Green finance: a way to escape the “climate investment trap” and ensure a sustainable transition

Unattractive local conditions for investment increase the perception of risk and prevent emerging countries from obtaining the funds needed to finance climate change policies. But breaking free from this trap is possible

At the COP26 conference, which ended on 12 November, the roughly 200 countries that attended the historic event adopted the “Glasgow Pact” to accelerate the fight against climate change and lay the foundations for its future financing. The agreement confirms the goal of limiting global warming to 1.5° C compared to pre-industrial levels. In order to achieve this target, global greenhouse gas emissions will have to be significantly reduced, reaching zero emissions by 2050.

In light of these ambitious goals, developed economies have a serious responsibility to mobilise sufficient resources in poorer and developing countries to meet the cost of climate change policies. The International Energy Agency (IEA) estimates that the developing world requires more than 1 trillion dollars per year to support the necessary transition towards clean energy and the resulting reduction in emissions.

Government funding or resources provided by international cooperation organisations do not come close to the necessary amount of money needed to allow developing countries to meet their emission reduction targets by 2030. So private investments are crucial in enabling the poorest countries to reduce their emissions and launch energy transition policies without compromising their path to development. 

However, a number of obstacles remain. The vulnerability of most poor countries to economic and climate shocks has heightened over recent decades and this, combined with political and economic instability, has made them less attractive to investors. This blocks these countries in a “climate investment trap”: a vicious circle by which unattractive local conditions for investment increase the perception of risk. How can developing countries break free from this “trap”?


Green Bond and “blended finance” based on public-private collaboration

In a recent report, the United Nations Conference on Trade and Development (UNCTAD) suggested that one way to adapt to climate change and attract resources is to move away from austerity as the default policy framework for managing aggregate demand and move towards policies that favour large-scale public investments in building a diversified low-carbon economy, powered by renewable energy sources and green technology, and in which economic activity within and across sectors are interconnected through resource-efficient links.

An essential role is also played by the strengthening of local financial systems, from the development of the green bond market to the use of “blended finance” - i.e. financing mechanisms based on collaboration between the public and private sectors, so that public bodies can provide a safety net for investments, establishing a virtuous circle that attracts new private investors, with an effect that is amplified if accompanied by collaboration with international development banks.

Among the financial instruments able to support this transition, so-called “green bonds” are playing an increasingly important role and, in the wake of the 2015 Paris Agreement, have seen considerable growth over the past years. These instruments differ from conventional bonds in the environmental benefits expected of the financial project. Issued for the first time in 2007 by the European Investment Bank (EIB), green bonds – also known as climate bonds – only finance projects with positive climate, environmental and sustainability outcomes across various sectors including energy, transport, construction, agriculture and water resources. These projects range from renewable energy infrastructure to transport and low-emission buildings.

According to Climate Bonds Initiative, a non-profit international organisation, global issuance of green bonds reached a record 269.5 billion dollars last year. The United States, Germany and France are the top three issuing countries, with China in fourth place. However, the rest of Asia is also catching up in the wake of the green transition. According to a Moody’s report, during the first three months of 2021, issuers from Asia Pacific made up 24 percent of global issuance, compared to 18 percent in the whole of 2020.

Green bond issuance is also slowly gaining momentum in Africa where some countries most affected by climate change are seeing emissions at 4 percent, a relatively low figure compared to other continents.
According to UNECA's estimates, Africa needs roughly 1,3 trillion dollars per year to reach the 2030 Agenda goals for sustainable development. Despite efforts to improve the mobilisation of domestic revenue, however, Africa faces a huge financial gap to sustain its development agenda.

To date, six countries in the continent have issued green bonds to fund green projects in various sectors of the economy: South Africa, Morocco, Nigeria, the Seychelles, Namibia and Kenya. However, other countries are also making the most of the opportunity. At the beginning of 2021, Ghana committed to issuing up to 2 billion dollars in green bonds to improve the sustainability of its economy. At the end of September, Egypt – which will host COP27 in November 2022 – also began issuing green bonds, becoming the first Arab country to use this instrument. Cairo has also set a target for 30 percent of public projects to meet environmental standards by 2024. 


“Blended finance” mechanisms, towards sustainable development

Another system used to support projects otherwise considered risky by investors is “blended finance”, which aims to attract commercial capital to projects that contribute to sustainable development, while providing financial returns to investors. This innovative approach helps increase the total amount of resources available to developing countries, integrating their own investments with ODA (Official Development Assistance) inflows to close the funding gap of the Sustainable Development Goals set by the UN and support the implementation of climate agreements.

According to a report published at the end of October by Convergence (the global network for blended finance), from 2015 to 2020, annual flows of blended financial capital averaged roughly 9 billion dollars. However, like the rest of the global financial system, the blended finance market has felt the unprecedented effects of the Covid-19 pandemic. In 2020, the year covered by the current report, blended finance flows were significantly lower at 4.5 billion dollars. Sub-Saharan Africa remains the region where most blended financial activity takes place: almost two thirds (62 percent) of blended financial transactions in 2020 went to the Sub-Saharan region. Asia has also emerged as an increasingly important destination for blended finance, accounting for roughly 36 percent of transactions in 2020.