Dominated by public sources and development funds, climate investments in the emerging markets and developing economies (EMDEs) have not been enough to meet the targets set in the 2015 Paris Agreement till now. Moreover, private investors, local capital markets, and green banking have come into the climate finance picture fairly recently. With economies across the world trying to recover from the impact of the covid-19 crisis, there is ample opportunity to make this a “green recovery” with upfront investments in sustainable infrastructure and renewable energy sources. Thus, there is expectation of significant private participation being channeled in these green investments in the medium to long term. Against this backdrop, the Center for Global Development’s new paper on “Private Sector Climate Finance After the Crisis” authored by Alexander Lehmann surveys the incentives for the provision of dedicated green financial products by private investors and lenders in the emerging markets and developing economies (EMDEs), and the related challenges for regulators. REGlobal presents an extract from this paper…

Climate investment: potential and financing patterns

Portfolio and direct investors in developing countries allocate capital across competing jurisdictions and investment environments. To gauge the potential for private sector climate finance and assess priorities across different sectors, some measure of the shortfall between targets and committed public capital expenditures is needed. At present, private capital flows show little relation to such financing gaps. The Paris Agreement has resulted in detailed investment targets in most EMDEs. Each country set out plans for mitigation and climate adaptation in the Nationally Determined Contributions (NDCs). The early NDC submissions often lacked cost estimates. Few NDCs were sufficiently specific to give clear signals to investors, lacking detail on technologies and pathways envisaged by the government to achieve the goals (Zhou et al, 2018). In the absence of clear costing from countries themselves the NDCs can still be used to estimate investment needs and potential for private climate finance in individual sectors. Apart from the unclear costing, most EMDE commitments have been conditional on external support being made available. 

There has been a long-standing commitment, which the advanced countries first made in 2009, to mobilize USD 100 billion annually by 2020 from both public and private sources for climate mitigation and adaption investment in developing countries. Accounting for such climate-related development aid has been contentious. Funds from bilateral and multilateral agencies, for instance, are highly fragmented in multiple instruments, and often offered on a regional basis. Having revised its accounting methodology a number of times the OECD in its latest estimate suggests that the advanced countries were converging to this target, with funds provided directly by development institutions at USD 54.5 billion in 2017, or mobilised through blended finance schemes from the private sector (at USD 14.5 billion). Even on the side of recipient countries tracking climate-related financial flows has been problematic. 

There are some attempts to record primary investment in climate mitigation and adaptation directly, which also allow to track the type of financing, and the source of financing by geographical region. Climate Policy Initiative (2019) recorded USD 579 billion global climate investments on average in 2017-18. The data shows that private sources account for just over half of total climate finance mobilized (56 per cent) globally. Moreover, the vast majority of investments were directed at climate mitigation, not climate adaptation and 61 per cent of global climate investment was mobilized for projects in non-OECD countries.

Green finance instruments in the EMDEs

Private climate finance has long been offered through standard bank lending and project finance. Financial instruments that are labelled as ‘green’ are a much more recent and as yet less significant source of finance in the EMDEs. While green bonds can be easily tracked in capital markets, lending by banks to the low- carbon transition is more significant and subject to much more varied standards. Financial policy that seeks to develop funding for mitigation and adaptation investment will need to aim at the financing conditions for a typical green investment project, not necessarily at individual instruments. This could be an energy or infrastructure project with a protracted project construction phase, and an extended phase of utilization. In sectors such as renewable energy, the project size may be small relative to typical bond financing, and the quality of disclosure by the project sponsor may vary greatly. External project finance is primarily in the form debt, will need to be in local currency and offer a sufficiently long maturity to match the project’s revenue stream.

Sustainable banking: Unlike for green bonds, there is no single definition as to which bank loans meet an environmental standard. Taxonomies that classify certain exposures as sustainable are still poorly developed in the EMDEs, and categories are often based on national priorities and local climate challenges. At the same time, banking sectors in many EMDEs are subject to some form of sustainable banking standard, either based on an industry-led initiative, or through guidance by the supervisor. 

Climate projects are often too small for funding by large institutional investors in capital markets where investors seek financial markets and instruments that are liquid. Banks can play a useful role in implementing uniform standards, and aggregating assets. In developed markets sustainable bank loans are regularly combined into portfolios that back a securitized green bond issue by the originating bank. This refinances green lending, relieves the bank of the underlying risk, and develops green instruments in the local capital market. In the EMDEs the lack of a standardized taxonomy and transparency of the underlying borrowers is still an obstacle to developing such instruments.

Green bonds: Green bonds have been a rapidly growing instrument of climate finance in emerging markets up to 2019. The World Bank and other development finance institutions were the first to design and issue green bonds from 2007. By now, a wide range of corporate and financial institutions, and increasingly sovereigns and other public institutions, are regular issuers. Green bonds are essentially standard bonds that offer enhanced transparency on the use of proceeds. The designated green projects and assets, not the quality of the issuer, distinguishes the instrument. Up to now, verification has been based on two private standards developed in the UK, and one promoted by the People’s Bank of China. In the EU this is set to be formalized through regulation, which will be largely based on the private standard that has gained the broadest market acceptance.

In early 2020, a total of USD 633 billion in green bonds were outstanding under any one of these standards, of which about a fifth had been issued by EMDEs. China, which has its own certification standard, accounted for two thirds of the issuance within EMDEs. There are also small amounts outstanding in other bond instruments linked to sustainability objectives, such as social or impact bonds, though these are not significant in emerging capital markets. Green bonds are as yet a marginal instrument for financing infrastructure projects in the developing world. Only about a quarter of cumulative green bond issuance has been directed to non-financial enterprises, with half of total volumes issued by banks and other financial institutions, and a further quarter by governments, public institutions and supranational institutions within these markets. Data from the leading certification standard provider also suggest that the limited issuance of green bonds by EMDEs was primarily done in hard currency (with euro and dollar-denominated issues accounting for 71 per cent of issuance volume in 2018), which may have raised currency risks among EMDE issuers.

EMDEs often lack a deep local investor base, such as pension funds, for bonds issued under local law and in local currency. A corporate issuer can in principle place a bond directly with individual local investors. However, where local capital markets are illiquid the yield for both marketable and privately placed instruments will reflect a premium and result in less attractive financing costs. Where an enterprise has already issued bonds, it may be reluctant to erode liquidity in outstanding securities through the issuance of a new type of instrument. As in other capital market instruments, smaller issuers appear to have faced problems accessing institutional investors. By contrast, governments may overcome the inherent illiquidity of corporate green bonds, by issuing within their local or foreign sovereign bond markets, and by accessing a much wider and established investor base through the primary auction process.

Sovereign green bonds: Sovereign green bonds are a very recent phenomenon. The governments of Poland and France were the first to issue such bonds in 2016-17, and in the case of France a substantial USD 25 billion issuance was based on an elaborate programme of environmental projects. Since then, sovereign green bonds have been offered by at least six EMDE central governments, of which four have issued repeatedly. Indonesia, Chile and Nigeria could rely on local investors, and Nigeria issued two smaller instruments in local currency on its local market in 2017. The total amount raised up to mid-2020 through sovereign green bonds of about USD 11 billion is small compared to the total volumes raised on local and international sovereign bond markets (net non-resident flows of portfolio debt to emerging markets were about USD 270 billion in 2019 alone). Some countries would clearly like to present their bond market funding programme as supporting sustainable growth, given that capital market access is more uncertain in the current recession and any future recovery. Funds raised through the sovereign green bonds were generally supportive of investment and of targets in emissions reductions prescribed under the NDCs, though documentation provided to investors as part of the issuance process seems to have set more detailed targets, which were subject to external verification.

Institutional investors focused on ESG criteria: Among the mutual funds invested in emerging markets, those with an explicit focus on ESG criteria have grown particularly rapidly. By end 2018, such funds made up about 10 percent of dedicated emerging market funds, at roughly USD 20 billion. The potential is significant, as a growing number of asset managers sign on to one or several ESG codes. These funds for portfolio debt and equity may include certified green bonds, though typically capture a much broader range of securities whose issuers have been screened for ESG compliance in some form. 

Crucially, this asset class is not directly aimed at financing climate investment, and the screening process by the fund manager rarely targets specific activities. It is often based on ESG ratings provided by commercial providers, and governance, rather than environmental considerations, plays a key role. Unlike for green bonds, ESG compliance could cover a broad range of acceptable issuers and activities, and there is no uniform taxonomy. In any case, such type of portfolio investment is of limited value for climate related projects, which will require early-stage project funding, whereas listed companies accessible to ESG investors will be more mature, with sufficient disclosure, sound corporate governance and limited risk. Institutional investors will normally be focused on only those emerging markets with liquid local capital pools.

Regulation of green finance 

To date, sustainable finance bonds and loans have emerged with limited regulatory encouragement, and climate risks in the financial sector have been only lightly scrutinized. Since about 2015, the case for regulation has been made on two grounds. Firstly, climate risks present a risk to financial stability, and therefore warrant attention by prudential supervisors. Secondly, the stated policy objective that green finance is generated by banking systems and capital markets requires common classification systems and standards defined by regulation. To date, many such standards have emerged through private providers and initiatives. The main planks of green finance regulation are now being put in place, and emerging and developing economies increasingly adopt international standards, for instance on corporate disclosure, or models from individual jurisdictions, such as the EU’s green bond standard. EMDEs also begin to participate more actively in the rule-making effort, and about 18 EMDE regulators have joined in the Network for Greening the Financial System that has defined principles for the regulation and supervision of climate risks in the financial system.

Disclosures and taxonomies: To support borrower disclosure, and lending that is aligned with climate targets, the G20 Task Force on Climate Related Financial Disclosures (TCFD) made wide-ranging recommendations in 2017. Financial firms and large enterprises are to disclose metrics and targets for their climate exposures, and establish internal governance, strategy and risk management to track and reduce such exposures. This is now gradually implemented in the advanced countries, in the EU for instance in the form of the non-financial reporting directive. However, a stocktake of implementation suggests that the TCFD’s standards will be challenging for all but the largest firms in the EMDEs. 

A second objective in regulators’ quest for greater transparency is a common delineation of which economic activities are seen as sustainable and could hence be included in green financial products or incentive schemes. A so-called taxonomy for sustainable activities was a central deliverable under the EU regulatory programme and will be binding for large EU financial firms, and EU member states from 2021. This is the most advanced classification system to date, with the only meaningful alternative model defined by the People’s Bank of China. The EU’s taxonomy will therefore be key in defining the attractiveness of EMDE green assets to investors from the EU, and possibly elsewhere.

The EU regulation essentially sets screening criteria for those activities which make a contribution to environmental objectives. As yet, criteria for 70 climate mitigation activities and 68 adaptation activities have been defined. Activities supporting the other four objectives will be published later and may present trade-offs. A firm will be considered ‘taxonomy-aligned’ based on the proportion of taxonomy activities in total turnover. Certain activities are aligned by definition (for instance wind powered energy generation), others only if they meet certain technical thresholds. However, its adoption outside the EU may be limited due to – a rigid definition of environmental activities and of technical criteria within individual sectors, it remains agnostic on the impact which aligned financing will have on the recipient and it could create tension with other jurisdictions if EU plans to define ‘brown’ assets were to be implemented with a view to penalizing or excluding certain exposures by the financial sector.

Standards for the origination of green financial products: The EU taxonomy will be fundamental to a number of other standards and EU financial markets. An immediate application was the definition of EU benchmarks for portfolio investors. These are designed to help institutional investors, such as pension funds, to assess the exposure of entire portfolios to climate risks, and for certain other asset managers to offer portfolios that target a demanding carbon reduction. In mid-2019 the EU also released its proposal for a green bond standard. This standard may be less flexible than the private standards used to date, which have adapted continually to technological change and innovation. For instance, funds raised through a green bond would have to be used for activities set out in the EU taxonomy, and accredited private providers would need to verify the borrower’s activities.

Several emerging markets have also established their own local standards for bond issuance. These are typically designed for the local investor base and classification systems which reflect national priorities and investment plans. Investment funds with an ESG mandate from developed countries may ultimately use the EU standard. The Chinese bond standard is the only rival format that has been used more widely in emerging markets (IMF, 2019a). There are large overlaps between the EU taxonomy and the People’s Bank of China Green Projects Catalogue which defines assets and projects that are eligible for green bond financing. The Chinese catalogue contains some activities such as certain fossil fuel projects (clean utilisation of coal), and transport projects based on fossil fuel, which are not covered in the EU, and relative to the EU standard excludes certain processes in the supply chain of green projects (CBI, IISD and UK FCO, 2016).


Substantial additional fiscal expenditures are being marshalled to counter the 2020 recession in the developing countries. Longer term climate policy commitments should guide fiscal policy throughout the recovery phase. The decline in energy prices in 2020 may provide an opening for the further elimination of fuel price subsidies and adoption of efficient carbon prices. A second key policy ambition could be the reform of the investment environment that will help generate more projects of a consistent high quality. Only where corporate accounts are transparent and reliable, and where creditors rights can be enforced, will low-carbon projects emerge that are ultimately attractive to funding in the capital markets. Green infrastructure funds or asset-backed securities could be instruments to aggregate numerous small projects, creating the scale that is sought by investors.

The official development institutions seek to catalyse the private sector into financing climate goals and the SDG through a variety of blended finance schemes. These generally offer to private investors a mix of guarantees, concessional debt or equity contributions. A recent OECD study identified 195 blended finance funds with USD 42 billion in development finance currently available. The World Bank’s Global Environment Facility for instance claims to have leveraged its USD 700 million investment by a factor of ten. While leveraging private sector finance is on the surface attractive, a stocktake suggests overall these initiatives are too fragmented and lack scale for them to be become self- sustaining. Investors suggest that risk mitigation instruments financing by the DFIs in local currency and of early stage projects are particularly needed. 

The overwhelming majority of climate mitigation efforts in the early NDCs of the EMDEs is conditional on additional finance being provided. Funding from the advanced country development funds, and mobilized private funding, have addressed this shortfall, though still falls short of the earlier commitment. A new set EMDE national commitments ahead of the next UN climate summit will likely expose a persistent funding shortfall. Cross-border private investors could help address this gap.

For most EMDEs domestic bank credit will remain more important than capital market finance as source of climate finance. As a rapid expansion of capital market depth is not realistic, the sheer size of banking assets relative to capital markets dictates that banks be made the priority for developing local sources of climate finance. Adopting sustainable banking principles remains a key agenda for many EDMEs, even though in the 2020 recession banking sectors have been impacted by rising loan defaults, which will constrain credit flows and may discourage innovation (IFC, 2020). Numerous EMDEs are also committed to developing green assets within their domestic capital markets. Funding through green bonds can be mobilized where the broader challenges in the development of liquid local currency bond markets are addressed.

Various emerging market banks suggest that where incentives for the private sector are well defined, a portfolio of green bank loans can be created without public sector interest subsidies or risk sharing. The blending of donors’ concessional finance with private commercial funds should therefore also create the private sector incentives and skills that build self-sustaining green banking businesses. This will depend on a conducive investment environment, a reliable designation of encouraged activities, and a private market infrastructure that fosters good disclosure and transparency.

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The original paper can be accessed here.