Getting Financial Markets to Work for Climate Finance

Abstract

Financing the Paris Agreement commitments would require trillions of dollars per year, and most of that would need to come from private sources. Despite huge potential, climate finance flows remain constrained by many barriers, key among them the lack of financial viability of climate-focused projects. Despite several initiatives and innovative financing solutions to incentivize private finance—such as blended finance to leverage public finance and risk mitigation solutions to enable commercial climate investments—private investments in green projects are limited. To a large extent, the regulated financial system of banking and capital markets and the extant regulations do not align well with the goals of climate finance. A major shift is required in the existing trajectory of the current targets for climate-focused investments to be met, both by lending institutions and capital markets.

One approach to addressing the concern about adequate finance for green projects focuses on factoring climate risks into investment and lending decisions (that is, into pricing and capital allocation) through banking regulation. These alternatives are discussed in this article. Another concern, the risk associated with the greening financial markets themselves, could be countered by offering a risk subsidy for banks and financial institutions that finance climate investments; this strategy would include subsidizing the cost of financing green projects through a reduction in the risk premium or capital charges of the project. Risks could be priced by using the mechanism of trading and pricing carbon emissions, and resources from a carbon tax also could be allocated to pay for the subsidy. This article discusses a structure to make a blended finance option effective. Both of these approaches—enabling regulations and blended finance to lower the cost of capital—can unlock substantial financing opportunities for climate projects. Institutional commitment is paramount to facilitate both the financing of green projects and the greening of the financial sector.