Clean energy investment is an example of climate finance. It has benefited from post-pandemic economic recovery, a global energy crisis involving high fossil fuel prices, and growing policy support across various nations.[1]

Climate finance are funding processes for investments related to climate change mitigation and adaptation. The term has been used in a narrower sense to refer to transfers of public resources from developed to developing countries, in light of their UN Climate Convention obligations to provide "new and additional financial resources". In a wider sense, the term refers to all financial flows relating to climate change mitigation and adaptation.

The 2015 United Nations Climate Change Conference introduced a new era for climate finance, policies, and markets. The Paris Agreement adopted there defined a global action plan to put the world on track to avoid dangerous climate change by limiting global warming to well below 2 °C above preindustrial levels. The agreement covers climate change mitigation, adaptation, and finance. The financing element includes climate-specific support mechanisms and financial aid for mitigation and adaptation activities to spur and enable the transition towards low-carbon, climate-resilient growth and development through capacity building, R&D and economic development.[2]

As of November 2020, development banks and private finance had not reached the US$100 billion per year investment stipulated in the UN climate negotiations for 2020.[3] However, in the face of the COVID-19 pandemic's economic downturn, 450 development banks pledged to fund a "Green recovery" in developing countries.[3]

Definition and context

Climate finance is "finance that 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", as defined by the United Nations Framework Convention on Climate Change (UNFCCC) Standing Committee on Finance.[4]

The term has also been used in a narrower sense to refer to transfers of public resources from developed to developing countries, in light of their UNFCCC obligations to provide "new and additional financial resources". Furthermore, in a wider sense it is used to refer to all financial flows relating to climate change mitigation and adaptation.[5]

UNFCCC obligations

At the 16th Conference of the Parties in 2010 (Cancun 2010) developed countries committed to the goal of mobilizing jointly USD 100 billion per year by 2020 to address the needs of developing countries. The decision by the 21st Conference of the Parties (Paris 2015) also included the commitment to continue their existing collective mobilization goal through 2025.[6] In 2025 a new goal is expected to be adopted.

However, the amount of finance actually provided has been estimated as well below this. According to OECD figures, climate finance provided and mobilized reached $83.3bn in 2020 and $89.6bn in 2021.[7][8] This means that the US$100 billion per year by 2020 target has been missed.

European Investment Bank Investment Survey 2020 on green firms investing in climate[9][10]

Subcategories

Mitigation finance is investment that aims to reduce global carbon emissions. Adaptation finance aims to respond to the consequences of climate change.[11]: 1553–1554  These two subcategories of climate finance are normally considered separately. However, the two areas are known to have many trade-offs, co-benefits and overlapping policy considerations. The Paris Agreement is an important international agreement between governments, which has also helped to engage financial institutions in the climate agenda. The third aim of the Agreement (article 2.1 c) is to make finance flows consistent with the mitigation and adaptation goals of the agreement.[11]: 1553–1555  The Agreement called for a balance of climate finance between adaptation and mitigation.

Finance for mitigation

Main article: Economics of climate change mitigation § Finance

Global climate finance is heavily focused on mitigation. Key sectors for investment have been renewable energy, energy efficiency and transport.[11]: 1549, 1564  There has also been an increase in international climate finance towards the 100 billion target. Most of the estimated US$83.3 billion provided to developing countries in 2020, was targeted at mitigation (US$48.6 billion, or 58%).[7] On a worldwide scale, mitigation financing accounts for over 90% of investment in climate finance. Around 70% of this mitigation money has gone towards renewable energy, however low-carbon mobility is a key development sector.[12] Global energy investment has increased since the 2020 COVID-19 pandemic crisis. However, the crisis has placed a great additional strain on the global economy, debt and the availability of finance, which is expected to be felt in years to come.[11]: 1555 

Mitigation costs and mitigation financing needs

In 2010, the World Development Report preliminary estimates of financing needs for mitigation and adaptation activities in developing countries range from $140 to 175 billion per year for mitigation over the next 20 years with associated financing needs of $265–565 billion and $30–100 billion a year over the period 2010–2050 for adaptation.[13]

The International Energy Agency's 2011 World Energy Outlook (WEO) estimates that in order to meet the growing demand for energy through 2035, $16.9 trillion in new investment for new power generation is projected, with renewable energy (RE) comprising 60% of the total.[14] The capital required to meet projected energy demand through 2030 amounts to $1.1 trillion per year on average, distributed (almost evenly) between the large emerging economies (China, India, Brazil, etc.) and the remaining developing countries.[15] It is believed that over the next 15 years, the world will require about $90 trillion in new infrastructure – most of it in developing and middle-income countries.[16] The IEA estimates that limiting the rise in global temperature to below 2 Celsius by the end of the century will require an average of $3.5 trillion a year in energy sector investments until 2050.[16]

A meta-analysis from 2023 investigated the "required technology-level investment shifts for climate-relevant infrastructure until 2035" within the EU, and found these are "most drastic for power plants, electricity grids and rail infrastructure", ~€87 billion above the planned budgets in the near-term (2021–25), and in need of sustainable finance policies.[17][18]

Finance for adaptation

Finance is an important enabler for climate adaptation, for both developed and developing countries.[19]: 2586  It can come from a variety of sources. Public finance is provided directly by governments or via intermediaries such as development finance institutions (eg. MDBs or other development agencies). It can also be channelled through multilateral climate funds. Some multilateral climate funds have a specific focus on adaptation within their mandate. These include the Green Climate Fund, the CIFs and the Adaptation Fund. Private finance can come from commercial banks, institutional investors, other private equity or other companies or from household or community funding. The vast majority of tracked finance (around 98%) has originated from public sources. This is partly because of the lack of a well-defined income stream or business case with an attractive return on investment on projects.[19]: 2590 [20]

Finance can be delivered through a range of instruments including grants or subsidies, concessional and non-concessional (i.e. market) loans as well as other debt instruments, equity issuances (listed or unlisted shares) or can be delivered through own funds, such as savings.[19]: 2588  The largest proportions of adaptation finance have been invested in infrastructure, energy, built environment, agriculture, forestry/nature and water-related projects.[19]: 2596 

Only around 4-8% of total climate finance has been allocated to adaptation. The vast majority has been allocated to mitigation with only around 1-2% on multiple objectives.[19]: 2590 

Adaptation costs and adaptation financing needs

Adaptation costs are the costs of planning, preparing for, facilitating and implementing adaptation.[21]: 31  Adaptation benefits can be estimated in terms of reduced damages from the effects of climate change. In economic terms, the cost to benefit ratio of adaptation shows that each dollar can deliver large benefits. For example, it is estimated that every US$1 billion invested in adaptation against coastal flooding leads to a US$14 billion reduction in economic damages.[21]: 52  Investing in more resilient infrastructure in developing countries would provide an average of $4 in benefit for each $1 invested.[22] In other words, a small percentage increase in investment costs can mitigate the potentially very large disruption to infrastructure costs.

A 2023 study found the overall adaptation costs for all developing countries to be around US$215 billion per year for the period up to 2030. The highest adaptation expenses are for river flood protection, infrastructure and coastal protection. They also found that in most cases, adaptation costs will be significantly higher by 2050.[21]: 35–36 

It is difficult to estimate both the costs of adaptation and the adaptation finance needs. The costs of adaptation varies with the objective and the level of adaptation required and what is acceptable as residual, i.e. 'unmanaged' risk.[21]: 33  Similarly, adaptation finance needs vary depending on the overall adaptation plans for the country, city, or region. It also depends on the assessment methods used. A 2023 study analysed country-level information submitted to the UNFCCC in National Adaptation Plans and Nationally Determined Contributions (85 countries). It estimated global adaptation needs of developing countries annual average to be US$387 billion, for the period up to 2030.[21]: 31 

Both the cost estimates and needs estimates have high uncertainty. Adaptation costs are usually derived from economic modelling analysis (global or sectoral models). Adaptation needs are based on programme and project-level costing.[21]: 37  These programmes depend on the high level adaptation instrument – such as a plan, policy or strategy. For many developing countries, the implementation of certain actions specified in the plans is conditional on receiving international support. in these countries, a majority (85%) of finance needs are expected to be met from international public climate finance, i.e. funding from developed to developing countries.[21]: 38  There is less data available for adaptation costs and adaptation finance needs in high income countries. Data show that per capita needs tend to increase with income level, but these countries can also afford to invest more domestically.[21]: 39 

Current levels of financing and the finance gap

Between 2017 and 2021, total international public finance to developing countries for climate adaptation has remained well below US$30 billion per year.[21]: 42  This equals about 33% of the total public climate finance, with an additional 14% spending on cross-cutting activities (supporting both adaptation and mitigation). This includes finance from multilateral development banks, bilateral agencies and multilateral climate funds as the three largest types of provider. 63% of the adaptation-specific funding was provided as loans, and 36% as grants.[21]: 45  Disbursement of funds for adaptation, at 66% of the amounts committed, is much lower than for mitigation. This indicates difficulty and complexity of implementation.[21]: 46 

The adaptation finance gap is the difference between estimated costs of adaptation and the amount of finance available for adaptation.[21]: 31  Based on data over 2017-2021, the estimated costs or needs are around 10-18 times as much as current levels of public flows. Domestic budgets and private climate finance for adaptation are not included in these figures. The gap has widened compared to previous assessments. Increasing both international and domestic public finance and mobilising private finance can help to close the finance gap. Other options include remittances, increased finance for small businesses, and reform of the international financial system, for example through changes in managing vulnerable countries' debt burden.[11]: 1550 [21]: 16 

Types of finance

Multilateral climate finance

Multilateral climate funds

The multilateral climate funds (i.e. governed by multiple national governments) are important for paying out money in climate finance. As of 2022, there are five multilateral climate funds coordinated by the UNFCCC. These are the Green Climate Fund (GCF), the Adaptation Fund (AF), the Least Developed Countries Fund (LDCF), the Special Climate Change Fund (SCCF) and the Global Environment Facility (GEF). The largest of these, the GCF, was formed in 2010.[23][24]

The other main multilateral fund, Climate Investment Funds (CIFs), is coordinated by the World Bank. The Climate Investment Funds has been important in climate finance since 2008.[25][26] It comprises two funds, the Clean Technology Fund and the Strategic Climate Fund. The latter sponsors innovative approaches to existing climate change challenges, whereas the former invests in clean technology projects in developing countries.

Also in 2022, nations agreed on a proposal to establish a multilateral loss and damage fund to support communities in averting, minimizing, and addressing damages and risks where adaptation is not enough or comes too late.[27]: 63 

Some multi-lateral climate change funds work through grant-only programmes. Other multilateral climate funds use a wider range of financing instruments, including grants, concessional loans, equity,[clarification needed] and risk mitigation options.[19]: 2583  These are intended to crowd in other sources of finance, whether from domestic governments, other donors, or the private sector.

Multilateral development banks

Multilateral development banks (MDBs) are important providers of international climate finance. MDBs are financial vehicles created by governments to support economic and social efforts, predominantly in developing countries. The MDBs goals usually mirror the aid and collaboration regulations of their founding members.[28] They complement the programmes of (national government) members' bilateral development agencies, allowing them to work in more countries and at a larger scale.[29] The Paris Agreement also provided momentum for the MDBs to align their investments and strategies with climate goals, and in 2018 the MDBs collectively announced a joint framework for financial flows.[11]: 1553  The MDBs use the widest range of financing instruments including grants, investment loans, equity, guarantees, policy-based financing and results-based financing.[19]: 2583 

The World Bank uses money contributed by governments and companies in OECD countries to purchase project-based greenhouse gas emission reductions in developing countries and countries with economies in transition. These include the BioCarbon Fund Initiative, which is a public-private partnership providing finance for the land use sector. The Partnership for Market Readiness focuses on market-based mechanisms. The Forest Carbon Partnership Facility explores use of carbon market revenues for reducing emissions from deforestation and forest degradation (REDD+).[30]

Bilateral climate finance

Financial flows for climate change mitigation and adaptation in developing countries

Bilateral institutions include development cooperation agencies and national development banks. Until quite recently they have been the largest contributors to climate finance, but since 2020 bilateral flows have decreased whilst multilateral funding has grown.[11]: 1553  Some bilateral donors have thematic or sectoral priorities, whilst many also have geopolitical preferences for working in certain countries or regions.[19]: 2583 

Bilateral institutions include donors such as the USAID, the Japan International Cooperation Agency (JICA), Germany's KfW Development Bank and the UK Foreign, Commonwealth and Development Office (FCDO). Many bilateral agencies also make donations through multilateral channels and this allows them to work in more countries and at a larger scale.[29] However the overall international climate finance system (for financial flows from developed to developing countries) is complex and fragmented, with overlapping mandates and objectives. This creates significant co-ordination problems.[31][32]: 9 

Domestic public climate finance

Financial flows and expenditures by national governments on climate are significant. Domestic targets on addressing climate change are set out in national strategies and plans, including those submitted to the UNFCCC under the Paris Agreement. For many developing countries, the plans submitted include targets attached to international financial and technical support (i.e. conditional targets).

National-level coordination of climate funding is important for meeting these domestic targets, and in the case of developing countries, also for accessing international funding.[32]: 9  For all countries and regions, it is recognised that public funding will not be sufficient to meet all finance needs. This means that policy makers need to take a strategic approach through using public funding to leverage additional private finance. Other funding can come from financial institutions such as banks, pension funds, insurance companies and asset managers.

Private climate finance

Public finance has traditionally been a significant source of infrastructure investment. However, public budgets are often insufficient for larger and more complex infrastructure projects, particularly in lower-income countries. Climate-compatible investments often have higher investment needs than conventional (fossil fuel) measures,[33] and may also carry higher financial risks because the technologies are not proven or the projects have high upfront costs.[34] If countries are going to access the scale of funding required, it is critical to consider the full spectrum of funding sources and their requirements, as well as the different mechanisms available from them, and how they can be combined.[35] There is therefore growing recognition that private finance will be needed to cover the financing shortfall.[36]

Private investors could be drawn to sustainable urban infrastructure projects where a sufficient return on investment is forecast based on project income flows or low-risk government debt repayments. Bankability and creditworthiness are therefore prerequisites to attracting private finance.[37] Potential sources of climate finance include commercial banks, investment companies, pension funds, insurance companies and sovereign wealth funds. These different investor types will have different risk-return expectations and investment horizons, and projects will need to be structured appropriately.[38]

During the COVID-19 pandemic, climate change was addressed by 43% of EU enterprises. Despite the pandemic's effect on businesses, the percentage of firms planning climate-related investment rose to 47%. This was a rise from 2020, when the percentage of climate related investment was at 41%.[39][40] Climate investment in Europe has been growing in the 2020s. However, the need for the EU's "Fit for 55" climate package remains 356 billion euros a year. Since 2020, US firms' desire to innovate has increased, whereas European firms' has decreased.[41] As of 2022, spending in climate for European enterprises has climbed by 10%, reaching 53% on average. This has been especially noticeable in Central and Eastern Europe at 25% and in small and medium-sized firms (SMEs) with a 22% increase in climate financing.[42]

Carbon offsetting through voluntary carbon markets is a way for private sector enterprises to invest in projects that avoid or reduce emissions elsewhere. The original carbon offsetting and credit mechanisms were "flexibility mechanisms" defined in the Kyoto Protocol. They comprise the compliance carbon market, focusing on trading/crediting (obligatory) emission reductions between countries. In voluntary carbon markets, companies or individuals use carbon offsets to meet the goals they set themselves for reducing emissions. Voluntary carbon markets are growing significantly.[43] Mechanisms such as REDD+ include private sector contributions via voluntary carbon markets.[11]: 1608  However, the relative flows of private finance from developed to developing countries remain quite small. It is estimated that over 90% of private climate flows remain within national borders.[11]: 1577 

Financial instruments

Several different financial models or instruments have been used for financing climate actions. The overall business model may include several of these financing mechanisms combined to create the climate solution. Financial models can belong to different categories e.g. public budgets, debt, equity, land value capture or revenue generating models etc.

Debt-for-climate swaps

Debt-for-climate swaps happen where debt accumulated by a country is repaid upon fresh discounted terms agreed between the debtor and creditor, where repayment funds in local currency are redirected to domestic projects that boost climate mitigation and adaptation activities.[44] Climate mitigation activities that can benefit from debt-for-climate swaps includes projects that enhance carbon sequestration, renewable energy and conservation of biodiversity as well as oceans.

For instance, Argentina succeed in carrying out such a swap which was implemented by the Environment Minister at the time, Romina Picolotti. The value of debt addressed was $38,100,000 and the environmental swap was $3,100,000 which was redirected to conservation of biodiversity, forests and other climate mitigation activities.[45] Seychelles in collaboration with the Nature Conservancy also undertook a similar debt-for-nature swap where $27 million of debt was redirected to establish marine parks, ocean conservation and ecotourism activities.[46]

Green bonds (or climate bonds)

A Green bond (also known as climate bond) is a fixed-income financial instruments (bond) which is used to fund projects that have positive environmental and/or climate benefits.[47][48] They follow the Green Bond Principles stated by the International Capital Market Association (ICMA),[49] and the proceeds from the issuance of which are to be used for the pre-specified types of projects.[1]

Like normal bonds, climate bonds can be issued by governments, multi-national banks or corporations and the issuing organization repays the bond and any interest. The main difference is that the funds will be used only for positive climate change or environmental projects. This allows investors to target their environmental, social, and corporate governance (ESG) goals by investing in them. They are similar to Sustainability Bonds but sustainability bonds also need to have a positive social outcome.[50]

Offsetting (credit trading)

Wind turbines near Aalborg, Denmark. Renewable energy projects constitute one common type of carbon offset project.[51]
Carbon offsetting is a trading mechanism that allows entities such as governments, individuals, or businesses to compensate for (i.e. “offset”) their greenhouse gas emissions by supporting projects that reduce, avoid, or remove emissions elsewhere.[52][53][54] A carbon credit or offset credit is a transferable financial instrument, that is a derivative of an underlying commodity.[55] It can be bought or sold after certification by a government or independent certification body.[56][57][58] When an entity invests in a carbon offsetting program, it receives carbon credits, i.e "tokens" used to account for net climate benefits from one entity to another.[55] One carbon offset or credit represents a reduction, avoidance or removal of one tonne of carbon dioxide or its carbon dioxide-equivalent (CO2e). Offset projects that take place in the future can be considered to be a type of promissory note: The purchaser of the offset credit pays carbon market rates for the credits and in turn receives a promise that the purchaser's greenhouse emissions generated in the present (e.g. a roundtrip flight to London) will be offset by elimination of an equal amount at some point in the future (e.g. 10 to 20 years for planting 110 seedlings). Offsets that were generated in the past are credible only if they were in addition to reductions that would have happened anyway.[59]
Payments for Ecosystem Services (PES)
Payments for ecosystem services (PES), also known as payments for environmental services (or benefits), are incentives offered to farmers or landowners in exchange for managing their land to provide some sort of ecological service. They have been defined as "a transparent system for the additional provision of environmental services through conditional payments to voluntary providers".[60] These programmes promote the conservation of natural resources in the marketplace.

Other financial instruments

The following financial instruments can also be used for climate finance but were not developed specifically for climate finance:

Finance committed and dispersed

In 2019, CPI estimated that annual climate finance reached more than US$600 billion.[61] Data for 2021/2022 showed it to be almost USD 1.3 trillion, with most of the increase coming from acceleration in mitigation finance (renewable energy and transport sectors).[62] These figures take into account all countries and both private and public finance. The bulk of this finance is raised and spent domestically (84% in 2021/2022). International public climate finance from developed to developing countries was found to be well below US$70 billion per year for the period 2017-2021.[21]: 42  The OECD, which includes export credits and mobilised private finance, estimated 2021 flows to be USD$89.6 billion.[8] There are differences in estimates due to different definitions and methods used.

In 2009, developed countries committed to jointly mobilize $100 billion annually in climate finance by 2020 to support developing countries in reducing emissions and adapting to climate change.[63]

In 2016, the four main multilateral climate funds approved $2.78 billion of project support. India received the most single-country support, followed by Ukraine and Chile. Tuvalu received the most funding per person, followed by Samoa and Dominica. The US is the largest donor across the four funds, while Norway makes the largest contribution relative to population size.[64] Climate financing by the world's six largest multilateral development banks (MDBs) rose to a seven-year high of $35.2 billion in 2017. According to OECD figures, climate finance provided and mobilized reached $83.3bn in 2020. Another study reported that the money given for climate change was only worth about a third of what was said ($21–24.5bn).[65]

European Investment Bank

Since 2012, the European Investment Bank (EIB) has provided €170 billion in climate funding, which has funded over €600 billion in programs to mitigate emissions and help people respond to climate change and biodiversity depletion across Europe and the world.[66][67] In 2022, the Bank's funding for climate change and environmental sustainability projects totaled €36.5 billion. This includes €35 billion for initiatives supporting climate action and €15.9 billion for programs supporting environmental sustainability goals. Projects with combined climate action and environmental sustainability advantages received €14.3 billion in funding.[68] Over 2021-2030, the Bank wants to assist €1 trillion in green investment.[69] Currently, only 5.4% of the Bank's loans for climate action are dedicated to climate adaptation, but funding did increase significantly in 2022, reaching €1.9 billion.[70]

Challenges

Tracking climate finance flows

Information on climate finance flows is much better for international climate finance than for domestic climate finance.[11]: 1566  International public finance from multilateral and bilateral sources can be tagged to specify that it is targeting climate mitigation or adaptation or both (i.e. is cross-cutting).[71] A number of initiatives are underway to monitor and track flows of international climate finance.[72] For example analysts at Climate Policy Initiative (CPI) have tracked public and private sector climate finance flows from a variety of sources on a yearly basis since 2011.

This work has fed into the United Nations Framework Convention on Climate Change Biennial Assessment and Overview of Climate Finance Flows[73] and in the IPCC Fifth Assessment Report and IPCC Sixth Assessment Report chapters on climate finance. These suggest a need for more efficient monitoring of climate finance flows.[74] In particular, they suggest that funds can do better at synchronizing their reporting of data, being consistent in the way that they report their figures, and providing detailed information on the implementation of projects and programs over time. There is also a need for improved reporting and tracking by domestic and private climate finance actors. This could be achieved through national regulations for mandatory and standardized disclosure.[20]: 55 

Climate finance gap

Research finds substantially lower bilateral climate finance numbers than current official estimates.[75][76][77][78] Reasons are among others a lack of universally agreed-upon definitions of what qualifies as international climate finance and no oversight.[79] This has led to an inclusion of non-climate projects, a lack of transparency and ultimately a credibility issue regarding official international climate finance reporting.[79]

The estimates of the climate finance gap - that is, the shortfall in investment - vary according to the geographies, sectors and activities included, timescale and phasing, target and the underlying assumptions. The 2018 Biennial Assessment estimated financing needs for mitigation between 2020 and 2030 to be USD$1.7-2.4 trillion per year.[73]

Moral responsibility and legal obligation

See also: Climate justice

Developed countries are responsible for the majority of cumulative greenhouse gas emissions since the industrialization and generally have greater capacity to provide support. Therefore, it is argued, that they have a moral responsibility and a legal obligation to provide finance to help developing countries undertake climate action.[6] At the 16th Conference of the Parties in 2010 developed countries committed to the goal of mobilizing jointly USD 100 billion per year by 2020 to address the needs of developing countries, and the decision by the 2015 United Nations Climate Change Conference also included the commitment to continue their existing collective mobilization goal through 2025.[6] However, these agreements don't offer guidance on how to allocate climate finance responsibility to individual countries.

Several institutions and researchers have developed methodologies to determine country-specific contribution shares based on equity-principles. All models have in common that they at least use one wealth variable (e.g. share of GDP or GNI) to consider the ability to pay and an emission variable (share of CO2 or GHG) to reflect emission responsibility.[6] Some models additionally consider countries' population or their willingness to pay.[6] Furthermore, another proposal of a mechanism suggests to incorporate forward-looking data in so-called dynamic model. For the dynamic components, the share of GDP is determined by a 2030 forecast adjusted for expected climate damages and the share of GHGs covers future emissions up to 2030 and accounts for unconditional emission reduction targets submitted by the countries where available.[80]

Incentivizing private investment in adaptation

Climate change adaptation is a much more complex investment area than mitigation. This is mainly because of the lack of a well-defined income stream or business case with an attractive return on investment on projects. There are several specific challenges for private investment:[81][82]

However, there is considerable innovation in this area. This is increasing the potential for private sector finance to play a larger role in closing the adaptation finance gap.[83] Economists state that climate adaptation initiatives should be an urgent priority for business investment.[84][85]

See also

References

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