address the needs of developing countries in the context of meaningful mitigation actions and transparency on implementation. In the Addis Ababa Action Agenda, all parties agreed that the overall focus is not just on aid, but on domestic finance, foreign direct investment and other ‘means of implementation’, including trade and technology.

The UNFCCC’s COP21 launched a process of Nationally Determined Contributions (NDCs) that outlines goals for each country for their mitigation and adaptation action, often with different levels of ambition, with and without external support. Mobilising resources for the integration and implementation of these NDCs will be one of the key challenges for developing countries in the coming years, and one of key drivers for selection of projects for financing by the Green Climate Fund (GCF) and a wide range of other sources of bilateral and multilateral development finance.

As discussed in the Chapters above, climate change will – unless checked – undermine the economic and social development of low- and middle-income countries, putting years of investment at risk. A key challenge, therefore, is to find solutions that stimulate private sector action and investment to support climate compatible development.

National planning customarily looks back in time to help guide decision-making for the future. This approach to policy development is no longer adequate, however, given the high level of climate-related risk and uncertainty. This is already placing a strain on public finance management systems – systems that are not particularly robust in many developing countries.

Finance strategies and policies for inclusive green growth that address risk and uncertainty must therefore be developed and implemented and become an integral part of the vision for economic policy. Public sector support at a market level is required in order to facilitate additional private finance. This in turn will necessitate changes in the approaches used for collection and dissemination of investment data at a national, regional and international level.

Climate change is a crisis-multiplier and CDKN suggests climate change should be seen primarily as an economic concern that calls for ‘3As’ – attention, acknowledgement, action – from both the public sector (including national finance and planning ministries and local governments) and businesses.

What form does climate finance take?

The 2014 Biennial Assessment and Overview of Climate finance flows, prepared for the UNFCCC Standing Committee on Climate Finance, frames the concept as follows: “Climate finance aims at reducing emissions, and enhancing sinks of greenhouse gases and aims at reducing vulnerability of, and maintaining and increasing the resilience of, human and ecological systems to negative climate change impacts.” It can be interpreted to include international and domestic public finance for, and private investment in, climate specific mitigation and adaptation activities to enable the transition towards climate compatible development.

Where will this money come from?

The challenge is to make all development expenditure climate compatible. At a time when industrialised countries are largely focused on deficit reduction and/or austerity measures, high-income countries are determined that only limited amounts will come via the taxpayer. The need to look beyond traditional aid mechanisms towards wider development finance has never been greater and the expectation – or perhaps hope – is that much of it should come from the private sector. At the same time, low- and middle-income countries are demanding additional resources, not just cash redirected from existing aid budgets.

Yet low-emission, climate-resilient development often requires upfront investments that, initially at least, can be costlier than conventional options. Moreover, current funding is largely directed at project interventions rather than programmatic approaches which would catalyse greater amounts of funding from public and private sources.

In middle-income countries, an immediate concern is to identify mitigation actions that will reduce carbon emissions, across energy, industrial, transport and land use sectors. These actions will require tailored funding strategies to secure private sector investment. In contrast, in low-income countries where per capita greenhouse gas emissions are low but the impacts of climate change are already felt, public expenditure is required to fund adaptation strategies, particularly to address the needs of poor and vulnerable people.

Although we are only just beginning to appreciate the true costs associated with responding to climate change, the ability to mobilise and leverage additional sources of domestic and international finance – for adaptation and mitigation – will be key. Given the scale of the challenge, international climate funds alone will never form the bulk of investment in low-carbon pathways or resilient infrastructure. Rather, they are a catalyst to shift resource allocation from many other diverse sources, in this direction.

As discussed elsewhere in this book – and also when it comes specifically to mobilising finance – there is a need for strong awareness in the public sector of the cost of inaction on climate change. This, coupled with leadership and innovative interventions by government, is required to stimulate private sector action and investment in climate compatible development.

The global landscape of climate finance 2015 by the Climate Policy Initiative draws together climate finance data from numerous sources to present policy makers with the most comprehensive information available about the scale, key actors, instruments, recipients and uses of finance supporting climate change mitigation and adaptation.

In 2014, annual global climate finance flows totalled approximately US$391 billion., an increase of 18% from 2013 levels. Public finance continues to drive private investment and grew steadily. Most came from development finance institutions which provided 33% of total climate finance flows. Private investment surged 26%. A total of 74% was spent in the country where it originated, which indicates a strong role for domestic resource mobilisation. Public support is significant but still totals less than a third of government subsidies for fossil fuel consumption which reached around US$490 billion in 2014.

Transformational change is far more likely when public finance leverages significant private finance, and the reality is that some 85% of all finance to address climate change will need to come from the private sector. There are, however, several constraints to private sector investment:

• domestic policy barriers;
• domestic market risks;
• lack of ‘investment ready’ low-emission, climate-resilient, projects; and
• the low price of carbon and resultant uncertainty in carbon markets.

This is why strong public sector leadership and innovative interventions are therefore required in order to stimulate private sector investment in climate compatible development. CDKN suggests a number of complementary strategies for overcoming the barriers to private sector investment including:

• using public funds to support early entry projects at the national level that will be of sufficient scale to help transform markets and pave the way for further private investment; and
• catalysing private capital with innovative tools that will attract the private sector as a large-scale investor.

Almost three-quarters of climate finance flows were invested with the expectation of earning commercial returns. This demonstrates that investment environments that are more familiar and perceived to be less risky dominate investment decisions. It also highlights the importance of domestic policy frameworks in unlocking climate finance. A study of climate change in key sectors of Uganda – a low-income country – found that by 2050, without the necessary adaptation measures, the costs of inaction on climate change by 2025 are 20 times the costs of adaptation (see also Chapter 2). Most crops would show reductions in total production. For example, yields of staple crops such as sweet potato and cassava could reduce by 40%; reductions of up to 75% in yields of its principal export crops, tea and coffee, are possible. These represented about 50% of Uganda’s export values in 2013. A major deficit of biomass could occur over the period 2010-2050 due to surplus demand and deforestation (the deforestation rate is currently 1.8% per year). These losses, together with reduced water available for hydropower, mean that Uganda must transition rapidly to obtain more power from low-carbon forms of energy, including renewable electrical power. Deficits in water supply may also occur; a conservative estimate puts losses at US$5.5 billion and they could be as high as US$50.3 billion.

Strong rates of return on adaptation activities, however, mean these offer very ‘bankable’ investments. An existing government of Uganda programme to increase the efficiency of water use by households – which simultaneously increases clean water access to households that have lacked it – shows excellent economic returns. Such facts can help engage a Ministry of Finance to address resource allocation across different sectors to address and prepare for the different impacts of climate change.

A CDKN-supported report on public–private partnerships for climate resilience identified six success factors for policy-makers to bring private businesses and other actors on board: 1. Build on a foundation of local engagement and trust; 2. Start small and local, but position for scale and replicability; 3. Integrate skill building to maximise community ownership; 4. Build adaptive capacity by strengthening businesses and livelihoods; 5. Create partnerships along—or across—value chains, and 6. Find innovative alternatives to traditional infrastructure.

As described in a CDKN Inside Story Harnessing geothermal energy: The case of Kenya, renewable energy development in that country is financed by the government, development partners and the private sector. The government finances energy development via the national budget, while development partners provide loans and grants. Alternatively, the private sector uses debt and equity to fund its geothermal projects. Debt financing occurs when a firm raises capital by selling bonds, bills or notes to investors; in return for lending money, the creditors are promised repayment of the principal and interest. Equity financing raises money for company activities by selling stocks to investors.

A number of innovative projects have been launched to develop, test and scale up resource mobilisation from the private sector for adaptation and mitigation action. These include payments for ecosystem services, making use of the carbon market in developing countries, and introducing new types of insurance schemes.

For example, ‘index-based insurance’ for livestock mortality has helped herders in Mongolia to build their resilience against extreme weather events. Traditional insurance is often not available in large, sparsely populated areas like Mongolia, but index-based insurance provides financial security.

In Bolivia and other Latin American countries, deforestation in upper river basins causes problems downstream, including soil erosion and declining water quality. A CDKN-supported project in the Bolivian Department of Santa Cruz – whose methodology has been widely replicated in other Latin American contexts – explored the potential to tackle these issues together through Reciprocal Water Arrangements. These enable land managers in upper catchments to receive in-kind compensation, designed to boost incomes and livelihood prospects, in exchange for conserving forest lands. Since the first such agreement was developed, over 50 municipal governments and water cooperatives across the Andes joined the movement and thousands of downstream users are now compensating upstream families for protecting 210,000 hectares. These ARA schemes are thus unlocking vital resources for upland farmers who otherwise risked becoming increasingly marginalised by their lack of capital. State law-makers from Bolivia’s Santa Cruz Department produced a draft ‘Sustainable Santa Cruz’ law to promote watershed protection, climate change adaptation, mitigation and economic development, based on this experience.

In Veracruz, Mexico, expansion of sugar cane production, cattle ranching and urban development threatens the tropical rainforest that serves as habitat for numerous species of key migratory bird species. A social marketing campaign was launched to motivate landowners to join a network of conservation areas in exchange for ecosystem payments under the country’s national payments for ecosystem services programme. Initial results indicate the application of social marketing methods facilitated a social change, enabling the protection of more than 1,500 hectares of previously unprotected forest.

There remains, however, a significant gap in support to the diffusion of decentralised and smaller-scale innovations, including technological innovations. This is particularly relevant for Africa. Consistent across energy and agriculture sub-sector case studies, the greatest private financing gap was found to be the lack of resources for widespread diffusion of small-scale technologies (both hard, such as distributed generation, and soft, such as conservation agricultural practices), which are particularly relevant to least developed country contexts.

Targeting smaller business requires a focus on different financial instruments, moving from a few large allocations of project financing to many small applications of working capital loans, lines of credit, venture capital, loan-to-own of consumer goods, etc. It also requires domestic financial institutions to broker such financial services at reasonable transaction costs at scale.

Using public resources to mobilise the financial sector and private economic choices for diffuse small-scale technological change also effectively serves the dual ambitions of climate compatibility and poverty alleviation, which are at the core of many public institutions.

A CDKN-supported study by Dalberg on micro, small and medium-sized enterprises (MSMEs) concluded that MSMEs have an important role to play in climate action as they account for 90% of enterprises in developing countries. Three key areas require attention to increase access to climate finance for MSMEs: improving the enabling environment; increasing knowledge and awareness of MSME climate finance opportunities; and providing tailored financial products. High transaction costs are a fundamental barrier to MSME investing – finance providers should work through local financial intermediaries and MSME aggregators to maximise their reach and efficiency. The vast majority of MSMEs in developing countries are in the informal sector – finance providers should test and expand use of alternative credit worthiness assessments and alternative collateral approaches to reach informal businesses. Based on market projections for MSME climate technology sectors in developing countries, wastewater, small hydropower, and water technologies will support the highest number of MSMEs, so support to these businesses will be crucial.

The challenge is to allocate and prioritise resources towards climate compatible options, and the focus should be on strengthening national systems to ensure effective and efficient management of public capital.

This mirrors the many years of international assistance to improve national budgetary systems, and climate finance adds to the necessity of these reforms. Governments must ‘own’ their national climate finance strategies, with key public institutions on board. At the same time, climate-financing strategies should be aligned with national spending agendas and matched to the readiness level and prevailing conditions in country. In many developing countries, significant public expenditure on adapting to climate change is taking place through national budgets. CDKN is supporting countries like Colombia and Peru to develop frameworks for national climate finance strategies with a view to speeding up the shift to domestic resource flows towards climate compatible investments (see boxes below).

Unfortunately fossil fuel subsidies still hold sway, however. They represent a drain on national budgets and undermine international efforts to avert dangerous climate change. Phasing out these subsides by 2020 for G20 countries (and globally by 2025) would eliminate the perverse incentives that drive up carbon emissions, create price signals for investment in a low-carbon transition and reduce pressure on public finances. A CDKN feature on escaping the fuel subsidy trap in Indonesia highlights the importance of building up the domestic energy infrastructure and systems for reducing the country’s dependence on imported oil and truly breaking free from the fuel allowance trap.

When governments establish strong institutions and commit their own national budgets to climate-related action, this will boost international climate finance flows (e.g. through the Green Climate Fund, GCF). CDKN is helping, for example, the Ethiopian and Rwandan governments to develop their institutional and fiduciary approaches to managing climate finance flows. A CDKN-funded research report by Germanwatch Learning from Direct access modalities in Africa provides valuable lessons from the accreditation process of National Implementing Entities (NIE) for the Adaptation Fund in enhancing developing countries’ direct access to the GCF. CDKN’s experience in supporting Ethiopia in building capacity to gain accreditation to the GCF and Adaptation Fund is summarised in the box (see below).

National Climate Change Funds (NCCFs) have so far not played a significant role in global climate change financing and have often been unable to mobilise sufficient resources to achieve their goals. NCCFs accounted for less than 0.2% of global climate finance flows in 2013. The majority of NCCFs have received less than US$100 million. in lifetime capitalisation. Following a CDKN-supported study by Dalberg, it is clear that successful resource mobilisations often comprise three common elements: 1. Well-defined vision and theory of change; 2. Clear analysis of institutional capacities, gaps, and requirements; and 3. Systematic approach to investor engagement.

Adaptation and mitigation funding are often on different tracks and this can lead to projects that are at cross-purposes to each other. A CDKN-supported research project by Germanwatch concludes that in the case of financing for climate-smart agriculture and food security, the answer could lie in establishing so-called ‘national gatekeeper institutions’ with the primary objective of channelling climate finance for agriculture and food security – without separating mitigation and adaptation funding. These gatekeeper institutions would ensure that the joint mitigation and adaptation potential of agriculture projects was spotted and pursued at country level. Such national institutions might also be best attuned to a country’s diverse farming types. For example, they might be better than international financial institutions at supporting smallholder farmers who depend heavily on their agricultural lands for food security.

In addition, local government should play a crucial part in any national response to climate change. This requires:

• strengthened flows of funding to subnational bodies;
• subnational strategies and governance to be aligned with national ones; and
• subnational entities to be empowered to mobilise and deliver resources for climate compatible development investments, including reallocating existing resources.

For CDKN, climate finance readiness includes the introduction of models for national climate finance delivery, testing innovative schemes for raising and distributing revenue, and improving developing countries’ abilities to reallocate national resources and tap international support for low-emission and climate-resilient investment options. However, even when the necessary institutional and fiduciary capacities are in place for identifying required interventions and managing domestic and international financing, readiness support programmes have frequently identified the lack of a portfolio of bankable projects as a key obstacle to success. This reflects weak capacity in technical preparation, risk assessment, consultative processes and financial engineering for projects that would be based on the needs and priorities of the requesting country/city and in line with the criteria of potential sources of funds.

The term ‘bankable’ means different things to different people and in different contexts. At heart bankability refers to the ability of a funder to finance an investment, having weighed up its expected risks and returns. However, the range of possible funders varies widely in the climate and development context, ranging from commercial banks and pension funds to international climate funds and national governments. The criteria and thresholds contributing to bankability vary depending on the type and source of finance pursued. A number of factors particularly relevant to the bankability of investments and projects in the climate and development context include: vision and transformation, time and scale, cost-benefit trade-offs, and leadership and government ownership.

By combining these characteristics and aligning them with conducive national and subnational policies and regulations, developing countries will be in a position to mobilise the resources necessary for implementing and increasing the ambition of their Nationally Determined Contributions (NDCs) agreed to at COP21 in Paris.