How to unblock green investment in developing countries

Avinash Persaud is special envoy to the Prime Minister of Barbados Mia Amor Mottley and one of the architects of the Bridgetown Initiative on climate finance that will be a cornerstone of the Paris Summit for a New Global Financing Pact.

We face the brutal reality that catastrophic climate change is upon us unless we direct massive private-sector capital flows towards the green transition in developing countries. Though rich countries contributed 70% of the stock of greenhouse gases causing global warming, developing economies now contribute over 63% of greenhouse gas emissions. And rising. There is no pathway for the world to remain below critical climate tipping points that does not include an accelerated investment in the green transformation of emerging economies.

The scale of the problem has been well-mapped. The 2022 report of the High-Level Expert Group on Climate Finance estimated that by 2030 annual investments exceeding $2.4 trillion are needed in developing countries, of which, given the scale and limits of domestic resources, up to $1 trillion will need to be foreign private investment.

But international and domestic capital is not heading there at the scale or pace required to save the planet. Solving this problem requires recognizing some realities about the functioning of the international financial system and coming up with solutions that meet the challenge with equity, scale and pace.

Tackling this puzzle has been at the heart of the Bridgetown Initiative led by Barbados Prime Minister Mia Mottley. It will be front and centre at the Summit for a New Global Financial Pact hosted by French President Emmanuel Macron on June 22-23.

The surface problem is not hard to pinpoint – a high cost of capital in the developing world means that while the private sector finances renewable energy technologies in advanced economies, the public sector is left in the driving seat in poorer countries.

According to the International Energy Agency, the weighted cost of capital for a typical utility-scale solar PV project is 2.6-4.3% in the Euro Area and over 10% in the big emerging economies. Green projects with the same technology and similar returns make money in developed but not developing countries. The result is a world where the private sector finances 81% of renewable energy generation in the developed world, yet the public sector funds 86% of parallel efforts in poorer countries.

Debt problem

That can't work. Developing-country governments cannot fund the green transformation to the scale or pace the world needs. Overseas Development Assistance is not increasing and developing countries do not have any space on their balance sheets to borrow more. Developing countries start from high debt levels, worsened by the pandemic, the food and fuel crisis following the Russian–Ukraine conflict, and rising loss and damage from climate change impacts. About a third of developing countries are already at high risk of or in debt distress.

Take the example of the debilitating difference in the cost of capital between the same green transformation projects in the Euro Area and industrializing emerging economies like India, Brazil and South Africa. The difference reflects the country and project risks, but we can attribute most, if not all of it to the difference between country risks witnessed by what emerging governments pay to borrow in local currencies vs what European governments pay. The South African Government recently offered investors 11% annually when it borrowed ten-year money, while the German Government paid 1%.

A substantial chunk of this country risk arises from currency risk concerns that relate to how the currency markets work rather than domestic fundamentals. Despite Covid and being unable to participate in quantitative easing to any significant extent, India, for instance, has a lower debt-to-GDP ratio than the Eurozone average and much higher bond yields.

Private investors know that developing country currencies routinely come under pressure whenever there is international financial stress, paying the price for the flight to a small number of global reserve currencies. Developing countries pay heavily for this actual and feared short-term volatility. Looking at where exchange rates end up reveals that at times of above-average market stress, half of the currency risk premiums are an excess risk premium or 'overpayment' for how things turn out. Because this overpayment is holding back the investment we need, it is a planet-sized market failure.

But all this points to a solvable problem: sharply reduce fear of currency risk, and we can break the dam preventing the flow of private savings to energy and other green transformations in developing countries.

FX guarantee mechanism

One solution is a new international mechanism that offers investors cheaper currency hedges when market risk premiums rise above average, but only for approved green transformation projects. A private firm cannot solve systemic market failure. They would need to hold but not use capital in booms when others were making out like bandits and only use their capital when it was scarce and markets were stressed, but for only modest, long-term returns.

We need a counter-cyclical mechanism with a public-good mandate, pooling FX risks, and the necessary liquidity and capital to hold fundamentally profitable positions over time. It could be implemented by a joint agency of the multilateral development banks, like the World Bank and others, with liquidity support from the IMF.

An FX guarantee mechanism would reduce the cost of capital blocking the flow of investment into developing countries for the green transformation. It would reduce the largest risk premia, the currency premia, where and when the market failure is most significant. The evidence is that we can reduce the risk premia and cost of capital safely and by enough in industrialising emerging economies to make green investments attractive for investors everywhere.

This means we can scale it up, at pace, to drive the $1trn a year of vital green investments into developing countries. It is a planet-sized solution for a planet-sized problem.