Despite some progress, we continue to hurtle towards '1.5'.
The problem is not the poor spread of scientific understanding of climate change or technology. It is financial and political. Concessionary loans are scarce. Most developing countries have limited space on their balance sheets for more debt. Grants are even scarcer. And there are many things the private sector cannot finance, even with high incentives and over-optimism over cross-border carbon credits (Young 2022). We need a financing framework that aligns grants, concessionary loans, and private sector incentives where they are most effective and addresses the current obstacles to progress up front. Below is such a framework.
Climate mitigation trusts
Without progress on mitigation, investment in 'adaptation' and relief for 'loss and damage' would never be enough. Luckily, many critical low-carbon transitions have revenue streams that could draw in private sector investment. To bring forward these investments at the pace required to defend ‘1.5’, we need to raise costs on existing high-carbon activities and provide incentives for low carbon investments. We know this (e.g. Caselli et al. 2021). What is holding the world back from doing enough is that although the climate is indivisible, this has been set up as a country-by-country effort and become country versus country. Legitimate issues of historical justice for developing countries and energy security concerns in developed countries mean that almost every country is resentful that others are not doing more (Fullerton and Levinson 2022). Many in Asia, Africa, and Latin America believe they have a developmental right to exploit fossil fuels and will likely pursue that at future COPs. We need to replace the finger-pointing between countries with a scramble by promoters for projects that will reduce the greenhouse gas (GHG) emissions while not sitting on the balance sheets of developing countries – enter climate mitigation trusts.
The trusts will invest long-term, cheap capital into credible projects that replace the most carbon-intensive activities - they will re-organise the market system around GHG reduction and not unmitigated profit. Projects in developing countries would be prime candidates, but this will also excite developed country capital and technology, creating coalitions for change, not resentment. The trusts would be capitalised by re-channelling a new allocation of 500 billion of Special Drawing Rights (SDRs) or callable guarantees which the trust would use to borrow cheaply in the market and lend these funds back out. SDRs are a right to access official sector reserves, and if the trust fails, the SDRs are a call on part of the $12.7 trillion of reserves held for a rainy day. This is that rainy day. By loaning funds cheaply, the trust will spice up returns of a climate mitigation project, drawing in five times the amount in private sector savings, or up to $2.5 trillion, without taxpayers needing any current transfer. The trusts could invest using convertible preference shares to share success or senior debt for those wanting more protection for their SDRs.
There would be regular monitoring and evaluation of the trust's climate and other environmental, social, and governance (ESG) impacts. A further SDR 500 billion could be allocated and re-channelled if they prove effective. Trusts could be formed by the main Regional Development Banks and World Bank and include the IMF as a trustee to facilitate the use of the SDRs. Recently the US announced it would double the capital of the private sector arm of the Inter-American Development Bank (IDB 2022). If IDB shareholders committed to using at least half of this additional capital for climate mitigation investments, it would be an example of the first Climate Mitigation Trust.
Concessional finance for resilience of climate vulnerable countries
One of the reasons the world is not doing enough to mitigate climate change is that those that can are not experiencing climate change the same way as those on the frontline (Peri and Robert-Nicoud 2021). When thousands die tragically in scorching European summer, five million die from extreme temperatures elsewhere. The worst floods in living memory in Germany and Belgium knocked off 0.1% of GDP. When Category 5 hurricanes Maria and Irma slammed into the Caribbean a few years ago, it wiped off 200% of GDP. In northern latitudes, climate change is expanding the growing season for agriculture, while droughts and floods crimp agricultural production on the frontline.
The World Bank reports that every dollar spent on climate resilience saves four to six dollars in a future disaster (Hallegatte et al. 2019). Many climate-vulnerable countries can't make that investment. Despite market optimism, the most significant climate adaptation investments like sea level and flood defences do not provide a substantial revenue stream for the private sector. Most adaptation costs are on the public sector. Yet, developing countries don't have the fiscal space for the expense, and many are not eligible for concessional funding internationally because their Gross National Income is above $1,255 per year.
Of course, 75% of the world's poor live in countries not eligible for concessional funding.
Scarce concessional government funding should be focused on lending to climate-vulnerable countries for climate adaptation - leaving mitigation to the private sector. This requires more lending capacity by the traditional lending arms of development banks. We propose that their lending collectively increases by $1 trillion in three ways: allowing them to hold re-channelled SDRs and guarantees as capital and increasing their risk appetite within existing credit ratings as outlined in the Independent Review of MDB capital adequacy frameworks.
At least 50% of this new lending must be ear-marked for concessional lending for adaptation by climate-vulnerable countries. Balancing needs with the scarcity of concessional resources, we propose defining a climate-vulnerable country as one with a high probability of experiencing a loss of greater than 5% of GDP through climate events or slow onset events over the following two years.
A mechanism for funding climate loss and damage
Mopping up after a climate event weighs heavily on the balance sheets of countries that contributed least to the stock of greenhouse gases. Dominica reports that 85% of its debt stock is related to climate events. In the Caribbean, the most indebted region in the world, 50% of the increase in debt is attributable to natural disasters. The climate crisis is leading to a debt crisis. Developing countries demand compensation, but there is no appetite for that in the rich world. The Warsaw Mechanism for Loss and Damage Related to Climate Change lies empty. The Santiago Network offers technical assistance to those who could teach national disaster management.
The industrialised world promotes better insurance instead. Apart from the troublesome notion that the victim should pay, just in instalments, the rising probability of rising losses that are increasingly correlated with other losses makes climate change an uninsurable event, commercially, for those on the frontline. Concessional funding for resilience in climate-vulnerable countries will help to reduce loss and damage. But before this kicks in, there needs to be a fund that provides immediate grant-like support in the wake of a disaster - you can't offer more debt to a country that has just lost 200% of its GDP. We recommend building on the International Oil Pollution Compensation Fund.
The Fund stemmed from the 1969 International Convention on Civil Liability for Oil Pollution Damage following the Torrey Canyon oil spill in British and French waters and was established in 1992 under the auspices of the International Maritime Organisation. It is funded by a small variable levy of one to five pence per tonne on any country importing more than 150,000 tonnes of oil. There are 118 member countries. It pays out a maximum of SDR 202 million or ($280 million) per incident and has been involved in 150 pay-outs. Creating a separate fund alongside this one, also funded by up to five pence per tonne of oil, to make a first loss pay out of up to $280 million pay-out to any country hit by a climate event that has cost more than 5% of GDP would be a good starting point to avert a crisis of climate debt.
Natural disaster clauses in all debt instruments
Financial instruments that are a bet on climate change will no longer be provided or will not provide the necessary relief (Schlenker and Taylor 2019). On the other hand, Barbados-style natural disaster clauses in debt instruments leave creditors whole while providing borrowers with the scale of liquidity when they need it. When disaster strikes, independently verified, debt service is suspended for two years and added back with interest at the end of the term. Barbados is the world's largest issuer of these clauses, and if a disaster hits, they release 17% of GDP that the government can redirect to dealing with the crisis. No other instrument offers that scale. Because it is predictable, automatic, and net-present-value-neutral, it would likely improve the credit rating of countries that would otherwise suffer speculation that a messy default lies ahead. If developing countries had these clauses during the pandemic, they would have received $1 trillion of liquidity and been able to treble the amount they spent on medical and economic relief. We propose that all official debt should have these clauses, and advanced nations should help to normalise them in private markets, so there is no stigma if a developing country issues them. Britain and Canada did that in 2000 with Collective Action Clauses.
These four initiatives are financially appropriate to the task, built on precedence and realism and offer what we have so far missed: scale.
Caselli, F, A Ludwig, R van der Ploeg, O Edenhofer, C Grefe and M Reguant (2021), “No brainers and low hanging fruit in national climate policy”, VoxEU.org, 8 October.
Fullerton, D and A Levinson (2022), “Linking climate and social justice makes both harder”, VoxEU.org, 15 February.
Hallegatte, S, J Rentschler and J Rozenberg (2019), Lifelines: The Resilient Infrastructure Opportunity, Washington, DC: World Bank.
Inter-American Development Bank (2022), “Statement on capital increase for IDB invest”, IDB News, 10 June.
Peri, G and F Robert-Nicoud (2021), “On the economic geography of climate change”, VoxEU.org, 11 October.
Schlenker, W and C Taylor (2019), “The market is betting on climate change”, VoxEU.org, 2 May.
World Meteorological Organization (2022), “WMO Global Annual to Decadal Climate Update”, WMO, 9 May.
Young, M (2022), “Improving carbon border adjustment mechanisms”, VoxEU.org, 22 August.