What does the evidence say on enabling private capital for climate action?
New insights on how governments can best address barriers to the flow of private capital for climate action.
As countries prepare to meet at the UNFCCC COP later this month, they face the sobering reality that USD 5 trillion in financing will be required annually by 2030 and be sustained at this level until 2050 to achieve net-zero emissions. The private sector is a critical stakeholder in addressing this financing gap, especially given the pressures that the global pandemic and high debt levels have exerted on public finances.
Along with investing in low-carbon technologies, the private sector can develop new technologies and build climate-resilience into its investments and operations. In many countries, however, private-sector participation in climate change adaptation and mitigation has been low. One reason for this is the lack of an adequate enabling environment in countries. The climate change enabling environment is the set of policies, incentives, standards, information, and institutions that facilitate the private sector to invest or behave in ways that reduce greenhouse gas emissions or adapt to climate change.
In view of its importance for private sector climate action, IEG has conducted an evaluation of World Bank Group efforts to improve the enabling environment, with a view to identifying lessons for future climate action The evidence derived from our evaluative work on the enabling environment also has important lessons for policymakers.
IEG’s evaluative evidence shows that three broad policies can help governments enable private sector engagement on climate.
Price-setting measures that remove market distortions can include carbon taxes or reduction of subsidies to fossil fuels. Additionally, tax incentives and other subsidies for renewable energy and green buildings and payments for ecosystem services for agroforestry operations can create incentives for investments in these sectors. Governments can also discourage emission-producing or non-resilient activities through non-price measures by enacting regulations, such as limiting greenhouse gas (GHG)-emitting activities, or issuing energy efficiency mandates, fuel standards, or resilient building codes.
The private sector requires adequate information to make investment decisions, especially for climate change–related sectors or actions that may be new or unfamiliar. Data, voluntary standards and certification of green products, and facilitation of climate-related research and development, can support investment decisions in climate-change related sectors.
Considering the increasing investor appetite for green investments, government actions that help investors identify sectors and activities that contribute to climate action can also guide investment decisions, including through green taxonomies and sustainable finance regulations that mandate disclosure.
Government institutions related to building public infrastructure are generally designed with the purpose of executing their budget and may not have the institutional capacity for designing and managing contracts with private-sector counterparts. Private investors may be reluctant to engage with such public sector institutions. Institutional capacity of the public sector is, therefore, key for developing effective contracts and building credibility with private sector counterparts.
Large climate-related investments involve significant capital and long payback periods. While mitigating or transferring excessive risks through effective risk management agreements with government institutions is critical, allocating risks to the party that is best able to bear them is also important.
The private sector is central to meeting the world’s climate goals, but engaging the sector at the scale needed will require scalable solutions. Our evidence points to the role of key policy actions that can help attract private financing for climate at scale.
Three factors could make a significant contribution to a government’s ability to attract private financing at scale on climate.
Standardized business models for private investment with clear contractual frameworks are likelier to attract more investors by helping improve transparency, bringing predictability in the selection process and the rights and obligations of the different parties, and reducing investor uncertainty. Standard business models would include, for example, contract and dispute settlement terms that meet international investor expectations, transparent and well-paced procurement processes, clear technical requirements, financing models that allow securitization of payment streams, and adequate risk allocation and mitigation. IEG finds that in the energy sector, standardization of contract terms, procurement processes, and financing models created replicable models that attracted investors.
Many climate-related investments in countries tend to be in non-tradable sectors of the economy, such as energy, urban, and road transport. While revenue generation from these projects comes from domestic users in local currency, financing can come from international sources, creating currency mismatches. This can require governments to hold currency risks for years leading to significant fiscal burden. Supporting policies that enable long-term financing in local currencies could help address this risk.
Governments may consider approaches limiting the use of public guarantees to specific purposes and, instead, rely on project financing. This will help optimize its contingent liabilities. At the same time, supporting the creation of long-term domestic investors and encouraging their participation in climate-financing can contribute to fostering domestic financing of projects.
When countries gather for the COP, focusing on these issues could inform discussions on how governments can best address the barriers to the flow of private capital for climate action.
For relevant IEG evaluative evidence, please see: