Deciphering climate finance

The global ambition to reduce greenhouse gas emissions and reach net zero by 2050 requires large-scale investment in climate-mitigation technologies, including renewable energy, clean transportation, energy storage, green hydrogen and direct air capture. Certain countries and regions are vulnerable to climate-induced events (e.g., rise in sea level, heatwaves, storms, floods and droughts), implying a high probability of human and economic loss. Hence, climate adaptation projects (e.g., sea walls, elevated roads, drought-resistant seeds) need massive investments. The large-scale investment in climate action requires mobilisation of capital – this is broadly termed climate finance. 

Meaning of climate finance

According to the United Nations Environment Programme (UNEP), climate finance refers to “local, national or transnational financing drawn from public, private and alternative sources of funding that seek to support climate mitigation and adaptation”. The source of capital includes private sources like commercial banks, private equities, insurance companies and public sources like governments, multilateral and bilateral institutions, and development banks. The capital could be in the form of grants, subsidies, loans, equities and guarantees. 

In international relations, climate finance refers to the financial support that developed countries provide to developing countries for climate action. However, developing countries contend that only public capital, like grants and concessional financing, should be counted as climate finance. They feel private capital should be excluded because of its profit-driven motive. 

Besides climate finance, other terminologies like green finance and sustainable finance are used interchangeably for climate finance. Green finance includes climate finance and other environmental finance, such as financing for protecting biodiversity and resource conservation. Sustainable finance is an umbrella term that includes green finance and financing for sustainable development activities, such as healthcare and education. 

Climate Adaptation Financing

Climate adaptation financing is more important for developing countries as they are more vulnerable to climate change than developed countries, and not able to invest as much as developed countries in climate adaptation. While developed countries are usually rich, developing countries have limited funds. 

To date, capital flows for climate finance are significantly less than what is required. Unlike climate mitigation projects, most climate adaptation projects are not commercially viable and do not have business models to attract private investors. Adaptation finance across the world, including in India, is largely driven by public finance. However, the financial gap to meet adaptation needs is substantial, requiring greater involvement of international public finance institutions and the private sector.

International public finance institutions can provide climate finance for adaptation in a manner that allows governments to repay the loan over a long period. Besides, the interest rate must be low or zero so that local governments can pay it back. In addition, they can provide grants and other risky capital, such as guarantees, that can be used to attract private capital. 

Despite the growing need for private capital in adaptation, several barriers hinder private sector participation. These barriers include a lack of business models, an absence of adaptation metrics to quantify the benefits of adaptation projects, inadequate regulatory and policy support, and fragmented information and awareness. However, innovative business models and the prudent use of financial instruments, such as blended finance, guarantees and risk-sharing mechanisms, help reduce the risks of climate adaptation projects. 

Financing for extreme climate situations

Climate change has increased the frequency and intensity of climate-induced disasters, such as hurricanes, floods, droughts and heatwaves. Financial support to affected countries, geographies and individuals can aid in a quick recovery. 

Parametric insurance is a robust financial instrument that compensates the insured based on a set of predefined parameters instead of processing the payment after damage assessment, which takes a long time. The key is whether the insured can pay the premium, which is usually higher than in the case of conventional insurance. The insured also needs to spend additional money to buy parametric insurance. Public finance can subsidise the insurance premium to make the policy premium affordable.  

Resilience bond is a debt instrument that provides financial support during extreme climate events. It is used to raise money for infrastructure projects that can help build resilience to climate change and other disasters. The insurance component protects the project developer (usually the local government) as they receive contingent payment from insurers in case of damage to the project. The more resilient the project to the disaster, the lower the insurance premium, which incentivises the developer to build strong and resilient projects.

A clear understanding of climate finance terminologies can help stakeholders better understand the subject. They can then nudge policymakers, regulators and international institutions to make the right interventions to drive capital for urgent climate action. 

This article was first published in Outlook Business.