The dangerously optimistic global climate finance agenda: why blended financing and domestic resource mobilization won’t help close the climate finance gap

The global climate finance agenda in its current form is insufficient for tackling climate change and fostering a green transition across the globe. Calls to close the massive climate finance gap that prevents developing countries from accessing much-needed funds often rely on the expectation that domestic resource mobilization and blended finance can help close the gap. In this article, we demonstrate why this expectation seems wildly optimistic and argue that instead of relying on insecure trends, global policy makers should take action by developing policies that grant a bigger role for public money and innovative monetary solutions.

Many emerging economies are having a tough time – they are still struggling to recover from the pandemic and simultaneously suffer from unprecedented debt levels and cost-of-living crises. What’s more, the climate crisis is manifesting itself more than ever, and international financial promises to enable a just energy transition across the globe continue to be broken. Meanwhile, the costs of climate mitigation, adaptation, and loss and damage are soaring, which makes it even less likely that these countries will get the climate funding needed to respond adequately to the crisis. As a result, the climate financing gap is widening.

In a response to these developments, the COP26 and COP27 presidencies some months before last year’s November COP27 summit launched an Independent High-Level Expert Group equipped with the task of “scaling up investment and finance to deliver on climate ambition and development goals”. This distinguished group of experts launched their report in November, calling for a “rapid and sustained investment push […] to drive a strong and sustainable recovery out of current and recent crises […] and to deliver on shared development and climate goals.”

The investment push that’s needed relies on domestic resource mobilization and blended finance that together with other financial levers form part of the so-called Grand Match financing strategy. This strategy was proposed by Amar Bhattacharya, Meagan Dooley, Homi Kharas, Charlotte Taylor and Nicholas Stern in a bid to foster a big investment push for emerging markets and developing economies. However, both the total amounts assumed for blended finance (USD 395 billion) and domestic resource mobilization (USD 653 billion) are unlikely to materialize and are unlikely to close the climate finance gap, as we will show.

 

Blended financing and domestic resource mobilization failing to deliver

As early as 2016, the rising popularity of blended finance as a way to close the global climate finance gap could be observed; in April that year, British weekly newspaper The Economist ran an article called “Trending: blending” that examined “[t]he fad for mixing public, charitable and private money”. In the past few years, the concept of blended finance has gained further traction; key global financial institutions such as the World Bank, IMF, and the G20 have pointed to blended finance as a solution to close the global climate investment gap. For example, during its last spring meeting, the IMF emphasized that its members should “recognize the importance of stepping up climate finance from all sources, including by mobilizing private investment”. Similarly, domestic resource mobilization (DRM), whereby governments channel their own resources towards public goods and services, such as by raising taxes or by improving auditing processes, is viewed as an important climate financing tool.

However, blended finance has not delivered on its promise. Back then, The Economist observed that “few data exist on the scale and success of blended finance”. Now, with more data available, it’s becoming clear that private investments made in low- and middle-income countries through blended finance actually have decreased from USD 150 billion to 100 billion, and between 2019 and 2021, only USD 14 billion was pledged  to poor countries through private channels. Similarly, the mobilization of domestic resources has not held up to its promises — its potential has been overestimated.

These tools are therefore unlikely to sufficiently help close the finance gap that has arisen. And with the current grim global economic outlook, an increasing number of low-income countries are already in debt distress and are increasingly impacted by the loss and damage of climate change itself, thus decreasing their ability to use these tools even more.

In fact, the reliance on these financing mechanisms is dangerously optimistic, as this prevents us from considering the additional sources of finance that are needed to provide climate investments at the scale and time needed. Here’s why:

 

1.    There is a huge climate finance gap, especially in low-income countries, and it’s becoming bigger, not smaller.

By 2025, if no measures to increase climate funds are taken, the amount of money needed by emerging economies (excluding China) to address the effects of climate change – generally referred to as the climate finance gap – would amount to USD 1 trillion (as estimated in 2022). Lower-income regions such as South Asia and Africa have the largest investment needs (7-14 times and 5-12 times more investment, respectively), but these are not being met. While most of the money needed to close the gap is supposed to be sourced through domestic resource mobilization (USD 653 billion) and private investment, supported by public funding through blended finance (USD 395 billion), in reality, this is not happening.

And the finance gap might be even bigger than we think. For example, in a recent report Oxfam estimates that the annual shortfall for necessary investments in health, education, social protection and tackling climate change in low- and middle-income countries could be as high as USD 3.9 trillion.

 

2. Advanced economies are not keeping their promises

Meanwhile, public finance is not contributing sufficiently. In 2009, high-income countries pledged to help fund the energy transition in developing countries by promising to commit USD 100 billion annually. But in 2020, only USD 83 billion had been pledged. What’s worse, to get to this figure, existing development assistance (ODA) money was relabelled as climate finance for developing countries. And only one-third of the funds that have been committed are in the form of grants, which means that debts continue to accumulate due to loans.

 

3. Blended finance should be helping funnel private funds to low-income countries, but it’s still mostly public money

 Blended finance[1] has gained the status of a silver bullet. The assumption underlying the belief in the effectiveness of this tool is that public capital investments would lever private investments according to a certain ratio of the ‘blend’. If done properly, investing by blending different financial sources indeed could result in a multiplied number of private investments that could be used to finance climate action.

However, the amount of private money available to match each public dollar is overestimated  – in reality, much less private money is invested, while public funds continue to form the largest share of the total amount. In one report, the IMF for instance expects the ratio of private to public money to be 9:1. In 2020 however, private finance constituted only around 50% of global climate finance, with the rest being public finance. And in low-income regions where climate investments need to increase most strongly, even a public-private ratio of 1:1 is often not tenable. In Sub-Saharan Africa, for example, around 90% of climate finance comes from public sources.

 

4. Mobilizing domestic resources requires challenging reforms

The IMF anticipated that emerging economies could raise as much as USD 236 billion in additional taxes by 2025 through domestic resource mobilization. To do this, they would have to implement relevant tax and administrative reforms to tackle their sometimes very low tax rates and high levels of tax exemptions.[2] However, implementing and enforcing these kinds of reforms is challenging. Emerging economies are renowned for administrative capacity constraints that prevent them from addressing tax evasion and keeping avoidance under control. Studies on the projected development of tax-to-GDP ratios in emerging economies show that their tax revenues are expected to only slightly, but not significantly, increase.

Moreover, some international support initiatives have already been in place, such as the Tax Inspectors Without Borders (TIWB) assistance programmes between 2012 and 2020. This has helped raise the tax revenues of these countries by a mere USD 537 million – a figure far below the necessary additional USD 417 billion in domestic resource mobilization estimated in the IHLEG’s report.

 

5. Countries are holding on to their money – tightly

Lastly, in response to the Russian invasion of Ukraine and the subsequent spike in inflation levels, a global monetary tightening cycle has begun. This has resulted in capital outflows by the private sector from emerging economies, which is bound to substantially hinder these countries’ economic growth. It has already been shown that the simultaneous monetary and fiscal tightening policies across the globe impact developing countries and emerging economies disproportionately.

This makes efforts to close the climate finance gap seem even more unrealistic, especially given the high value of the dollar and the outstanding dollar-denominated debt in the Global South. Of the low-income countries eligible for special IMF support, as of 2023, nine are currently in debt distress, while 27 are at a high risk, 26 countries at a moderate risk, and seven countries at low risk of debt distress.

 

More realism needed if we want to close the gap

The global climate finance gap (excluding China) currently amounts to a stunning 1 trillion until 2025 under the business-as-usual scenario. Promises of the past have not been lived up to while the climate crisis and green energy transition are becoming more urgent every day. Global policy makers seem to rely on domestic resource mobilization and blended finance to close the gap.

However, as this blog post has shown, the empirical success of blended finance remains very limited, while the challenges to boost domestic resource mobilization remain huge. Time is, however, very limited. Instead of relying on insecure trends, global policy makers should act by developing policies that grant a bigger role for public money and innovative monetary solutions.

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References

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Attridge, S. (2022). The potentials and limitations of blended finance. In D. Schoenmaker & U. Volz (Eds.), Scaling Up Sustainable Finance and Investment in the Global South. CEPR Press. https://cepr.org/system/files/publication-files/175477- scaling_up_sustainable_finance_and_investment_in_the_global_south.pdf

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[1] According to the OECD, blended finance is “‘the strategic use of development finance for the mobilization of additional finance towards sustainable development in developing countries’, with ‘additional finance’ referring primarily to commercial finance’” (OECD 2018).

[2] In this context, the IHLEG recommends an incremental tax effort of at least 2.7% of EMDEs’ GDP, equal to USD 650 billion, so an additional USD 417 billion by 2025 on top of IMF projections (Bhattacharya et al., 2022).

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