Viewpoint: Closing the emerging market climate finance gap

Reining in climate change requires urgent and fresh thinking about channeling finance to emerging and developing economies, write Nazmeera Moola and Nick Robins 

Channelling finance to emerging and developing economies is essential to tackle climate change. It is in these countries where the bulk of clean-energy investment is needed to hit the world’s net-zero targets. 

According to a new report from the International Energy Agency (IEA), achieving global carbon neutrality by 2050 requires a seven-fold increase in annual clean-energy investment in the developing/emerging world to reach $1trn (€850bn) by 2030.

Yet the same report concludes that “annual investments across all parts of the energy sector in emerging and developing markets have fallen by around 20% since 2016”.

At the June G7 meeting, the familiar pledges to “support developing countries and emerging markets in making the most of the opportunities in the transition” were made. However, developed nations have still not delivered on a long-standing commitment from 2009 to collectively mobilise $100bn a year to help poorer nations address climate change.

Given the vast climate-finance gap, urgent and fresh thinking is required. Much of the solution will depend on domestic capital mobilisation in emerging markets, yet sizeable international capital flows remain essential.

The development of carbon markets could be catalytic as this would allow either owners of electricity generation or a ‘bad carbon facility’ to access compensation for the early closure of coal fired power plants. There would be payment for the carbon mitigation. The recently announced energy retirement mechanism from the Asian Development Bank (ADB) begins to deal with this issue. 

The primary focus for the energy transition in emerging markets has to be electricity generation. According to Carbon Tracker, a think tank, Africa has the potential to be a “renewables superpower” with its abundant access to cheap solar and wind power at last making the goal of universal energy access achievable.

However, many emerging markets, including India, South Africa and Indonesia, still rely heavily on coal for electricity production, with the fossil fuel accounting for 25-40% of total carbon emissions. Transport accounts for a further 9-18%.

Since electric vehicles are at the core of the green transport solution, cutting electricity carbon emissions will contribute significantly to tackling the transport challenge and eliminate 40-50% of total emissions in many emerging markets.

Four key funding streams

Four key funding streams must be developed to clean up electricity generation in the developing world. First, the available capital must be scaled up for the renewable energy roll-out.

Second, sizeable investment needs to be directed towards expanding transmission infrastructure. A mix of extra development and commercial finance could contribute meaningfully here. For example, a multilateral guarantee could be used to lower the cost of capital for such projects, with proceeds ring-fenced for new investment in transmission or distribution infrastructure.

There are two other areas where new funding solutions are critical: creating financial incentives for state utilities to accelerate the closure of high-emitting plants; and providing funding for a fair transition for employees and communities that stand to lose out from the closure of high carbon-emission plants and mines.

In developed markets, governments have implemented a host of incentives and penalties to encourage a net-zero transition. Most emerging markets do not have the fiscal space to copy these measures, while the higher cost of capital for companies in the latter nations makes the clean-energy transition harder still. So to accelerate the transition in emerging markets, instruments to address these two constraints are needed.

Bad bank model for coal?

There are models to follow. The EU, for example, has established a Just Transition Mechanism, worth at least €65bn-75bn over 2021-27, to alleviate the socio-economic impact of the transition in its most affected regions. An equivalent mechanism is now needed for the coal regions of the Global South, combining grant funding from public and private sources with impact investment that can be directed towards retraining, regional revitalisation and community facilities to ensure all benefit from the transition.

Incentivising utilities to shut down high-emitting power plants early is a harder task. Research by the Rocky Mountain Institute, a non-profit organisation, lists a variety of measures used by developed market governments to manage the coal transition. Most of these have either allowed transition costs to be passed through to ratepayers or involved fiscal transfers.

Since neither of these options is possible or palatable in many emerging markets, inter-country and interregional coal-retirement mechanisms are needed. Loans will not provide sufficient incentive to deal with the local vested interests and political economy in these countries.

Developed countries will need to shoulder some of the costs of accelerating the closure of high-carbon assets. For example, development finance institutions could provide emerging market utilities with loans that would be written off over time provided stretching carbon-reduction targets were achieved. If the targets were not met, then the debt would remain payable by the utility.

A more ambitious version of this idea is to create a ‘bad-carbon facility’ – taking inspiration from the ‘bad bank’ structure sometimes used to hold nonperforming financial assets. This fund would deploy capital from developed public-sector investors and private institutions to buy up coal power stations in emerging markets. The coal plants would be decommissioned over time, with cashflows from them used to build renewable-energy assets.

In this way, over its life the fund would transition from owning coal plants to owning only renewable assets. Private-sector investors would receive a minimum yield on their investment, while the public-sector investors would bear most of the financial risk and accrue any excess return.

In both of these proposals, the capital providers have a built-in remedy if carbon-reduction targets are not met, and both would result in real-world carbon reduction. And while developed countries would bear some of emerging markets’ transition costs, these would be far less than would be required to achieve the same carbon reduction at home. In other words, mechanisms like this offer the best value-for-money way of making progress towards the world’s carbon reduction goals.

“The plain fact that someone will have to pay to decarbonise the global economy needs to be accepted”

For example, modelling suggests that South Africa’s electricity utility, Eskom, could reduce its emissions to 2050 by at least 1 gigatonne relative to the country’s 2019 energy policy, by accelerating the closure of coal-fired stations.

The utility’s CEO points out that it would cost it about $7 to mitigate one tonne of carbon. This is 10 to 50 times less than it would cost in developed countries such as the UK, continental Europe or the US.

Of course, robust accountability measures would be needed to ensure that the funding resulted in faster carbon-asset retirement than that set out in energy plans or that would be delivered anyway through market dynamics (primarily the falling cost of renewables). But with those measures in place, there is significant potential for approaches like this to close the climate-finance shortfall in emerging markets and speed up their net-zero transitions.

To start off the process, the $2bn recently allocated to the Climate Investment Funds to accelerate the coal transition in India, Indonesia and South Africa could be used to seed structures such as those described to achieve carbon reduction.

It is high time the world moved beyond high-level statements on climate finance in emerging markets to find practical solutions that effect real-world carbon reduction. And the plain fact that someone will have to pay to decarbonise the global economy needs to be accepted.

Extending loans to emerging markets will not be enough. If emerging markets are expected to shoulder the entire cost of their energy transitions, the collective net-zero ambition will not be achieved in our time. 

Nazmeera Moola is head of South Africa investments at asset manager Ninety One and Nick Robins is professor in practice – sustainable finance at Grantham Research Institute at the London School of Economics