Accelerating the speed and scale of climate finance in the post-pandemic context

ABSTRACT

In this paper, we examine how to trigger a wave of low-carbon investments compatible with the well-below 2°C target of the Paris Agreement in the current post-pandemic context of increasing private and public debt. We argue that one major obstacle to catalysing global excess savings at sufficient scale and speed on climate mitigation, and to ‘greening’ economic recovery packages, lies in the up-front risks of low-carbon investment. We then explain why public guarantees should be the preferred risk-sharing instrument to overcome that obstacle. We outline the basic principles of a multilateral sovereign guarantee mechanism able to maximize the leverage effect of public funds and massively redirect global savings towards low-carbon investments, with the double benefit of bridging the infrastructure investment gap in developing countries and reducing tension between developed and developing countries around accelerated funding for low-carbon transitions. We carry out numerical simulations demonstrating how the use of guarantees from AAA-rated sovereigns, calibrated on an agreed-upon ‘social value of carbon’, is compatible with public-budget constraints of developed countries. In summary, the use of such guarantee mechanisms provides a new form of ‘where flexibility’, which could turn real-world heterogeneity into a source of reciprocal gains for both developed and developing countries, and contribute to meeting the USD 100 billion + pledge of the Paris Agreement.

Key Policy Insights

• Catalysing excess world savings through low-carbon investments (LCIs) would secure a safer and fairer economic recovery from the COVID-19 crisis and avoid locking developing countries into carbon-intensive pathways.

• Public policy instruments focused on the creation of public guarantees can reduce the up-front financial risks associated with LCIs, mobilize private money and increase the leverage of public finance.

• A multi-sovereign guarantee mechanism would yield financial support from developed to developing countries in cash grant equivalent and equity inflows two to four times higher than the ‘USD 100 billion and more’ commitment of the Paris Agreement, and provide greater confidence in meeting this commitment equitably and effectively with benefits for all.

KEYWORDS:

• Climate finance
• public guarantees
• de-risking
• low-carbon investment
• post-COVID recovery
• 100 billion + pledge

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 This explains partly the low leverage of the Clean Development Mechanism of the Kyoto Protocol (Maclean et al., 2008; Ward et al., 2009; MDB, 2019).

2 If $e$ is the private equity share of some investment portfolio $I$, $g$ the share of private loans in the portfolio covered by public guarantee and $r$ the percentage of the guarantee appearing as a liability covering expected default on the guarantor's book, the guarantee’s public cost is $r\left(1-e\right)gI$. For example, if the equity share is 30% and the share of loans guaranteed is 70%, then the extent of risk carried by the guarantee fund is 49% of total investments ($\left(1-e\right)g=0.7\times 0.7$) and even setting the expected default rate at 25%, the total public cost of the guarantee is a small share of total investment ($0.49\times 0.25=0.1225$) and the leverage effect is as high as 8. We abstract here from a more complete model that accounts for residual value of restructured investments (accruing to the guarantor and lenders in seniority and not equity holders) in case a default occurs.

3 Direct public funding is necessary when returns are low (grants for non-marketable services) or when targeting finance directly to investors rather than intermediaries is more efficient (R&D funding) (Whitney et al., 2020; Geddes et al., 2020).

4 For example, in 2020 the Total group secured a USD 15 billion loan for an LNG train in Mozambique, the largest project financing for sub-Saharan Africa (Financial Times, 16 July 2020). One-third was guaranteed by the Export-Import Bank of the US, one-quarter by the Japan Bank for International Cooperation and the rest by the African Development Bank and others, including Indian State-owned oil and gas majors.

5 ‘Callable’ commitments have been used in the European Stabilization Mechanism (Cotterill, 2011) and most multilateral financial institutions.

6 An example is the not-yet-materialized proposal by the European Investment Bank (2014) of a Renewable Energy Platform for Institutional Investors (REPIN). The proposal envisions returns on investment closer to those of private equity than to those from long-term infrastructure, which suggests the interest of multi-sovereign guarantees. The African Development Bank has issued a similar proposal (https://platform.africainvestmentforum.com/) to advance projects under the Africa Investment Forum.

7 More recent estimates for more ambitious scenarios were unavailable at the time of our analyses.

8 Countries like China, Singapore, South Korea and Middle East oil exporters do not face the financial constraints of most developing countries. We considered that only 5% of their LCIs, for example in remote regions, will generate demand for foreign guarantees. We also excluded countries ‘closed’ for geopolitical reasons (SM-4).

9 $50\text{\%}\times \left(1-30\text{\%}\right)=35\text{\%}$ of the USD 855 to 2020 billion LCIs in developing countries.

10 See SM-5 for computational detail.

11 The likelihood of net fiscal benefit is increased by MSGF capitalization, which would reach USD 87 to 1,104 billion after 20 years, bringing gross fiscal costs to between USD 600 million and 804 billion. The breadth of this range stems from the contrasted nature of assumptions backing our 48 tests (see SM-3). The close-to-zero lower bound stands for linearly increasing LCIs, a decreasing default rate and risk perception remaining high at 25% throughout the horizon (which maximizes the size of the MSGF).

12 For 20-year totals of USD $855\times 20=17100$ billion to USD $2020\times 20=40400$ billion, LCIs starting slowly and scaling-up exponentially induce USD 36–94 billion of cumulated gross public costs over the first five years, compared with USD 52–136 billion for LCIs rising linearly (see SM-3).

13 Authors’ computation on World Development Indicators (The World Bank) data.

14 The range is that of the 24 tests of SM-3 that assume the higher bound of risk perception (25%).

15 This emergence is of importance for oil and gas-exporting countries to facilitate the reinvestment of fossil fuel rents in directions accelerating their economic diversification.

16 Negotiability of the system would be increased by the low sensitivity of the SVMA to the discount rate (Table 2), which should put into perspective controversies about that rate’s level.