A Better Approach to Climate Finance

Nov 23 , 2024
By Ricardo Hausmann

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Two years behind schedule, in 2022 the world’s developed countries finally fulfilled their 2009 pledge to mobilise 100 billion dollars annually to support developing countries’ climate efforts. But now it is time to look beyond this milestone.

The clean-energy transition represents a profound macroeconomic issue, yet we continue to approach it as a microeconomic problem. Without a course correction, support for decarbonisation in developing countries is bound to falter. One reason for this is that most developing countries are near their external debt ceiling, limiting their ability to borrow. The ceiling is low because of the high interest rates they face and their insufficient export capacity, which is too weak to generate the foreign exchange required to service external debts.

The original rationale for climate finance was straightforward: climate change is driven by carbon dioxide emissions. Wealthy countries, home to only 16pc of the world’s population, are responsible for most of the CO2 released into the atmosphere since the Industrial Revolution. They still account for about 25pc of annual emissions. To avert climate catastrophe, we should achieve net-zero emissions, which requires the remaining 84pc of the global population to forgo the benefits of fossil-fuel use.

To make this shift more attractive, rich-country governments committed to providing developing economies with cheap financing as an incentive to decarbonise.

Now that the target has finally been met, can we truly say this promise has been fulfilled?

The answer depends on how we understand the cost of finance. A microeconomic perspective would examine each project individually, assessing its costs and benefits. If the benefits outweigh the costs, the project creates value. By contrast, a macroeconomic approach would consider the opportunity cost of countries using their limited borrowing capacity for climate-related projects instead of other development goals like economic growth, education, and healthcare. The more a country borrows for climate initiatives, the less flexibility it has to address other priorities – unless climate finance can somehow expand its borrowing capacity.

In theory, this should be possible. Climate finance could increase developing countries' borrowing capacity by reducing the cost of debt or boosting exports, thereby saving or generating the foreign exchange needed to support a higher debt ceiling.

But neither of these options is currently on the table. Regrettably, the focus remains on the total amount of climate finance committed rather than the size of the subsidy component that – barring a boost in exports – could enable countries to secure additional financing without breaching their debt ceilings. In the absence of such subsidies, which private finance does not include, countries are left to pursue climate projects at the expense of other development goals.

Multilateral development banks (MDBs) illustrate this dynamic. While they increased their total annual financing, nearly all of the additional lending capacity has been directed toward climate finance, which reached a record-high 125 billion dollars in 2023, leaving other essential development needs unmet. Consequently, developing countries have been forced to shoulder the macroeconomic costs of decarbonisation on their own, despite the 2015 Paris Agreement’s assurances of meaningful burden-sharing.

Increased exports, on the other hand, could raise developing countries’ debt ceilings, making the climate effort far more beneficial. After all, carbon neutrality requires not only a commitment to reducing emissions but also access to the necessary tools for achieving that goal. This means scaling up global supply chains for clean-energy technologies such as solar panels, wind turbines, electric vehicles, and batteries, all of which rely on critical minerals.

Since transporting green energy is much more expensive than fossil fuels, it is more efficient to use it where it is produced. An effective global decarbonisation effort would thus seek to relocate energy-intensive industries to regions with ample, affordable, clean energy, a strategy known as "powersharing.”

To facilitate a more effective climate agreement, developing countries should play a much larger role in global mitigation efforts. There are two ways to achieve this.

The first is to enhance these countries’ ability to produce and export decarbonisation enablers and their components. The second is improving their green-energy infrastructure, encouraging major emitters to relocate to newly established green industry parks. Together, these steps could position developing countries as key suppliers in the clean-energy transition, fostering economic growth and sustainable development.

At Harvard's Growth Lab, we have been studying green value chains to identify the most feasible and promising clean-energy products and components, tailored to each country’s existing capabilities. With the support of Azerbaijan’s government, the host of this year’s United Nations Climate Change Conference (COP29), we have created a green growth website called Greenplexity. Together with our Atlas of Economic Complexity, which now covers green products, this tool allows countries to chart their unique growth paths in a decarbonising global economy.

By harnessing the capabilities of developing countries, we can accelerate global decarbonisation while creating new growth opportunities. This approach would advance crucial climate goals and ensure that a larger share of the world’s population can enjoy the fruits of the clean-energy transition.

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PUBLISHED ON Nov 23,2024 [ VOL 25 , NO 1282]

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