Why everyone exaggerates “climate finance”

Tackling climate change requires not just new technology or political will but money—more money than many poor countries have. This means new sources of finance must be found if we are to keep global temperature rises within limits like 1.5 or even 2 degrees Celsius. The problem is that most “climate finance” fails the test of additionality—we need additional money for additional carbon reduction.

At the United Nations’ 2021 climate change conference in Glasgow, COP26, $130 trillion was announced for the Glasgow Financial Alliance for Net Zero. But reality soon struck, not just in the practicality of deploying such funds, but also as people realized that this figure represented the total assets under management, most of which would be for infrastructure rather than fighting climate change. While these do intersect, “climate finance” is a nebulous term that must urgently be clarified. Too much is labeled as “climate finance.”

On the other side of the coin, many countries have estimated the funding they require to achieve net-zero carbon emissions, even in the short run. The numbers are all very big—in the trillions of dollars annually through 2030—and much of the funding is for developing countries. Developing countries have an incentive to be generous in assessing what they need, as they are asking for support or might be hedging their carbon mitigation targets as being “conditional on financial support.” However, they are also overstating how much “climate funding” they need.

Overstating the numbers leads to unachievable targets and distracts from where we should focus our efforts: the challenge of deep decarbonization beyond business as usual.

Climate change finance should be additional

The good news is if we redo the calculations, the actual requirements are much smaller than widely believed, particularly in the short run. Climate finance calculations should only reflect the additional cost of decarbonization beyond business-as-usual investments in infrastructure, some of which will lower emissions anyway as clean technologies become cheaper than conventional technologies.

The Intergovernmental Panel on Climate Change’s newest assessment report showed that a substantial fraction of emissions can be reduced at no additional cost. This means that the cleanest solutions (specifically, wind and solar power, without a battery) are the cheapest solutions and thus what countries will use anyway. These solutions don’t need “climate finance”—they just need finance, even if a substantial fraction needs to come from external sources.

At COP15 in 2009, rich nations pledged to support poorer nations with $100 billion per year of additional financial support for climate change mitigation and adaptation by 2020. At COP21 in 2015, this pledge was reaffirmed but the date was extended until 2025. $100 billion per year is now viewed as the floor for what level of finance must be made available beyond 2025 under the U.N.’s New Collective Quantified Goal on Climate Finance. The new goal must be agreed upon by all countries at COP29 later this year, which is informally dubbed a “climate finance” COP. But instead of just focusing on the quantity of finance, we should also worry about the quality of finance.

Finance quality, not just quantity, matters

The COP15 $100-billion annual pledge was vague: there was no clarity on what should or shouldn’t qualify as climate finance. This has led to ambiguity and the unwarranted labeling of diverse funds as climate finance. Under the pledge, donors counted funding for solar projects as climate finance, the majority of which was financed as debt. If we focus on multilateral public funding, which was the largest component of the $100-billion pledge as paid over the last decade through 2022, analysis from the Organization for Economic Co-operation and Development (OECD) shows 89% of 2016-2022 support was debt, and 59% of it was at market rates. That’s not what climate finance should be. Even with a soft loan, only the differential to market interest rates should qualify as climate finance support. In addition, given the scale of money involved, a portion of climate support for low-income countries should ideally be a grant. This is not just due to fairness but also because if external funding requires repatriation, it will add to many developing countries’ already high debts and risk macroeconomic destabilization.

If we examine the funding requirements of recipient low-income countries, their low base of development means they will need to build many power plants and additional public transportation and housing. But it would be wrong to place all of this under the heading of climate finance. There will always be an overlap between development and climate finance, but the lines shouldn’t blur to the point one displaces the other. Ideally, they should synergize.

A similar labeling challenge exists for adaptation accounting as well. If we measure the cost of a new home that is climate resilient, we cannot call the entire cost climate financing. Only the additional cost of climate resilience should be considered climate finance. OECD analysis of the $100-billion pledge includes a sample climate finance project covering “construction of a 23 km metro line and purchase of a fleet of about 80 metro cars.” A metro may reduce emissions more than a fleet of buses (which is better than cars and SUVs), but its total cost isn’t climate finance. Similar relabeling of diverse projects as requiring climate finance has also been seen in World Bank funding, as a study by the Center for Global Development found. In addition to the mislabeling problem, climate finance risks crowding out other development support.

If we don’t do proper climate finance accounting, at best we risk maintaining the current rate of decarbonization, which is too low. At worst, we may be greenwashing: not only failing to do what is needed but actually doing less than we think we are doing.

True climate finance costs are lower than the headline numbers

How much additional money is needed for decarbonizing beyond what would happen anyway with already viable technologies? This is a tricky question that depends on the ambitions of infrastructure deployment (which are linked to economic growth); what the alternatives are (which helps benchmark business-as-usual); and the evolution of technology.

Developing nations’ exact climate mitigation finance requirements are complex to calculate. Yet a back-of-the-envelope calculation suggests that these would be a minority of total investments across infrastructure. Viability gap funding, which compares the costs of alternatives with or without extra decarbonization, is a useful framework for many cleantech solutions. Compared to pure fossil fuel-based electricity supply, solar (without a battery) would save money and is thus considered business as usual. Adding an expensive battery could even be viable up to a point, but not yet for the size of battery required to make the solar as reliable as the traditional grid (as solar plants only give up to 25% of daily output, based on when the sun shines). Climate finance is needed to support the incremental cost of more storage and additional solar capacity dedicated to battery charging. That is what the $100 billion of global climate finance should enable—leveraging business-as-usual investments to enable even more greening.

By properly classifying and segregating finance, we can release more and different pots of money, each with different risk profiles and objectives. Traditional (“market”) money would be most effective by focusing on return on investment and would be applicable for infrastructure and business-as-usual decarbonizing investments like solar or even a little bit of storage. But deeper decarbonization, beyond what is viable and amenable to market finance, could be based on special funds from donors, multilateral and aid organizations, or blended sources, whose objective would be maximizing decarbonization. It could span grants, soft loans, or public credit enhancement. These two categories would approximately match the superset today labeled as “climate finance.”

Both sides are unlikely to agree on where the line is between business-as-usual and climate finance because that may also imply boundaries between regular and concessional finance. However, the reason to try is because poor countries will not find concessional funding available for everything they need to reduce their emissions. There is yet another complexity—some “development” finance is also worthy of concessional support, like for building schools and basic infrastructure for the poor. The exact details will need to evolve across financing types and options. Yet, on a positive note, even maximum decarbonization can align with a hard-nosed return on investment if we recognize the social cost of carbon. Time is running out—lack of money shouldn’t be why.