Reader

Introduction

by Oscar Reyes on .

Climate change plus finance. When you put together two of the most hotly contested political issues of the day, there’s unlikely to be much agreement over what the terms even mean, let alone what action should be taken. The Reader you have before you sets out to understand what climate change means for the financial sector, and what financial opportunities financial markets, private banks and investors see in relation to climate change. Those issues are at the center of debates on climate finance right now, but are a long way removed from what has conventionally been placed under the rubric of “climate finance.”

Let’s rewind a little, then, to consider climate finance as it is usually discussed: a series of national, regional and international sources of funding directed towards climate change. Climate finance in this sense refers to the transfer of public funds from Northern industrialized to Southern developing countries to cover the costs of dealing with the long-term impacts of climate change.

The basic idea is that it should help Southern countries to pursue low-emissions paths without repeating the unsustainable reliance on fossil-fuels that was central to the industrialization of Northern countries. That’s called “mitigation.” In addition, money is allocated towards “adaptation,” which aims to address the problems that are caused by the concentration of greenhouse gases already emitted: increased droughts, flooding and other extreme weather patterns.

The obligations and flows of finance are not equally spread across the globe. Southern countries will suffer three-quarters of the damage caused by climate change, but have done and are still doing the least to cause it. Sometimes these global imbalances are referred to as “climate debt,” a term that clarifies where the responsibility for climate change lies, and makes clear that it is a responsibility of Northern industrialized countries. Approaching climate finance as reparations for climate debt distinguishes it from aid (“official development assistance”), private charity or the creation of new trade and investment opportunities for transnational companies.

The UN Framework Convention on Climate Change (UNFCCC) sets out the basis for climate finance in similar, if slightly more technical terms. Article 4.3 of that agreement commits Annex II countries (a list that includes all members of the European Union, the USA, Canada, Japan, Australia, Switzerland and New Zealand) to provide “new and additional financial resources” for the “full incremental costs” of addressing climate change. But if we look at how finance has actually flowed, we find that there has only been a trickle of funding, mostly directed towards mitigation in middle-income countries, and that the public financing is now drying up.

At the same time, the waters are being muddied by redefinitions of climate finance to encompass all financial flows relating to climate mitigation and adaptation. Many of the activities reported as “climate finance” are barely related to, or even worsen, climate change. The $30 billion pledged for “fast-start” finance at the Copenhagen climate conference in 2009 includes everything from multi-million dollar loans to coal-fired power stations in Indonesia, oil refineries in Brazil, subsidies for maritime border security in Yemen and Tunisia, and Coca-Cola bottling plants in Nigeria.

In part, this reflects attempts to broaden the definition of climate finance to encompass all forms of “climate-related” finance. Rather than focusing only on public financial flows, the climate finance investment landscape is being mapped as one that includes any grants, loans or loan guarantees, private as well as public money, that go towards renewable energy, energy efficiency and fuel switching, forestry and land use, urban transport and carbon sequestration projects, as well as technical assistance and capacity building to address climate change. Adaptation includes projects are those which are partly or wholly dedicated to addressing the impacts of climate change, such as water scarcity, agricultural resilience, infrastructure to withstand floods and other extreme weather, and capacity building.

The key difference between these broader and narrower definitions of climate finance are that the latter includes one or more of the following: sources that are not “additional” (such as aid money), private finance, and “capital investment” (rather than just “incremental costs”). Counting capital investment means including market-rate loans (which will need to be paid back) as well as equity investments (ownership of a stake in projects, or companies running these projects) in the figures.

The implications stretch beyond issues of accounting, and even those of industrialized countries’ disproportionate historic and current responsibility for climate change. Broader definitions of the climate finance landscape are increasingly re-framing the climate change debate in terms of the norms of the financial sector, rather than the needs and perspectives of communities at the frontlines of climate change. This, in turn, is limiting the role and understanding of what “public” finance can do, and how its priorities are set. Public finance is not simply money based on taxation, but has broader implications around local control, accountable decision-making and economic sovereignty – concerns that activists and NGOs continue to bring to the “climate finance” table.

What is underlying the private sector turn in climate finance? The causes are undoubtedly complex, but one of main elements is that, after the 2008 financial crisis, budget-strapped industrialized countries started to claim more and more loudly that they could ill-afford public financial transfers. At the same time, inaction on emissions and a clearer understanding of the impacts of climate change have led to ever growing estimates as to how much mitigation and adaptation will cost. The starting point for UN climate negotiations is a figure of $100 billion a year by 2020, although a 2011 estimate by the UN’s Department of Economic and Social Affairs (UN-DESA) suggested that $1.1 trillion  would be required for the transformation of energy and agricultural systems in Southern countries.

“Scaling up” public financial flows is insufficient to meet the challenge posed by climate change, and with public budgets in industrialized countries constrained by the financial crisis and cross-government austerity, those countries argue that it is unrealistic to expect them to do so.

This lack, or perceived lack, of conventional “climate financing” spurred a search for “innovative” sources of finance. These include a number of proposals that hold the potential to unlock significant finance while going some way to challenging the dominance of the financial sector – such as financial transaction taxes, measures to crack down on tax-havens, Special Drawing Rights and global shipping and aviation levies.

In general, however, the ambition for publicly-provided finance has been narrowed to simply “leveraging” private sector investment. Leveraging has a precise meaning in relation to the financial sector, where it refers to the ratio between equity (shareholders’ capital) and the debt that is taken on in relation to that. But in climate change discussions, its use is far more vague, and it is taken to describe any measure whose intention is to catalyze (encourage) private sector investment in renewable energy, energy efficiency and low-carbon infrastructure projects and programmes in Southern countries.

The proponents of more leveraging argue that it is vital for policy-makers to learn to think like investors, evaluating risks and returns. “Investment-grade policy” means that “investment opportunities must be commercially attractive compared to alternative uses of capital, with different capital providers having different appetite for risk and expectation of the return for that risk,” according to the UK-government sponsored Capital Markets Climate Initiative. In particular, proposals to scale-up private finance focus on encouraging more low-carbon investment by institutional investors (pension funds, insurance funds and mutual funds), which have the largest pools of capital to deploy as well as a longer-term investment outlook that could be suited to low-carbon infrastructure financing.

This is consistent with a broader private sector turn in development and infrastructure financing, where public institutions seek “more bang for their buck” by taking on the role of reducing risk for or guaranteeing private sector investments, rather than emphasizing direct project financing.

The nature of financial sector involvement in climate-related investment is also changing in two major ways. First, it has become clear that carbon markets, once the favored solution for engaging capital markets in climate change, face considerable challenges, most immediately from an oversupply of tradable allowances (as a result of corporate lobbying for lax rules, weak climate targets, and economic slowdown in the European market) that has collapsed prices. The accompanying loss of confidence has seen many actors withdraw from the market, with carbon investors diversifying into broader climate-related financial products (bonds and private equity). Institutional investors (eg. pension funds), which have generally steered clear of carbon markets, are being eyed as important players in the future of climate, energy and infrastructure finance.

Second, climate-related financing is affected by broader trends in the financial sector, where lending is continuing to move onto capital markets, and off the balance sheets of banks and other financial institutions. The new Basel III regulations for international banking could exacerbate these trends, with ‘project financing’ increasingly displaced by investment via capital market instruments.

These trends are reflected in the emerging structure of “public” lending itself, be it through the World Bank, bilateral financing or the design of the Green Climate Fund. They bring with them several new concerns, and reinforce some long-standing considerations held by social movements and civil society groups.  

The aim of this Reader is to help understand these issues, and the emerging institutional and financial architecture for private climate finance. It is based on a series of readings that were at the heart of a “crash course” on this topic, hosted by the Institute for Policy Studies in the spring of 2012. Its emphasis, reflected in the readings selected here, was on understanding the financial trends, mechanisms and institutions underlying the turn to private sector finance. Often, the clearest and most salient explanations emanate not from the field of climate finance itself, but from studies on development economics, public services or focused squarely on the financial sector itself – so that’s what we’ve included. We have emphasized understanding the financial sector in general over understanding “climate finance,” about which numerous texts abound (see “Further Reading” for more details).

The Reader is divided into five sections.

The first section, on Financial Trends, sets out the economic backdrop for the changes that we are currently seeing in climate change financing. These relate to the era of financial liberalization, dating from the 1970s, that led to the 2008 financial crisis – the consequences of which are still unfolding.

In the second section, on Private Sector Actors, we look at how some of the major financial investors make their decisions. In particular, our aim here has been on explaining how some of the main market actors function.

The third section looks at how International Financial Institutions are adapting their focus towards “leveraging” private sector finance, and what this means for climate change investment.

The fourth section on Carbon Markets and other Financial Instruments looks at carbon trading, which has to date been the major instrument for private sector climate finance. It also examines how these markets are being expanded into other “ecosystem services,” while at the same time other instruments (notably “public-private partnerships”) are emerging to broaden the scope of the private climate finance.

The coverage here is partial, at times because the texts we really wanted to include have not yet been written. But a lot of useful information and analysis is already out there, and we’ve included that in the final Further Reading section, an annotated bibliography of books, chapters and websites that we’ve found useful in our work, or that have proved influential on the current debate.

 

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