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CreditWeek: What Is The Climate Finance Gap?

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CreditWeek: What Is The Climate Finance Gap?

(Editor's Note: CreditWeek is a weekly research offering from S&P Global Ratings, providing actionable and forward-looking insights on emerging credit risks and exploring the questions that matter to markets today. Subscribe to receive a new edition every Thursday at: https://www.linkedin.com/newsletters/creditweek-7115686044951273472/)

Low- and lower-middle-income countries are most vulnerable and least ready to adapt to climate change—yet receive the least amount of public and private investment to transition their economies and build resilience to physical climate risks.

What We're Watching

Our research shows that low- and lower-middle-income countries—which we define according to the World Bank's threshold of $4,465 of gross national income per capita—are disproportionally at risk of economic losses from, and are most exposed to, physical climate risks. They are also attracting a disproportionally low fraction of public and private investment in clean energy infrastructure. As extreme weather conditions and worsening physical risks continue to increase and influence credit fundamentals, more frequent climate risks could pose an additional barrier to low-carbon economic development—especially because financing adaptation to, and recovery, from physical climate risks is more difficult for countries with fewer resources and more restricted access to capital.

Most broadly, climate finance represents financial flows to facilitate actions to mitigate and adapt to climate change. The most common public sector funding ranges across domestic, bilateral, and multilateral funding, while private sector sources can include philanthropic capital, investors, asset managers, insurance companies, banks, and nonfinancial corporations. Market participants are able to access climate finance through a plethora of instruments—including grants, concessional loans, guarantees, equity, loans, bonds, insurance, funds, securitization, and swaps—all of which can be combined as blended finance solutions to address stakeholders' specific and unique needs. Market participants have the potential to utilize innovative financing solutions that are gaining traction in these countries and may become more prevalent in the coming years, such as public-private partnerships and debt-for-nature swaps.

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The exacerbating and expanding transition and adaptation financing gap, and broader failure to address the United Nation's Sustainable Development Goals (SDG), in low- and lower-middle-income countries is an area of increasing focus in multiple international forums.

At the International Monetary Fund meetings in Washington D.C. in mid-April, discussions centralized on the persistence of high funding costs and lack of progress mobilizing private capital into this grouping of countries. The United Nations met in late April to discuss the Paris Agreement's collective quantified goal on climate finance, where plentiful options were put on the table for how the goal should cover funding developing countries' climate transitions including capital for adaptation. The goal, to be agreed upon at COP29, could send political signals for the private sector to increase its provision of funds in collaboration with public financing. In the near-term, debt restructuring could be a priority, given the limited fiscal space many low- and middle-income countries have to realize their climate goals.

Looking ahead, countries will have two further opportunities to advance discussions on climate finance ahead of COP29 in November. While a broad range of initiatives aiming to provide access to more affordable sources of financing are in flux, agreement on how to implement such directives continues to be elusive—and we expect this topic to be central to the agenda of the October IMF meetings, as well as at the G-20 annual meetings taking place this November in Brazil.

What We Think And Why

Failure to address low- and middle-income countries' climate transition and adaptation needs (as well as broader SDG initiatives), could undermine global climate transition goals, enhance long-term environmental and social risks to global financial stability, and heighten risks to economic development and local populations' health. Closing the financing gap would require a significant scaling of international capital flows—and financing may become even more difficult in periods of slowing global growth, higher-for-longer interest rates, and challenging credit conditions.

Market participants estimate that several trillions of dollars in climate finance mobilization every year will be needed to fund transition and adaptation needs, which most often far exceed both these countries' domestic funding capacities alongside international sources of public finance. Despite the upward trend seen in the past decade, the amount of private finance currently mobilized is modest, totaling just $61 billion in 2022, according to the Organization for Economic Co-operation and Development. Our research shows that private direct climate finance mobilization through multilateral lending institutions to low- and middle-income countries reached a meager $ 17 billion in 2022. This is likely due to what many investors cite as the lack of both bankable projects and stability of policy and institutional frameworks.

Blended finance solutions—which use development finance to mobilize additional capital from the private sector, and allow for different stakeholders to leverage capabilities and needs—can be integral for risk mitigation and stimulating the funding needed to address the climate financing gap. At the same time, it remains important that each country works on improving its own institutional setting into a more predictable, reliable, and pro-private sector investment framework. While blended finance solutions can provide risk mitigation, reducing the overall inherent risk that weak institutional settings present can make a meaningful difference due to the long-term nature of these investments.

Few issuers in lower-income countries are issuing sustainability-labeled debt instruments—with just 1% of the sustainability-labeled bond market issued in low- and lower-middle-income countries. But high-income countries in Asia-Pacific, Latin America, and the Middle East have recently increased their share of issuance, which could lay the groundwork for issuers in lower-income countries in these regions to access the sustainable bond market.

In a meaningful development for the market, Rwanda Development Bank issued its inaugural bond in the form of a sustainability-linked transaction with credit enhancement features in collaboration with the World Bank in September 2023. Our second party opinion affirmed its performance indicators are aligned to Sustainability-Linked Bond Principles as the bank strives to improve ESG practices, and increase lending to women-led small and midsize enterprises and affordable housing.

Still, labelled debt markets are only a small part of the solution. Ultimately, a mix of government, public, and private capital will be needed to close the climate finance gap. Given the public sector's position in protecting populations and public infrastructure, public funding can fuel investment in resilience and adaptation efforts—while private or blended capital can address needs to develop clean energy infrastructure and other transition elements.

What Could Change

Implementing comprehensive and coordinated climate policies and strategies, which can underpin opportunities for climate finance mobilization, remains a challenge for governments and companies. Closing the climate finance gap for the approximately 140 lower-middle-income countries worldwide will require mobilization of all market stakeholders—from public lending to private capital to philanthropic participants and beyond—to surpass the $100 billion committed annually under COP through 2025 and yield the trillions in financing needed.

Among the encouraging signs we see is a heightened level of international stakeholder mobilization alongside evolving financial innovation, which combined can contribute to increasing financing momentum. Market participants' toolkit of already-tested solutions—including co-lending frameworks, securitization conduits, and investment solutions which provide diversification benefits and allow credit enhancement though liability tranches and guarantees—has been continuously expanding.

Against this backdrop, the space at large is still confronting numerous multi-faceted challenges.

The lack of favorable local institutional frameworks, unfriendly business environments, and the need to enhance local building capacity for infrastructure projects are among the non-financial roadblocks most often mentioned by stakeholders. Practical issues related to the difficulty of matching projects with providers of appropriate and accessible finance, small scale of projects, and lack of project standardization are among the constraining factors. Financial risk-related roadblocks can materialize from many developing countries' high foreign-exchange risk in illiquid currencies; transfer and convertibility risks that prevent an issuer in a sovereign's jurisdiction from moving money out of that jurisdiction; and the reality that adaptation investments are often non-cashflow generative despite their significant positive financial externalities; among others.

We expect governments, multilateral lending institutions, and other financial institutions and impact stakeholders to remain focused on determining how to deliver climate financing to developing countries—especially with mounting pressure from the G-20 to advance on meeting the SDG commitments by 2030 in what market participants have deemed "the critical decade," the need to close the financing gap in a transition toward net-zero by 2050, and amidst the current challenges of persistently high interest rates.

The cost of inaction could be critical over time for populations and economies. According to our research, lower-income countries could see approximately 12% of their GDP at risk annually—4.4 times greater than their wealthier peers—if global warming does not stay well below 2 degrees Celsius by 2050.

Writer: Molly Mintz

This report does not constitute a rating action.

Primary Credit Analysts:Bernard De Longevialle, Paris + 33 14 075 2517;
bernard.delongevialle@spglobal.com
Roberto H Sifon-arevalo, New York + 1 (212) 438 7358;
roberto.sifon-arevalo@spglobal.com
Author:Beth Burks, London + 44 20 7176 9829;
Beth.Burks@spglobal.com
Secondary Contact:Alexandra Dimitrijevic, London + 44 20 7176 3128;
alexandra.dimitrijevic@spglobal.com

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