Editing IPCC:AR6/WGIII/Chapter-15 (section)

== 15.6 Approaches to Accelerate Alignment of Financial Flows with Long-term Global Goals ==

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Near-term actions to shift the financial system over the next decade are critically important and possible with globally coordinated efforts. Taking into account the inertia of the financial system as well as the magnitude of the challenge to align financial flows with the long-term global goals, fast action is required to ensure the readiness of the financial sector as an enabler of the transition ( ''high confidence'' ). The following subsections elaborate on key areas which can have a catalytic effect in terms of addressing existing barriers – besides political leadership and interventions discussed in other Chapters of AR6.

Addressing knowledge gaps with regard to climate risk analysis and transparency will be one key driver for more appropriate climate risk assessment and efficient capital allocation ( [[#15.6.1|Section 15.6.1]] ), efficient enabling environments to support the reduction of financing costs and reduce dependency on public financing ( [[#15.6.2|Section 15.6.2]] ), a revised common understanding of debt sustainability, including that negative implications of deferred climate investments on future GDP, particularly stranded assets and resources to be compensated, can facilitate the stronger access to public climate finance, domestically and internationally ( [[#15.6.3|Section 15.6.3]] ), climate risk pooling and insurance approaches are a key element of financing of a just transition ( [[#15.6.4|Section 15.6.4]] ), the supply of finance to a widened focus on relevant actors can ensure transformational climate action at all levels ( [[#15.6.5|Section 15.6.5]] ), new green asset classes and financial products can attract the attention of capital markets and support the scale up of financing by providing standardised investment opportunities which can be well integrated in existing investment processes ( [[#15.6.6|Section 15.6.6]] ), a stronger focus on the development of local capital markets can help mobilise new investor groups and to some extent mitigate home bias effects ( [[#15.6.7|Section 15.6.7]] ), new business models and financing approaches can help to overcome barriers related to transactions costs by aggregating and/or transferring financing needs and establishing a supply of finance for needs of stakeholder groups lacking financial inclusion ( [[#15.6.8|Section 15.6.8]] ).

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=== 15.6.1 Addressing Knowledge Gaps with Regard to Climate Risk Analysis and Transparency ===

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Achieving climate mitigation and adaptation objectives requires ambitious climate finance flows in the near-term, that is, 5–10 years ahead. However, knowledge gaps in the assessment of climate-related financial risk are a key barrier to such climate finance flows. Therefore, this section discusses the main knowledge gaps that are currently being addressed in the literature and those that remain outstanding.

Climate-related financial risk is meant here as the potential adverse impact of climate change on the value of financial assets. A recent but remarkable development since AR5 is that climate change has been explicitly recognised by financial supervisors as a source of financial risk that matters both for financial institutions and citizens’ savings ( [[#Bolton--2020|Bolton et al. 2020]] ). Previously, climate change was mostly regarded in the finance community only as an ethical issue. The reasons why climate change implies financial risk are not new and are discussed more in detail below. What is new is that climate enters now as a factor in the assessment of financial institutions’ risk (e.g., the European Central Bank or the European Banking Authority) and credit rating ( [[#15.6.3|Section 15.6.3]] ), and, going forward, into stress-test exercises. This implies changes in incentives of the supervised financial actors, both public and private, and thus changes in the landscape of mitigation action by generating a new potential for climate finance flows. However, critical knowledge gaps remain. In particular, the underestimation of climate-related financial risk by public and private financial actors can explain that the current allocation of capital among financial institutions is often inconsistent with the mitigation objectives (Rempel et al. 2020). Moreover, even a correct assessment of risk, which could provide incentives for divesting from carbon-intensive activities, does not necessarily lead to investing in the technical options needed for deep decarbonisation. Therefore, understanding the dynamics of the low-carbon transition require to fill in at the same time gaps about risk and gaps about investments in enabling activities in a broader sense.

'''Physical risk.''' On the one hand, unmitigated climate change implies an increased potential for adverse socio-economic impacts especially in more exposed economic activities and areas ( ''high confidence'' ). Accordingly, ''physical risk'' refers to the component of financial risk associated with the adverse physical impact of hazards related to climate change (e.g., extreme weather events or sea level rise) on the financial value of assets such as industrial plants or real estate. In turn, these losses can translate into losses on the values of financial assets issued by exposed companies (e.g., equity/bonds) and or sovereign entities as well as losses for insurance companies. The assessment of climate financial physical risks poses challenges in terms of data, methods and scenarios. It requires cross-match scenarios of climate-related hazards at granular geographical scale, with the geolocation and financial value of physical assets. The relationship between the value of physical assets (such as plants or real estate) and the financial value of securities issued by the owners of those assets is not straightforward. Further, the repercussion of climate-related hazards on sovereign risk should also be accounted for.

'''Transition risks and opportunities.''' On the other hand, the mitigation of climate change, by means of a transition to a low-carbon economy, requires a transformation of the energy and production system at a pace and scale that implies adverse impacts on a range of economic activities, but also opportunities for some other activities ( ''high confidence'' ). If these impacts are factored in by financial markets, they are reflected in the value of financial assets. Thus, ''transition risks and'' ''opportunities'' refers to the component of financial risk (opportunities) associated with negative (positive) adjustments in assets’ values resulting directly or indirectly from the low-carbon transition.

The concepts of ''carbon stranded assets'' (see e.g., [[#Leaton--2011|Leaton and Sussams 2011]] ), and ''orderly'' vs ''disorderly transition'' ( [[#Sussams--2015|Sussams et al. 2015]] ) which emerged in the NGO community, have provided powerful metaphors to conceptualise transition risks and have evolved into concepts used also by financial supervisors ( [[#NGFS--2019|NGFS 2019]] )and academics. The term ''carbon stranded assets'' refers to fossil fuel-related assets (fuel or equipment) that become unproductive. An ''orderly transition'' is defined here as a situation in which market players are able to fully anticipate the price adjustments that could arise from the transition. In this case, there would still be losses associated with stranded assets, but it would be possible for market players to spread losses over time and plan ahead. In contrast, a ''disorderly transition'' is defined here as a situation in which a transition to a low-carbon economy on a 2°C path is achieved (i.e., by about 2040), but the impact of climate policies in terms of reallocation of capital into low-carbon activities and the corresponding adjustment in prices of financial assets (e.g., bonds and equity shares) is large, sudden and not fully anticipated by market players and investors. Note the impact could be unanticipated even if the date of the introduction is known in advance by the market players. There are several reasons why such adjustments could occur. One simple argument is that the political economy of the transition is characterised by forces pulling in different directions, including opposing interests within the industry, and mounting pressure from social awareness of unmitigated climate risks. Politics will have to find a synthesis and the outcome could remain uncertain until it suddenly unravels. Note also that, in order to be relevant for financial risk, the disorderly transition does not need to be a catastrophic scenario in terms of the fabric of markets. It also does not automatically entail systemic risk, as discussed below. Knowledge gaps in this area are related to emerging questions, including: What are, in detail, the transmission channels of physical and transition risk? How to assess the magnitude of the exposure to these risks for financial institutions and ultimately for people’s savings? How do transition risk and opportunities depend on the future scenarios of climate change and climate policies? How to deal with the intrinsic uncertainty around the scenarios? To what extent could an underestimation of climate-related financial risk feed back on the alignment of climate finance flows and hamper the low-carbon transition? Should climate risk be explicitly accounted for in regulatory frameworks for financial institutions, such as Basel III for banks and national frameworks for insurance? What lessons from the 2008 financial crisis are relevant here, regarding moral hazard and the trustworthiness of credit risk ratings? The attention of both practitioners and the scientific community to these questions has grown since the Paris Agreement. In the following we review some of the findings from the literature, but the field is relatively young and many of the questions are still open. [[#footnote-005|12]] Damages from climate change are expected to escalate dramatically in Europe ( [[#Forzieri--2018|Forzieri et al. 2018]] ) and in some EU countries there is already some evidence that banks, anticipating possible losses on the their loan books, lend proportionally less as a consequence.

'''Assessment of physical risk.''' There is a literature on estimates of economic losses on physical assets (see Cross-Working Group Box ECONOMIC in chapter 16 of AR6 WGII). Here we discuss some figures and mechanisms that are relevant for the financial system. Significant cost increases have been observed related to increases in frequency and magnitude of extreme events ( ''high confidence'' ) ( [[#15.4.2|Section 15.4.2]] ). At the global level, the expected ‘climate value at risk’ (climate VaR) of financial assets has been estimated to be 1.8% along a business-as-usual emissions path ( [[#Dietz--2016|Dietz et al. 2016]] ), with however, a concentration of risk in the tail (e.g., 99th VaR equals to 16.9%, or USD24.2 [[#footnote-004|13]] trillion, in 2016). Climate-related impacts are estimated to increase the frequency of banking crises (up over 200% across scenarios) while rescuing insolvent banks could increase the ratio of public debt to gross domestic product by a factor of two ( [[#Lamperti--2019|Lamperti et al. 2019]] ). Further assessments of physical risk for financial assets ( [[#Mandel--2020|Mandel 2020]] ), accounting in particular for the propagation of losses through financial networks, estimate global yearly GDP losses at 7.1% (1.13%) in 2080, without adaptation (with adaptation), the former corresponding to a 10-fold increase with respect to the current yearly losses (0.76% of global GDP). Finally, climate physical risk can impact on the value of sovereign '''bonds''' (one of the top asset classes by size), in particular for vulnerable countries ( [[#Volz--2020|Volz et al. 2020]] ).

Insurance pay-outs for catastrophes have increased significantly over the last 10 years, with dramatic cost spikes in years with multiple major catastrophes (such as in 2018 with hurricanes Harvey, Irma, and Maria). This trend is expected to continue. The indirect costs of a climate-related flooding event can be up to 50% of the total costs, the majority of which is not covered by insurance ( [[#Alnes--2018|Alnes et al. 2018]] ) (Section15.6.4). The gap between total damage losses and insurance pay-outs has increased over the past 10 years ( [[#Swiss%20Re%20Institute--2019|Swiss Re Institute 2019]] ). Indeed, the probability of ‘extreme but plausible’ scenarios will be progressively revised upwards in the ‘value at risk’. As a result it becomes more difficult to find financial actors willing to provide insurance, as was observed for real estate in relation to flood and wildfires in California ( [[#Ouazad--2019|Ouazad and Kahn 2019]] ). This progressive adjustment would keep the financial system safe ( [[#Climate-Related%20Market%20Risk%20Subcommittee--2020|Climate-Related Market Risk Subcommittee 2020]] ; [[#Keenan--2020|Keenan and Bradt 2020]] ), but transfer to taxpayers the onus of damage compensation and the financing of adaptation investments ( [[#OECD--2021c|OECD 2021c]] ) as well as build up latent liabilities.

'''Assessment of transition risk. Carbon stranded assets.''' Fossil fuel reserve and resource estimates exceed in equivalent quantity of CO 2 with virtual certainty the carbon budget available to reach the 1.5°C and 2°C targets ( ''high confidence'' ) ( [[#Meinshausen--2009|Meinshausen et al. 2009]] ; [[#McGlade--2015|McGlade and Ekins 2015]] ; [[#Millar--2017|Millar et al. 2017]] ). In relative terms, stranded assets of fossil fuel companies amount to 82% of global coal reserves, 49% of global gas reserves and 33% of global oil reserves ( [[#McGlade--2015|McGlade and Ekins 2015]] ). This suggests that only less than the whole quantity of fossil fuels currently valued (either currently extracted, waiting for extraction as reserves or assets on company balance sheets) can yield economic return if the carbon budget is respected. The devaluation of fossil fuel assets implies financial losses for both the public sector ( [[#15.6.8|Section 15.6.8]] ) and the private sector ( [[#Coffin--2019|Coffin and Grant 2019]] ). Global estimates of potential stranded fossil fuel assets amount to at least 1 trillion, based on ongoing low-carbon technology trends and in the absence of climate policies (cumulated to 2035 with 10% discount rate applied; USD8 trillion without discounting ( [[#Mercure--2018a|Mercure et al. 2018a]] )). With worldwide climate policies to achieve the 2°C target with 75% likelihood, this could increase to over USD4 trillion (until 2035, 10% discount rate; USD12 trillion without discounting). Other estimates indicate USD8–15 trillion (until 2050, 5% discount rate, ( [[#Bauer--2015|Bauer et al. 2015]] )) and USD185 trillion (cumulated to year 2115 using combined social and private discount rate ( [[#Linquiti--2016|Linquiti and Cogswell 2016]] )). However the geographical distribution of potential stranded fossil fuel assets (also called ‘unburnable carbon’) is not even across the world due to differences in production costs ( [[#McGlade--2015|McGlade and Ekins 2015]] ). In this context, a delayed deployment of climate finance and consequently limited alignment of investment activity with the Paris Agreement tend to strengthen carbon and thus to increase the magnitude of stranded assets.

'''Assets directly and indirectly exposed to transition risk.''' In terms of types of assets and economic activities, the focus of estimates of carbon stranded assets tends to be on physical reserves of fossil fuel (e.g., oil fields) and sometimes financial assets of fossil fuel companies ( [[#van%20der%20Ploeg--2020|van der Ploeg and Rezai 2020]] ). However, a precondition for a broader analysis of transition risks and opportunities is to go beyond the narrative of stranded assets and to consider a classification of sectors of all the economic activities that could be affected ( [[#Monasterolo--2020|Monasterolo 2020]] ). This, in turn depends on their direct or indirect role in the GHG value chain, their level of substitutability with respect to fossil fuel and their role in the policy landscape. Moreover, such a classification needs to be replicable and comparable across portfolios and jurisdictions. One classification that meets these criteria is the Climate Policy Relevant Sectors (CPRS) ( [[#Battiston--2017|Battiston et al. 2017]] ) which has been used in several studies by financial supervisors ( [[#EIOPA--2018|EIOPA 2018]] ; [[#ECB--2019|ECB 2019]] ; [[#EBA--2020|EBA 2020]] ; [[#ESMA--2020|ESMA 2020]] ). The CPRS classification builds on the international classification of economic activities (ISIC) to map the most granular level (4 digits) into a small set of categories characterised by differing types of risk: fossil fuel (i.e., all activities whose revenues depend mostly and directly on fossil fuel, including concession of reserves and operating industrial plants for extraction and refinement); electricity (affected in terms of input but that can in principle diversify their energy sources); energy intensive (e.g., steel or cement production plants, automotive manufacturing plants), which are affected in terms of energy cost but not in terms of the main input); and transport and buildings (affected in terms of both energy sources and specific policies). All financial assets (e.g., bonds, equity shares, loans) having as issuers or counterparties firms whose revenues depend significantly on the above activities are thus potentially exposed to transition risks and opportunities. Further, investors’ portfolios have to be part of the analysis since changes in financial assets values affect the stability of financial institutions and can thus feed back into the transition dynamics itself (e.g., through cost of debt for firms and through costs for assisting the financial sector). One outstanding challenge for the analysis of investors’ exposure to climate risks is the difficulty of gathering granular and standardised information on the breakdown of non-financial firms’ revenues and CAPEX in terms of low-/high-carbon activities ( ''hig'' ''h confidence'' ).

Several financial supervisors have conducted assessments of transition risk for the financial system at the regional level. For instance, the European Central Bank (ECB) reported preliminary estimates of aggregate exposures of financial institutions to CPRS relative to their total debt securities holdings as ranging between 1% for banks to about 9% for investment funds ( [[#ECB--2019|ECB 2019]] ). The European Insurance and Occupational Pensions Authority (EIOPA) reported aggregate exposures to CPRS of EU insurance companies at about 13% of their total securities holdings ( [[#EIOPA--2018|EIOPA 2018]] ). Further analyses on the EU securities holdings indicate that among financial investments in bonds issued by non-financial corporations, EU institutions hold exposures to CPRS ranging between 36.8% for investment funds to 47.7% for insurance corporations; analogous figures for equity holdings range from 36.4% for banks to 43.1% for pension funds ( [[#Alessi--2019|Alessi et al. 2019]] ). Another study indicates that losses on EU insurance portfolios of sovereign bonds could reach up to 1%, in conservative scenarios ( [[#Battiston--2019|Battiston et al. 2019]] ).

Given the magnitude of the assets that are potentially exposed, reported in the previously cited studies, a delayed or uncoordinated transition risk can have implications for financial stability not only at the level of individual financial institutions, but also at the macro level. The possible systemic nature of climate financial risk has been highlighted on the basis of general equilibrium economic analysis ( [[#Stern--2021|Stern and Stiglitz 2021]] ).

Some financial authorities recognise that climate change represents a major source of systemic risk, particularly for banks with portfolios concentrated in certain economic sectors or geographical areas ( [[#de%20Guindos--2021|de Guindos 2021]] ). Specifically, the concern that central banks would have to act as ‘climate rescuers of last resort’ in a systemic financial crisis stemming from some combination of physical and transition risk has been raised in the financial supervisor community ( [[#Bolton--2020|Bolton et al. 2020]] ). The systemic nature of climate risk is reinforced by the possible presence of moral hazard. Indeed, if a sufficient number of financial actors have an incentive to downplay climate-related financial risk, then systemic risk builds up in the financial system, eventually materialising for taxpayers ( [[#Climate-Related%20Market%20Risk%20Subcommittee--2020|Climate-Related Market Risk Subcommittee 2020]] ). While such type of risk may go undetected to standard market indicators for a while, it can materialise with a time delay, similarly to the developments observed in the run up to the 2008 financial crisis.

These considerations are part of an ongoing discussion on whether the current financial frameworks, including Basel III, should incorporate explicitly climate risk as a systemic risk. In particular, the challenges in quantifying the extent of climate risk, reviewed in this section, especially if risk is systemic, raise the question whether a combination of quantitative and qualitative restrictions on banks’ portfolios could be put in place to limit the build-up of climate risks ( [[#Baranović--2021|Baranović et al. 2021]] ).

'''Endogeneity of risk and''' '''multiplicity of scenarios.''' One fundamental challenge is that climate-related financial risk is endogenous ( ''high confidence'' ). This means that the perception of the risk changes the risk itself, unlike most contexts of financial risk. Indeed, transition risk depends on whether governments and firms continue on a business-as-usual pathway (i.e., misaligned with the Paris Agreement targets) or engage on a climate mitigation pathway. But the realisation of the transition pathway depends itself on how, collectively, society, including financial investors and supervisors, perceive the risk of taking or not taking the transition scenario. The circularity between perception of risk and realisation of the scenario implies that multiple scenarios are possible, and that which scenario is ultimately realised can depend on policy action. The coordination problem associated also with low-carbon investments opportunities increases the uncertainty. Further, not all low-carbon activities are directly functional to the transition (e.g., investments in pharmaceutical, IT companies, or financial intermediaries), thus not all reallocations of capital lead to the same path.

In this context, probabilities of occurrence of scenarios are difficult to assess and this is important because risks vary widely across the different scenarios. In this context a major challenge is the fat-tail nature of physical risk. One the one hand, forecasts of climate change and its impact on humans and ecosystems imply tail events ( [[#Weitzman--2014|Weitzman 2014]] ) and tipping points which cannot be overcome by model consensus ( [[#Knutti--2010|Knutti 2010]] ). On the other hand, everything else the same, costs and benefits vary substantially with assumptions on agents’ utility, productivity, and intertemporal discount rate, which ultimately depend on philosophical and ethical considerations ( [[#Nordhaus--2007|Nordhaus 2007]] ; [[#Stern--2008|Stern 2008]] ; [[#Pindyck--2013|Pindyck 2013]] ). Thus, more knowledge is needed on the interaction of climate physical and transition risks, the possible reinforcing feedbacks and transmission channels to the economy and to finance. Moreover, models need to account for compound risk, that is, the interaction of climate physical and/or transition risk with other sources of risk such as pandemics, such as COVID-19.

'''Challenges for climate transition scenarios.''' The endogeneity of risk and its associated deep uncertainty implies that the standard approach to financial risk, consisting of computing expected values and risk based on historical values of market prices, is not adequate for climate risk ( ''high confidence'' ) ( [[#Bolton--2020|Bolton et al. 2020]] ). To address this challenge, a recent stream of work has developed an approach to make use of climate policy scenarios to derive risk measures (e.g., expected shortfall) for financial assets and portfolios, conditioned to scenarios of disorderly transition ( [[#Battiston--2017|Battiston et al. 2017]] ; [[#Monasterolo--2020|Monasterolo and Battiston 2020]] ; [[#Roncoroni--2020|Roncoroni et al. 2020]] ). In particular, climate policy shocks on the output of low-/high-carbon economic activities are calculated based on trajectories of energy technologies as provided by large-scale Integrated Assessment Models ( [[#Kriegler--2015|Kriegler et al. 2015]] ; [[#McCollum--2018|McCollum et al. 2018]] ) conditioned to the introduction of specific climate policies over time. This approach allows to conduct climate stress-tests both at the level of financial institutions and at the level of the financial system of a given jurisdiction.

In a similar spirit, recently, the community of financial supervisors in collaboration with the community of climate economics has identified a set of climate policy scenarios, based on large-scale IAM, as candidate scenarios for assessing transition risk ( [[#Monasterolo--2020|Monasterolo and Battiston 2020]] ). These scenarios have been used, for instance, in an assessment of transition risk conducted at a national central bank ( [[#Allen--2020|Allen et al. 2020]] ). This development is key to mainstreaming the assessment of transition risk among financial institutions, but the following challenges emerge ( ''high confidence'' ). First, a consensus among financial supervisors and actors on scenarios of transition risk that are too mild could lead to a systematic underestimation of risk. The reason is that the default probability of leveraged financial institutions is sensitive to errors in the estimation of the loss distribution and hence sensitive on the choice of transition scenarios ( [[#Battiston--2020|Battiston and]] [[#Monasterolo--2020|Monasterolo 2020]] ). This in turn could lead to an allocation of capital across low-/high-carbon activities that is insufficient to cater for the investment needs of the low-carbon transition.

Second, IAM do not contain a description of the financial system in terms of actors and instruments and make assumptions on agents’ expectations that could be inconsistent with the nature of a disorderly transition ( [[#Espagne--2018|Espagne 2018]] ; [[#Pollitt--2018a|Pollitt and Mercure 2018a]] ; [[#Battiston--2020b|Battiston et al. 2020b]] ). In particular, IAMs solve for least cost pathways to an emissions target in 2100 (AR4 WGIII SPM Box 3), while the financial sector’s time horizon is much shorter and risk is an important factor in investment decisions.

Third, the current modelling frameworks used to develop climate mitigation scenarios, which are based on large-scale IAM, assume that the financial system acts always as an enabler and do not account for the fact that, under some condition (i.e., if there is underestimation of climate transition risk) can also act as a barrier to the transition ( [[#Battiston--2020a|Battiston et al. 2020a]] ) because it invests disproportionately more in high-carbon activities.

'''Macroeconomic implications of the technological transition''' . Global macroeconomic changes that may affect asset prices are expected to take place as a result of a possible reduction in growth or contraction of fossil fuel demand, in scenarios in which climate targets are met according to carbon budgets, but also following ongoing energy efficiency changes ( ''high confidence'' ) ( [[#Clarke--2014|Clarke et al. 2014]] ; [[#Mercure--2018a|Mercure et al. 2018a]] ). A review of the economic mechanisms involved in the accumulation of systemic risk associated with declining industries, with focus on fossil fuels, is given by [[#Semieniuk--2021|Semieniuk et al. (2021)]] . An example is the transport sector, which uses around 50% of oil extracted ( [[#IEA--2018|IEA 2018]] ; [[#Thomä--2018|Thomä 2018]] ). A rapid diffusion of EV (and other alternative vehicle types) poses an important risk as it could lead to oil demand peaking far before mid-century ( [[#Mercure--2018b|Mercure et al. 2018b]] ; 2021). New technologies and fuel switching in aviation, heavy industry and shipping could further displace liquid fossil fuel demand ( [[#IEA--2017|IEA 2017]] ). A rapid diffusion of solar photovoltaic could displace electricity generation based predominantly on coal and gas ( [[#Sussams--2017|Sussams and Leaton 2017]] ). A rapid diffusion of household and commercial indoor heating and cooling based on electricity could further reduce the demand for oil, coal and gas ( [[#Knobloch--2019|Knobloch et al. 2019]] ). Parallels can be made with earlier literature on great waves of innovation, eras of clustered technological innovation and diffusion between which periods of economic, financial and social instability have emerged (Freeman and Louca 2001; [[#Perez--2009|Perez 2009]] ).

Due to the predominantly international nature of fossil fuel markets, assets may be at risk from regulatory and technological changes both domestically and in foreign countries ( ''medium confidence'' ). Fossil fuel exporting nations with lower competitiveness could lose substantial amounts of industrial activity and employment in scenarios of peaking or declining demand for fossil fuels. In scenarios of peaking oil demand, production is likely to concentrate towards the Middle East and OPEC countries ( [[#IEA--2017|IEA 2017]] ). Since state-owned fossil fuel companies tend to enjoy lower production costs, privately-owned fossil fuel companies are more at risk ( [[#Thomä--2018|Thomä 2018]] ). Losses of employment may be directly linked to losses of fossil fuel-related industrial activity or indirectly linked through losses of large institutions, notably of government income from extraction royalties and export duties. A multiplier effect may take place making losses of employment spill out of fossil fuel extraction, transformation and transportation sectors into other supplying sectors ( [[#Mercure--2018a|Mercure et al. 2018a]] ).

'''Main regulatory developments and''' '''voluntary responses to climate risk''' . Framing climate risk as a financial risk (not just as an ethical issue) is key for it to become an actionable criterion for investment decision among mainstream investors ( ''high confidence'' ) ( [[#TCFD--2019|TCFD 2019]] ). Since 2015 financial supervisors and central banks (e.g., the Financial Stability Board, the G20 Green Finance Study Group, and the Network for Greening the Financial System (NGFS)) have played a central role in raising awareness and increasing transparency of the potential material financial impacts of climate change within the financial sector ( [[#Bank%20of%20England--2015|Bank of England 2015]] , 2018; [[#TCFD--2019|TCFD 2019]] ). The NGFS initiative has engaged, in particular, in the elaboration of climate financial risk scenarios.

Although disclosure has increased since the TCFD recommendations were published, the information is still insufficient for investors and more clarity is needed on potential financial impacts and how resilient corporate strategies are under different scenarios ( [[#TCFD--2019|TCFD 2019]] ). Several efforts to provide guidance and tools for the application of the TCFD recommendations have been made (using Sustainability Accounting Standards Board (SASB) Standards and the Climate Disclosure Standards Board (CDSB) Framework to Enhance Climate-Related Financial Disclosures in Mainstream Reporting TCFD Implementation Guide ( [[#UNEP%20FI--2018|UNEP FI 2018]] ; CDSB and SASB 2019). Results of voluntary reporting have been mixed, with one study pointing to unreliable and incomparable results reported by the US utilities sector to the CDP ( [[#Stanny--2018|Stanny 2018]] ).

There have been also similar initiatives at the national level ( [[#DNB--2017|DNB 2017]] ; UK Government 2017; [[#US%20GCRP--2018b|US GCRP 2018b]] ). In particular, France was the first country to mandate climate risk disclosure from financial institutions (via Article 173 of the law on energy transition). However, disclosure responses have been so far mixed in scope and detail, with the majority of insurance companies not reporting on physical risk ( [[#Evain--2018|Evain et al. 2018]] ). In the UK, mandatory GHG emissions reporting for UK-listed companies has not led to substantial emissions reductions to date but could be laying the foundation for future mitigation ( [[#Tang--2018|Tang and Demeritt 2018]] ).

A key recent development is the EU Taxonomy for Sustainable Finance ( [[#TEG--2019|TEG 2019]] ), which provides a classification of economic activities that (among other dimensions) contribute to climate mitigation or can be enabling for the low-carbon transition. Indirectly, such classification provides useful information on investors’ exposure to transition risk ( [[#Alessi--2019|Alessi et al. 2019]] ; [[#ESMA--2020|ESMA 2020]] ). Finally, many consultancies have stepped forward offering services related to climate risk. However, the methods are typically proprietary, non-transparent, or based primarily on carbon footprinting, which is a necessary but insufficient measure of climate risk. Further, ESG (environmental, social and governance) metrics can be useful but are, alone, inadequate to assess climate risk.

Decision-makers in financial risk management make increasing use of climate policy scenarios, in line with the TCFD guidelines and the recommendations of the NGFS. In order to reduce the number of scenarios to consider, Illustrative Mitigation Pathways (IMPs, Chapter 3), have been elaborated to illustrate key features that characterise the possible climate (policy) futures. The following considerations can be useful for scenario end-users who carry out risk analyses on the basis of the scenarios described in Chapter 3. It is possible to associate climate policy scenarios with levels of physical and/or transition risk, but these are not provided with the scenario data themselves.

On the one hand, each scenario is associated with a warming path, which in turn, on the basis of the results from WGII, implies certain levels of physical risk (AR6 WGII Chapter 16). However, climate impacts are not accounted for in the scenarios. Moreover, levels of risk may vary with the reason for concern and with the speed of the implementation of adaptation. On the other hand, while mitigation can come with transition risk, in the case of lack of coordination among the actors, as discussed earlier in this section, this is not modelled explicitly in the trajectories, since the financial sector is not represented in underlying models. The scientific state of the art in climate-related financial risk offers an analysis that is not yet comprehensive of both the physical and transition risk dimensions in the same quantitative framework. However, decision-makers can follow a mixed approach where they can combine quantitative risk assessment for transition risk with more qualitative risk analysis related to physical risk.

Figure 15.6 represents sequences of events following along a scenario both in terms of physical risk (left) and transition risk (right). Four groups of IMPs (more are considered based on the warming level they lead to in 2100. Current Policies (CurPol) considers climate policies implemented in 2020 with only a gradual strengthening afterwards, leading to above 4°C warming (with respect to pre-industrial levels). Moderate Action (ModAct) explores the impact of implementing the NDCs (pledged mitigation targets) as formulated in 2020 and some further strengthening afterwards, thereby limiting warming to less than 4°C (&gt;50%), but above 3°C (&gt;50%). In these two scenarios, there is no stabilisation of temperature, meaning that further warming occurs after 2100 (and higher risk) even if stabilisation could be eventually achieved. They are referred to as pathways with higher emissions. The warming levels reached along these two scenarios imply physical risk levels that are ‘Moderate’ until 2050 and ‘Very High’ in 2050–2100 (with low levels of adaptation). Noting, that ‘Moderate’ physical risk can mean for some countries (i.e., SIDS) significant and even hardly absorbable consequences (i.e., reaching hard adaptation limits). Transition risk is not relevant for these scenarios, since a transition is not pursued.

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'''Figure 15.6 | Schematic representation of climate scenarios in terms of both physical and transition risk.''' While the figure does not cover all possible events, it maps out how the combination of stated targets can lead to different paths in terms of risk, depending on implementation progress and policy credibility. IMP 1.5°C and IMP ''&lt;'' 2°C are representative for IMP-GS (Sens. Neg; Ren), IMP-Neg, IMP-LD; IMP-Ren; IMP-SP. Note that the figure defines ‘High’ progress as higher, but it is important that the physical risk varies by region and country. This means, that ‘Moderate’ physical risk can be significant and even hardly absorbable for some countries.

Illustrative Mitigation Pathways include two groups of scenarios consistent with modelled global pathways that limit warming to 2°C (&gt;67%) or lower, respectively. The two groups are representative for the IMPs defined in Chapter 3. In these scenarios, warming is stabilised before 2100. The warming levels along these paths imply ‘Moderate’ physical risk until 2050 and ‘High’ risk in 2050–2100 (with low levels of adaptation). Transition risk can arise along these trajectories from changes in expectations of economic actors about which of the scenarios is about to materialise. These changes imply, in turn, possible large variations in the financial valuation of securities and contracts, with losses on the portfolio of institutional investors and households. High policy credibility is key to avoiding transition risk, by making expectations consistent early on with the scenario. Low credibility can delay the adjustment of expectations by several years, leading either to a late and sudden adjustment. However, if the policy never becomes credible, this changes the scenario since the initial target is not met.

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=== 15.6.2 Enabling Environments ===

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The Paris Agreement recognised for the first time the key role of aligning financial flows to climate goals. It further emphasises the importance of making financial flows consistent with climate actions and SDGs ( [[#Zamarioli--2021|Zamarioli et al. 2021]] ).This alignment has now to be operated in a specific environment where the scaling-up of climate policies is conditional upon their contribution to post-COVID-19 recovery packages (Sections 15.2.2 and 15.2.3 and Box 15.6). The enabling environments that are to be established account for the structural parameters of the underinvestment in long-term assets. The persistent gap between the ‘propensity to save’ and ‘propensity to invest’ ( [[#Summers--2016|Summers 2016]] ) obstructs the scaling up of climate investments, and it results from a short-term bias of economic and financial decision-making ( [[#Miles--1993|Miles 1993]] ; [[#Bushee--2001|Bushee 2001]] ; [[#Black--2002|Black and Fraser 2002]] ) that returns weighted on short-term risk dominate the investment horizon of financial actors. Overcoming this bias is the objective of an enabling environment apt to ''launch of a self-reinforcing circle of trust'' between project initiators, industry, institutional investors, the banking system, and governments.

The role of government is crucial for creating an enabling environment for climate ( [[#Clark--2018|Clark 2018]] ), and governments are critical in the launching and maintenance of this circle of trust by lowering the political, regulatory, macroeconomic and business risks ( ''high confidence'' ). The issue is not just to progressively enlarge the space of low-carbon investments but to replace one system (fossil fuels energy system) rapidly with another (low-carbon energy system). This is a wave of ‘creative destruction’ with the public support for developing new markets and new entrepreneurship and finance for green products and technologies in a context which requires strong complementarities between Schumpeterian (technological) and Keynesian (demand-related) policies ( [[#Dosi--2017|Dosi et al. 2017]] ). However, it is challenging to overcome the constraint of public budget under the pressure of competing demands and of creditworthy constraints for countries that do not have an easy access to reserve currencies. It is needed to maximise, both at the national and international levels, the leverage ratio of public funds engaged in blended finance for climate change which is currently very low, especially in developing countries ( [[#Attridge--2019|Attridge and Engen 2019]] ).

'''Transparency:''' Policy de-risking measures, such as robust policy design and better transparency, as well as financial de-risking measures, such as green bonds and guarantees, at both domestic and international levels, enhance the attractiveness of clean energy investments ( ''high confidence'' ) ( [[#Steckel--2018|Steckel and Jakob 2018]] ). Organisations such as the Task Force on Climate-related Financial Disclosures (TCFD) can help increase capital markets’ climate financing, including private sector, by providing financial markets with information to price climate-related risks and opportunities ( [[#TCFD--2020|TCFD 2020]] ). However, risk disclosures alone would likely be insufficient as long as market failures that inhibit the emergence of low-carbon investment initiatives with positive risk-weighted returns ( ''high confidence'' ) ( [[#Christophers--2017|Christophers 2017]] ; [[#Ameli--2020|Ameli et al. 2020]] ).

'''Central banks and climate change''' '''.''' Central banks in all economies will likely have to play a critical role in supporting the financing of fiscal operations, particularly in a post-COVID-19 world ( ''high confidence'' ). Instruments and institutional arrangements for better international monetary policy coordination will likely be necessary in the context of growing external debt stress and negative credit rating pressures facing both emerging and low-income countries. Central bankers have started examining the implications of disruptive risks of climate change, as part of their core mandate of managing the stability of the financial system ( [[#Chenet--2021|Chenet et al. 2021]] ). Climate-related risk assessments and disclosure, including central banks’ stress testing of climate change risks, can be considered as a first step ( [[#Rudebusch--2019|Rudebusch 2019]] ), although such risk assessments and disclosure may not be enough by themselves to spur increased institutional low-carbon climate finance ( [[#Ameli--2020|Ameli et al. 2020]] ).

Green quantitative easing (QE) is now being examined as a tool for enabling climate investments ( [[#Dafermos--2018|Dafermos et al. 2018]] ) in which central banks could explicitly conduct a programme of purchases of low-carbon assets ( [[#Aglietta--2015|Aglietta et al. 2015]] ). A green QE programme ‘would have the benefit of providing large amounts of additional liquidity to companies interested’ in green projects ( ''medium confidence'' ) ( [[#Campiglio--2018|Campiglio et al. 2018]] ). Green QE would have positive effects for stimulating a low-carbon transition, such as accelerating the development of green bond markets ( [[#Hilmi--2021|Hilmi et al. 2021]] ), encouraging investments and banking reserves, and reducing risks of stranded assets, while it might increase income inequality and financial instability ( [[#Monasterolo--2017|Monasterolo and Raberto 2017]] ). While the short-term effectiveness would not be substantial, the central bank’s purchase of green bonds could have a positive effect on green investment in the long run ( [[#Dafermos--2018|Dafermos et al. 2018]] ). However, the use of green QE needs to be cautious on potential issues, such as undermining the central bank’s independence, affecting the central bank’s portfolio by including green assets with poor financial risk standards, and potential regulatory capture and rent-seeking behaviours ( [[#Krogstrup--2019|Krogstrup and Oman 2019]] ).

Additional monetary policies and macroprudential financial regulation may facilitate the expected role of carbon pricing on boosting low-carbon investments ( ''medium confidence'' ) ( [[#D’Orazio--2019|D’Orazio and Popoyan 2019]] ). Commercial banks may not respond to the price signal and allocate credits to low-carbon investments due to the existence of market failure ( [[#Campiglio--2016|Campiglio 2016]] ). This could support the productivity of green capital goods and encourage green investments in the short term, but might cause financial instability by raising non-performing loans ratio of dirty investments and creating green bubbles ( [[#Dunz--2021|Dunz et al. 2021]] ). Financial supervisors needs to implement stricter guidelines to overcome the greenwashing challenges ( [[#Caldecott--2020|Caldecott 2020]] ).

'''Efficient financial markets and financial regulation.''' An influential efficient financial markets hypothesis ( [[#Fama--1970|Fama 1970]] , 1991, 1997) proceeds from the assumption that in well-developed financial markets, available information at any point of time is already well captured in capital markets with many participants. Despite increasing challenges to the theory ( [[#Sewell--2011|Sewell 2011]] ), especially by repeated episodes of global financial crashes and crises, and other widely noted anomalies, a weaker form of the efficient markets hypothesis may still apply ( ''medium confidence'' ). It is arguable that accumulating scientific evidence of climate impacts is being accompanied by rising levels of climate finance. Banks and institutional investors are also progressively rebalancing their investment portfolios away from fossil fuels and towards low-carbon investments ( [[#IEA--2019b|IEA 2019b]] ; [[#Monasterolo--2020|Monasterolo and de Angelis 2020]] ) '''.''' In the meantime, the world runs the risk of sharp adjustments, crises and irreversible ‘tipping points’ ( [[#Lontzek--2015|Lontzek et al. 2015]] ) sufficiently destabilising climate outcomes. This leads to the policy prescription towards financial regulatory agencies requiring greater and swifter disclosure of information about rising climate risks faced by financial institutions in projects and portfolios and central bank attention to systemic climate risk problems as one possible route of policy action ( [[#Carney--2015|Carney 2015]] ; [[#Dietz--2016|Dietz et al. 2016]] ; [[#Zenghelis--2016|Zenghelis and Stern 2016]] ; [[#Campiglio--2018|Campiglio et al. 2018]] ). However, disclosure requirements of risks and information in private settings remain mostly voluntary and difficult to implement ( [[#Battiston--2017|Battiston et al. 2017]] ; [[#Monasterolo--2017|Monasterolo et al. 2017]] ).

Nevertheless, financial markets are innovating in search of solutions ( [[#15.6.6|Section 15.6.6]] ). Recognising and dealing with stranded fossil fuel assets is also a key area of growing concern that financial institutions are beginning to grapple with. Larger institutions with more patient capital (pensions, insurance) are also increasingly beginning to enter the financing of projects and green bond markets. The case for efficient financial markets in developing countries is worse ( [[#Abbasi--2016|Abbasi and Riaz 2016]] ; [[#Hong--2019|Hong et al. 2019]] ) because of weaker financial institutions ( [[#Hamid--2017|Hamid et al. 2017]] ), heightened credit rationing behaviour ( [[#Bond--2015|Bond et al. 2015]] ), and high risk aversion as most markets are rated as junk, or below/barely investment grade ( [[#Hanusch--2016|Hanusch et al. 2016]] ). Other constraints such as limited long-term financial instruments and underdeveloped domestic capital markets, absence of significant domestic bond markets for investments other than sovereign borrowing, and inadequate term and tenor of financing, make the efficient markets thesis practically inapplicable for most developing countries.

'''Markets, finance and creative destruction.''' Branches of macro-innovation theory could be grouped into two principal classes ( [[#Mercure--2016|Mercure et al. 2016]] ): ‘equilibrium – optimisation’ theories that treat innovators as rational perfectly informed agents and reaching equilibrium under market price signals; and ‘non-equilibrium’ theory where market choices are shaped by history and institutional forces and the role of public policy is to intervene in processes, given a historical context, to promote a better outcome or new economic trajectory. The latter suggests that new technologies might not find their way to the market without price or regulatory policies to reduce uncertainty on expected economic returns. A key issue is the perception of risk by investors and financial institutions. The financial system is part of complex policy packages involving multiple instruments (cutting subsidies to fossil fuels, supporting clean energy innovation and diffusion, levelling the institutional playing field and making risks transparent) ( [[#Polzin--2017|Polzin 2017]] ) and the needed big systemic push ( [[#Kern--2016|Kern and Rogge 2016]] ) requires it takes on the role of ‘institutional innovation intermediaries’ ( [[#Polzin--2016|Polzin et al. 2016]] ).

As far as climate finance is concerned, public R&amp;D support had large cross-border knowledge spill-overs indicating that openness to trade was important, capacity expansion had positive effects on learning-by-doing on innovation over time, and that feed-in-tariffs (FiTs), in particular, had positive impacts on technology diffusion ( [[#Grafström--2017|Grafström and Lindman 2017]] ) (Box 16.4). The FiTs programme has been associated with rapid increase in early renewables capacity expansion across the world by reducing market risks in financing and stability in project revenues ( [[#Menanteau--2003|Menanteau et al. 2003]] ; [[#Jacobsson--2009|Jacobsson et al. 2009]] ) ( [[IPCC:Wg3:Chapter:Chapter-9#9.9.5|Section 9.9.5]] ). Competitive auctions where the bidder with the lowest price or other criteria is selected for government’s call for tender are increasingly being utilised as an alternative to FITs due to their strengths of flexibility, potential for real price discovery, ability to ensure greater certainty in price and quantity, and capability to guarantee commitments and transparency ( [[#IRENA%20and%20CEM--2015|IRENA and CEM 2015]] ).

Outside of renewable energy, scattered but numerous examples are available on the role of innovative public policy to spur and create new markets and technologies ( [[#Arent--2017|Arent et al. 2017]] ): (i) proactive role of the state in energy transitions (e.g., the retirement of all coal-fired power plants in Ontario, Canada, between 2007 and 2014 ( [[#Kern--2016|Kern and Rogge 2016]] ; [[#Sovacool--2016|Sovacool 2016]] )); (ii) too early exit and design problems not considering the market acceptability and financing issues (e.g., energy-efficient retrofitting in housing in UK ( [[#Rosenow--2016|Rosenow and Eyre 2016]] ), low or negative returns in reality versus engineering estimates in weatherisation programmes in US ( [[#Fowlie--2018|Fowlie et al. 2018]] )); and (iii) energy performance contracting for sharing the business risks and profits and improving energy efficiency (energy service companies ( [[#Bertoldi--2017|Bertoldi and Boza-Kiss 2017]] ; [[#Qin--2017|Qin et al. 2017]] ) and utility energy service contracts in the USA ( [[#Clark--2018|Clark 2018]] )).

'''Crowding out.''' Literature has discussed the risks of low effectiveness of public interventions and of a crowding out effect of climate-targeted public support to other innovation sectors ( [[#Buchner--2013|Buchner et al. 2013]] ). However, much academic literature suggests no strong evidence of crowding out. ( [[#Deleidi--2020|Deleidi et al. 2020]] ). Examining the effect of public investment on private investment into renewables in 17 countries over 2004–2014, showed that the concept of crowding out or in does not apply well to sectoral studies and found that public investments positively support private investments in general.

'''Support climate action via carbon pricing, taxes, and emission trading systems.''' Literature and evidence suggest that futures markets regarding climate are incomplete because they do not price in externalities ( [[#Scholtens--2017|Scholtens 2017]] ). As a result, low-carbon investments do not take place to socially and economically optimal levels, and the correct market signals would involve setting carbon prices high enough or equivalent trading in reduced carbon emissions by regulatory action to induce sufficient and faster shift towards low-carbon investments ( ''high confidence'' ) ( [[#Aghion--2016|Aghion et al. 2016]] ). Nonetheless, durable carbon pricing in economic and political systems must be implemented and approached combining related elements to both price and quantity ( [[#Grubb--2014|Grubb 2014]] ).

The introduction of fiscal measures, such as carbon taxes, or market-based pricing, such as emission trading schemes, to reflect carbon pricing have benefits and drawbacks that policymakers need to consider, taking account of both country-specific conditions and policy characteristics. Carbon tax can be a simpler and easier way to implement carbon pricing, especially in developing countries, because countries can utilise the existing fiscal tools and do not need concrete enabling conditions as market-based frameworks ( ''high confidence'' ). The reallocation of revenues from carbon taxes can be used for low-carbon investments, supporting poorer sections of society and fostering technological change ( [[#High-Level%20Commission%20on%20Carbon%20Prices--2017|High-Level Commission on Carbon Prices 2017]] ). In combination with other policies, such as subsidies and public R&amp;D on resource-saving technologies, properly designed carbon taxes can facilitate the shift towards low-carbon, resource-efficient investments ( [[#Bovari--2018|Bovari et al. 2018]] ; [[#Naqvi--2018|Naqvi and Stockhammer 2018]] ; [[#Dunz--2021|Dunz et al. 2021]] ) ( [[IPCC:Wg3:Chapter:Chapter-9#9.9.3|Section 9.9.3]] ). The effectiveness of carbon pricing has been supported by various evidence. EU ETS has cut emissions by 42.8% in the main sectors covered ( [[#European%20Commission--2021a|European Commission 2021a]] ), and China had achieved emissions reductions and energy conservation through its pilot ETS between 2013 and 2015 ( [[#Zhang--2019|Zhang et al. 2019]] ; [[#Hu--2020|Hu et al. 2020]] ). Institutional learning, administrative prudence, appropriate carbon revenue management and stakeholder engagement are key ingredients for successful ETS regimes ( [[#Narassimhan--2018|Narassimhan et al. 2018]] ).

The presence of carbon prices can promote low-carbon technologies and investments ( [[#Best--2018|Best and Burke 2018]] ), and price signals, including carbon taxation, provide powerful and efficient incentives for households and firms to reduce CO 2 emissions ( [[#IMF--2019|IMF 2019]] ). The expansion of carbon prices is dependent on country-specific fiscal and social policies to hedge against regressive impacts on welfare, competitiveness, and employment ( [[#Michaelowa--2018|Michaelowa et al. 2018]] ). Such impacts need to be offset using the proceeds of carbon taxes or auctioned emission allowances to reduce distortive taxation ( [[#Bovenberg--1994|Bovenberg and de Mooij 1994]] ; [[#Goulder--1995|Goulder 1995]] ; [[#de%20Mooij--2000|de Mooij 2000]] ; [[#Chiroleu-Assouline--2014|Chiroleu-Assouline and Fodha 2014]] ) and fund compensating measures for the population sections that are most adversely impacted ( [[#Combet--2010|Combet et al. 2010]] ; [[#Jaccard--2012|Jaccard 2012]] ; [[#Klenert--2018|Klenert et al. 2018]] ). This is more difficult for developing countries with a large share of energy-intensive activities, fossil fuel exporting countries and countries which have lower potential to mitigate impacts due to lower wages or existing taxes ( [[#Lefèvre--2018|Lefèvre et al. 2018]] ).

Non-carbon price instruments, such as market-oriented regulation and public programmes involving low-carbon infrastructure, may be preferable in developing countries where market and regulatory failure and political economy constraints are more prevalent ( [[#Finon--2019|Finon 2019]] ). While carbon pricing was suggested by many economists and researchers (Nordhaus 2015; [[#Pahle--2018|Pahle et al. 2018]] ), overcoming the political and regulatory barriers would be necessary for the further implementation of an effective carbon pricing scheme nationally and internationally. Without strong political support, the effectiveness of carbon pricing would be limited to least-cost movements ( [[#Meckling--2015|Meckling et al. 2015]] ).

'''Role of domestic financing sources.''' Efforts to address climate change can be scaled up through the mobilisation of domestic funds ( [[#Fonta--2018|Fonta et al. 2018]] ). Publicly organised and supported low-carbon infrastructures through resurrected national development banks may be justified ( [[#Mazzucato--2016|Mazzucato and Penna 2016]] ). It is important to efficiently allocate the public financing, and State Investment Banks (SIBs) can take up key roles (i) to provide capital to assist with overcoming financial barriers, (ii) to signal and direct investments towards green projects, and (iii) to attract private investors by taking up a de-risking role. Also, they can become a first mover by investing in new and innovative technologies or business models ( [[#Geddes--2018|Geddes et al. 2018]] ). State-owned enterprises (SOEs) can also have an overall positive effect on renewables investments, outweighing any effect of crowding out private competitors ( [[#Prag--2018|Prag et al. 2018]] ). Green investment banks can assist in the green transition by developing valuable expertise in implementing effective public interventions to overcome investment barriers and mobilise private investment in infrastructure ( [[#OECD--2015c|OECD 2015c]] ). De-risking measures may reduce investment risks, but lacking research and data availability hinders designing such measures ( [[#Dietz--2016|Dietz et al. 2016]] ). Local governments’ efforts to de-risk by securitisation might have negative effects by narrowing the scope for a green developmental state and encouraging privatisation of public services ( [[#Gabor--2019|Gabor 2019]] ).

'''The potential role of coordinated multilateral initiatives.''' There is a growing awareness of the low leverage ratio of public to private capital in climate blended finance ( [[#Blended%20Finance%20Taskforce--2018b|Blended Finance Taskforce 2018b]] ) and of a ‘glass ceiling’, caused by a mix of agencies’ inertia and perceived loss of control over the use of funds, on the use of public guarantees by MDBs to increase it ( ''high confidence'' ) ( [[#Gropp--2014|Gropp et al. 2014]] ; [[#Schiff--2017|Schiff and Dithrich 2017]] ; [[#Lee--2018|Lee et al. 2018]] ). Many proposals have emerged for multilateral guarantee funds: Green Infrastructure Funds ( [[#de%20Gouvello--2010|de Gouvello and Zelenko 2010]] ; Studart and Gallagher 2015), Multilateral Investment Guarantee Agency (Enhanced Green MIGA) ( [[#Déau--2018|Déau and Touati 2018]] ), guarantee funds to bridge the infrastructure investment gap ( [[#Arezki--2016|Arezki et al. 2016]] ), and multi-sovereign guarantee mechanisms ( [[#Dasgupta--2019|Dasgupta et al. 2019]] ). The obstacle of limited fiscal space for economic recovery and climate actions in low-income and some emerging economies can be overcome only in a multilateral setting. Several multilateral actions are being envisaged: G20’s suspension of official bilateral debt payments, IMF’s adoption of new SDRs allocation ( [[#IMF--2021b|IMF 2021b]] ). However, any form of unconventional debt relief will generate development and climate benefits only if they credibly target bridging the countries’ infrastructure gap with low-carbon climate-resilient options.

Of interest in multilateral settings is a credibility-enhancing effect provided by reciprocal gains for both the donor and the host country. Guarantor countries can compensate the public cost of their commitments with the fiscal revenues of induced exports. As to the host countries, they would benefit from new capital inflows and the grant equivalents of reduced debt service which might potentially go far beyond USD100 billion yr –1 ( [[#Hourcade--2021a|Hourcade et al. 2021a]] ). A second interest would be to support a learning process about agreed-upon assessment and monitoring methods using clear metrics. Developing standardised and science-based assessment methods at low transaction costs is essential to strengthen the credibility of green investments and the emergence of a pipeline of high-quality bankable projects which can be capitalised in the form of credible assets and supported with transparent and credible domestic spending. Multi-sovereign guarantees would provide a quality backing to developing countries and allow for expanding developing countries’ access to capital markets at a lower cost and longer maturities, overcome the Basel III’s liquidity impediment and the EU’s Solvency II directive on liquidity ( [[#Blended%20Finance%20Taskforce--2018b|Blended Finance Taskforce 2018b]] ), and accelerate the recognition of climate assets by investors seeking safe investment havens ( [[#Hourcade--2021b|Hourcade et al. 2021b]] ). They would also strengthen the efficacy of climate disclosure through high grades climate assets and minimise the risks of ‘greening’ of the portfolios by investing in ‘carbon neutral’ activities and not in low-carbon infrastructures. Finally, they would free up grant capacities for SDGs and adaptation that mostly involve non-marketable activities by crowding in private investments for marketable mitigation activities.

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==== 15.6.2.1 The Public-Private and Mobilisation Narrative and Current Initiatives ====

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Financing by development finance institutions and development banks aims to address market failures and barriers related to limited access to capital as well as provide direct and indirect subsidisation by accepting higher risk, longer loan tenors and/or lower pricing. Many development and climate projects in developing and emerging countries have traditionally been supported with concessional loans by development finance institutions and/or international financial institutions (DFIs/IFIs). With an increasing number of sectors becoming viable and increasing complaints of private sector players with regard to crowding out ( [[#Bahal--2018|Bahal et al. 2018]] ), a stronger separation and crowding in of commercial financing at the project/asset level is targeted. MDBs and IFIs were crucial for opening and growth in the early years of the green bonds, which represent a substantial share of issuances ( [[#CBI--2019a|CBI 2019a]] ). Drivers of an efficient private sector involvement are stronger incentives to have projects delivered on time and in budget as well as market competition ( [[#Hodge--2018|Hodge et al. 2018]] ). It remains key that the private sector mobilisation goes hand in hand with institutional capacity building as well as strong sectoral development in the host country, as a strong, knowledgeable public partner with the ability to manage the private sector is a dominating success factor for public-private cooperation ( [[#WEF--2013|WEF 2013]] ; [[#Yescombe--2017|Yescombe 2017]] ; [[#Hodge--2018|Hodge et al. 2018]] ).

Limited research is available on the efficiency of mobilisation of the private sector at the various levels and/or the theory of change attached to the different approaches as applied in classical public-private partnerships. Also, transparency on current flows and private involvement at the various levels is limited with no differentiation being made in reporting (e.g., GCF co-financing reporting). Limited prioritisation and agreement on prioritisation of sectors and/or project categories being ready and/or preferred for direct private sector involvement might become a challenge in the coming years ( ''high confidence'' ) ( [[#Sudmant--2017a|Sudmant et al. 2017a]] ; [[#Sudmant--2017b|Sudmant et al. 2017b]] ).

Public guarantees have been increasingly proposed to expand climate finance, especially from the private sector, with scarce public finance, by reducing the risk premium of the low-carbon investment opportunities ( [[#de%20Gouvello--2010|de Gouvello and Zelenko 2010]] ; [[#Emin--2014|Emin et al. 2014]] ; Studart and Gallagher 2015; [[#Schiff--2017|Schiff and Dithrich 2017]] ; [[#Lee--2018|Lee et al. 2018]] ; [[#Steckel--2018|Steckel and Jakob 2018]] ). They have the advantage of a broad coverage including the ‘macro’ country risks and to tackle the up-front risks during the preparation, bidding and development phases of the project lifecycle that deter project initiators, especially for capital-intensive and immature options. Insurances are also powerful de-risking instruments ( [[#Déau--2018|Déau and Touati 2018]] ) but they entitle the issuer to review claims concerning events and cannot cope with up-front costs. Contractual arrangements like power purchase agreements are powerful instruments to reduce market risks through a guaranteed price but they weigh on public budgets. Risk-sharing that brings together public agencies, firms, local authorities, private corporates, professional cooperatives, and institutional financiers can reduce costs ( [[#UNEP--2011|UNEP 2011]] ), and support the deployment of innovative business models ( [[#Déau--2018|Déau and Touati 2018]] ). Combined with emission taxes they can contribute to reducing credit rationing of immature and risky low-carbon technologies ( [[#Haas--2020|Haas and Kempa 2020]] ).

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=== Box 15.5 | The Role of Enabling Environments for Decreasing Economic Cost of Renewable Energy ===

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A widely used indicator for the relative attractiveness of renewable energy but also development of price levels is the [https://www.sciencedirect.com/topics/engineering/levelised-cost-of-energy levelised cost of energy] (LCOE). It is applied by a wide range of public and private stakeholders when tracking progress with regard to cost degression ( [[#Aldersey-Williams--2019|Aldersey-Williams and Rubert 2019]] ). LCOE calculation methodologies vary but in principle consider project-level costs only ( [[#NEA--1989|NEA 1989]] ). Besides other weaknesses, the LCOE concept usually does not consider societal costs resulting from de-risking instruments and/or other public interventions/support and therefore caution has to be applied when using the LCOE as the sole indicator of the success of enabling environments. The yearly IRENA mapping on renewable energy auction results demonstrates the extremely broad ranges of LCOEs (equal to the agreed tariffs) for renewable energy which can be observed ( [[#IRENA--2019a|IRENA 2019a]] ). For example, in 2018, solar PV LCOEs for utility-scale projects came in between USD0.04 kWh –1 and USD0.35 kWh –1 with a global weighted average of USD0.085 kWh –1 . However, comparative analysis taking into account societal costs is hardly available driven by challenges in the context of the quantification of public support.

The GET FiT concept argued that the mitigation of political and regulatory risk by sovereign and international guarantees is cost-efficient in developing countries, illustrating the estimated impact of such risk-mitigation instruments on equity and debt financing costs, and consequently required feed-in tariff levels ( [[#Deutsche%20Bank%20Climate%20Change%20Advisors--2011|Deutsche Bank Climate Change Advisors 2011]] ). The impact of financing costs on cost of renewable energy generation is well researched with significant differences across countries and technologies being observed, with major drivers being the regulatory framework as well as the availability and type of public support instruments ( [[#Geddes--2018|Geddes et al. 2018]] ; [[#Steffen--2019|Steffen 2019]] ). With a focus on developing countries and based on a case study in Thailand [[#Huenteler--2016|Huenteler et al. (2016)]] demonstrate the significant effect of regulatory environments but also local learning and skilled workforce on cost of renewables. The effect of those exceeds the one of global technology learning curves.

[[#Egli--2018|Egli et al. (2018)]] identify macroeconomic conditions (general interest rate) and experience effects within the renewable energy finance industry as key drivers in developed countries with a stable regulatory environment, contributing 5% (PV) and 24% (wind) to the observed reductions in LCOEs in the German market with a relatively stable regulatory environment. They conclude that ‘extant studies may overestimate technological learning and that increases in the general interest rate may increase renewable energies’ LCOEs, casting doubt on the efficacy of plans to phase out policy support’ ( [[#Egli--2018|Egli et al. 2018]] ). A rising general interest rate level could heavily impact LCOEs – for Germany, a rise of interest rates to pre-financial crisis levels in five years could increase LCOEs of solar and wind by 11–25% respectively ( [[#Schmidt--2019|Schmidt et al. 2019]] ).

[[File:ce5f656da0e4234fa50b4f6a0213be34 IPCC_AR6_WGIII_Box_15_6_Figure_1.png]]

'''Box 15.6, Figure 1 | Two worlds – energy transition outcomes under alternative model assumptions (Keynesian vs General Equilibrium).''' Source: [[#Mercure--2019|Mercure et al. (2019)]] .

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=== 15.6.3 Considerations on Availability and Effectiveness of Public Sector Funding ===

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The gap analysis as well as other considerations presented in this chapter illustrate the critical role of increased volumes and efficient allocation of public finance to reach the long-term global goals, both nationally and internationally.

'''Higher public spending levels driven by the impacts of COVID-19 and related recovery packages.''' Higher levels of public funding represent a massive chance but also a substantial risk. A missing alignment of public funding and investment activity with the Paris Agreement (and Sustainable Development Goals) would result in significant carbon lock-ins, stranded assets and thus increase transition risks and ultimately economic costs of the transition ( ''high confidence'' ). Using IMF data for stimulus packages, [[#Andrijevic--2020|Andrijevic et al. (2020)]] estimated that COVID-19-related fiscal expenditure had surpassed USD12 trillion by October 2020 (80% in OECD countries), a third of which being spent in liquidity support and health care. Total stimulus pledged to date is ten times higher than low-Paris-consistent carbon investment needs from 2020–2024 ( [[#Andrijevic--2020|Andrijevic et al. 2020]] ; [[#Vivid%20Economics--2020|Vivid Economics 2020]] ). Overall, stimulus packages launched include USD3.5 trillion to sectors directly affecting future emissions, with overall fossil fuel investment flows outweighing low-carbon technology investment ( [[#Vivid%20Economics--2020|Vivid Economics 2020]] ).

Lessons from the global financial crises show that although deep economic crises create a sharp short-term emission drop, and green stimulus is argued to be the ideal response to tackle both the economic and the climate crises at once, disparities between regional strategies hinder the low-carbon transition ( ''high confidence'' ). Indeed, inconsistent policies within countries can also counterbalance emission reductions from green stimulus, as well as a lack of transparency and green spending pledged not materialising ( [[#Jaeger--2020|Jaeger et al. 2020]] ). Also, aggressive monetary policy as a response to the global financial crisis, including quantitative easing that did not target low-carbon sectors, has been heavily criticised ( [[#Jaeger--2020|Jaeger et al. 2020]] ). The COVID-19 crisis recovery, in contrast, benefits from developments which have taken place since, such as an emerging climate-risk awareness from the financial sector, reflected in the call from the Coalition of Finance Ministers for Climate Action ( [[#Coalition%20of%20Finance%20Ministers%20for%20Climate%20Action--2020|Coalition of Finance Ministers for Climate Action 2020]] ), which unites 50 countries’ finance ministers, for a climate-resilient recovery.

The steep decrease in renewable electricity costs since 2010 also represents a relevant driver for a low-carbon recovery ( [[#Jaeger--2020|Jaeger et al. 2020]] ). Many more sectors are starting to show similar opportunities for rapid growth with supportive public spending such as low-carbon transport and buildings ( [[#IEA--2020d|IEA 2020d]] ). Expectations that the package will increase economic activity rely on the assumption that increased credit will have a positive effect on demand, the so-called demand-led policy ( [[#Mercure--2019|Mercure et al. 2019]] ). Boosting investment should propel job creation, increasing household income and therefore demand across economic sectors ( ''high confidence'' ). A similar plan has also been proposed by the US administration and the European Union through the Next Generation EU ( [[#European%20Council--2020|European Council 2020]] ).

Nevertheless, three uncertainties remain. First, only those countries and regions with highest credit-ratings (AAA or AA) with access to deep financial markets and excess savings will be able to mount such counter-cyclical climate investment paths, typically high-income developed economies ( ''high confidence'' ). In more debt constrained developing countries lower access to global savings pools because of higher risk perceptions and lower credit ratings (BBB or less), exacerbated by COVID-19, are already leading to credit downgrades and defaults (Koseet al. 2020) and have long tended to be fiscally pro-cyclical ( [[#McManus--2015|McManus and Ozkan 2015]] ). These include the general class of virtually all major emerging and especially low-income developing countries, to which such demand-stimulating counter-cyclical climate-consistent borrowing path is likely . To access such funds, these countries would need globally coordinated fiscal policy and explicit supporting cross-border instruments, such as sovereign guarantees, strengthening local capital markets and boosting the USD100 billion annual climate finance commitment ( [[#Dasgupta--2019|Dasgupta et al. 2019]] ).

Second, a strong assumption is that voters will be politically supportive of extended and increased fiscal deficit spending on climate on top of COVID-19-related emergency spending and governments will overcome treasury biases towards fiscal conservatism (to preserve credit ratings). However, evidence strongly suggests that voters (and credit rating agencies) tend to be fiscally conservative ( [[#Peltzman--1992|Peltzman 1992]] ; [[#Lowry--1998|Lowry et al. 1998]] ; [[#Alesina--2011|Alesina et al. 2011]] ; [[#Borge--2020|Borge and Hopland 2020]] ) ''',''' especially where expenditures involve higher taxes in the future and do not identifiably flow back to their local bases (the ‘public good’ problem) ( ''high confidence'' ). Such mistrust has been a reason for abortive return to fiscal austerity often in the past (most recently during global financial crisis) and may benefit for political support by consistently reframing the climate expenditures in terms of job creation benefits ( [[#Bougrine--2012|Bougrine 2012]] ), effectiveness of least-cost fiscal spending on climate for reviving private activity, and the avoidance of catastrophic losses (Huebscher et, al. 2020) from higher carbon emissions. A new understanding of debt sustainability including negative implications of deferred climate investments on future GDP has not yet been mainstreamed (see more on the debt sustainability discussion below (e.g., [[#Buhr--2018|Buhr et al. 2018]] ; [[#Fresnillo--2020a|Fresnillo 2020a]] ). In addition, implications on the availability of international public finance flows are not yet clear since current additional funding prioritises urgent health care support rather than an increase in predictable mid-/long-term financial support. Heavy investment needs for recovery packages in developed countries on the one hand and their international climate finance commitments on the other might be perceived to compete for available ‘perceived as appropriate’ budgets.

<div id="Box 15.6 | Macroeconomics and Finance of a Post-COVID-19 Green Stimulus Economic Recovery Path" class="h2-container"></div>

<span id="box-15.6-macroeconomics-and-finance-of-a-post-covid-19-green-stimulus-economic-recovery-path"></span>
=== Box 15.6 | Macroeconomics and Finance of a Post-COVID-19 Green Stimulus Economic Recovery Path ===

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Financial history suggests that capital markets may be willing to accommodate extended public borrowing for transient spending spikes ( [[#Barro--1987|Barro 1987]] ) when macroeconomic conditions suggest excess savings relative to private investment opportunities ( [[#Summers--2015|Summers 2015]] ) and when public spending is seen as timely, effective and productive, with governments able to repay when conditions improve as economic crisis conditions abate ( ''high confidence'' ). A surge in global climate mitigation spending in the post-pandemic recovery may be an important opportunity, which global capital markets are signalling ( [[#Global%20Investor%20Statement--2019|Global Investor Statement 2019]] ). The standard ‘neo-classical’ macroeconomic model is often used in integrated energy-economy-climate assessments ( [[#Balint--2016|Balint et al. 2016]] ; [[#Nordhaus--2018|Nordhaus 2018]] ). This class of Computable General Equilibrium (CGE) models, however, has a limited treatment of the financial sector and assumes that all resources and factors of production are fully employed, there is no idle capacity and no inter-temporal financial intermediation ( [[#Pollitt--2018b|Pollitt and Mercure 2018b]] ). Investment cannot assume larger values than the sum of previously determined savings, as a fixed proportion of income. Such constraint, as stressed by [[#Mercure--2019|Mercure et al. (2019)]] , implies that investment in low-carbon infrastructure, under the equilibrium assumptions, necessarily creates a (neo-Ricardian) crowding-out effect that contracts the remaining sectors. Box 15.6, Figure 1 shows the implications (in the red-shaded part of Figure 1).

Post-Keynesian demand-side macroeconomic models, with financial sectors and supply-side effects, in contrast, allow for the reality of non-equilibrium situations: persistent short- to medium-term underemployed economy-wide resources and excess savings over investment because of unexpected shocks, such as COVID-19. In these settings, economic stimulus packages allow a faster recovery with demand-led effects: ‘Economic multipliers are near zero when the economy operates near capacity. In contrast, during crises such as the GFC, economic multipliers can be high’ ( [[#Blanchard--2013|Blanchard and Leigh 2013]] ; [[#Hepburn--2020b|Hepburn et al. 2020b]] ). The expected results are opposite to the standard supply-led equilibrium models as a response to investment stimulus (the green-shaded part of Box 15.6, Figure 1), as intended by ‘green-stimulus’ packages such as proposed by the EU ( [[#Balint--2016|Balint et al. 2016]] ; [[#Mercure--2019|Mercure et al. 2019]] ).

Even if demand-led models work better in depressions, the question nevertheless is whether the additional public borrowing for such ‘green stimulus’ can be undertaken by market borrowings given already high public debt levels and recovered in the future from taxes as the economy revives. The results of recent macroeconomic modelling work ( [[#Liu--2021|Liu et al. 2021]] ) represented by 10 major countries/regions suggests answers. It uses a non-standard macroeconomic framework, with Keynesian features such as financial and labour market rigidities and fiscal and monetary rules ( [[#McKibbin--2013|McKibbin and Wilcoxen 2013]] ). First, a global ‘green stimulus’ of about an average of 0.8% of GDP annually in additional fiscal spending between 2020–30 would be required to accelerate the emissions reduction path required for a 1.5°C transition. Second, such a stimulus would also accelerate the global recovery by boosting GDP growth rates by about 0.6% annually during the critical post-COVID period. Third, the optimal tax policy would be to backload the carbon taxes to later in the macroeconomic cycle, both because this would avoid dampening near-term growth while pre-announced carbon tax plans would incentivise long-term private energy transition investment decisions today and provide neutral borrowing. This macroeconomic modelling path thus replicates the ‘green stimulus’ impacts expected in theory (Box 15.6, Figure 1). There are also some other additional features of the modelled proposal: (i) fiscal stimulus – needed in the aftermath of the pandemic – can be an opportunity to boost green and resilient public infrastructure; (ii) green research and development ‘subsidies’ are feasible to boost technological innovations; and (iii) income transfers to lower income groups are necessary to offset negative impacts of rising carbon taxes.

Substantial effects of the COVID-19 pandemic, which is relatively unique in its public health impacts when combined with the consequences of deep economy-wide shocks (economic downturn, public finances, and debt), are expected to last for decades even in the absence of no significant future recurrence. A scenario where the pandemic recurs mildly every year for the foreseeable future further hinders GDP and investment recovery, where growth is unlikely to rebound to previous trajectories, even within OECD economies ( [[#McKibbin--2020|McKibbin and Vines 2020]] ) and with worse effects in developing regions. History is strongly supportive: studies on the longevity of pandemics’ impacts indicate significant macroeconomic effects persisting for decades, with depressed real rates of return, increased precautionary savings ( [[#Jordà--2020|Jordà et al. 2020]] ), unemployment ( [[#Rodríguez-Caballero--2020|Rodríguez-Caballero and Vera-Valdés 2020]] ) and social unrest ( [[#Barrett--2021|Barrett and Chen 2021]] ). The direct effect on emissions is likely to be a small reduction from previous trajectories, but the longer-lasting impacts are more on the macroeconomic-finance side. Pandemic responses have increased sovereign debt across countries in all income bands ( [[#IMF--2021e|IMF 2021e]] ). However, its sharp increase in most developing economies and regions has caused debt distress (Bulow et al. 2021), widening the gap in developing countries’ access to capital ( [[#Hourcade--2021b|Hourcade et al. 2021b]] ). While strong coordinated international recovery strategies with climate-compatible economic stimulus is justified ( [[#Barbier--2020|Barbier 2020]] ; [[#Barbier--2020|Barbier and Burgess 2020]] ; [[#IMF--2020c|IMF 2020c]] ; [[#Le%20Quéré--2021|Le Quéré et al. 2021]] ; [[#Pollitt--2021|Pollitt et al. 2021]] ), national recovery packages announced do not show substantial alignment with climate goals ( [[#D’Orazio--2021|D’Orazio 2021]] ; [[#Hourcade--2021b|Hourcade et al. 2021b]] ; [[#Rochedo--2021|Rochedo et al. 2021]] ; [[#Shan--2021|Shan et al. 2021]] ). Contradictory post-COVID-19 investments in fossil fuel-based infrastructure may create new carbon lock-ins, which would either hinder climate targets or create stranded assets ( [[#Hepburn--2020a|Hepburn et al. 2020a]] ; [[#Le%20Quéré--2021|Le Quéré et al. 2021]] ; [[#Shan--2021|Shan et al. 2021]] ), whilst deepening global inequalities ( [[#Hourcade--2021b|Hourcade et al. 2021b]] ).

'''Considerations on global debt levels and debt sustainability as well as implications for climate finance.''' The Paris Agreement marked the consensus of the international community that a temperature increase of well below 2°C needs to be achieved and the SR1.5 has demonstrated the economic viability of 1.5°C. However, in terms of increase of supply of, in particular, public finance, often the debate is still driven by the question on affordability, considerations around financial debt sustainability and budgetary constraints against the background of macroeconomic headwinds – even more in the (post-)COVID-19 world ( ''high confidence'' ). The level of climate alignment of debt is hardly considered in debt-related regulation and/or debt sustainability agreements like the Maastricht Treaty ceilings (3% of GDP government deficit and 60% of GDP (gross) government debt) not considering economic costs of deferred climate action as well as economic benefits of the transformation.

Robust studies on the economic costs and benefits in the short- to long-term of reaching the LTGG exist for only few countries and/or regions, primarily in the developed world ( ''high confidence'' ) (e.g. [[#BCG--2018|BCG 2018]] ; McKinsey 2020a). With many studies underpinning the strong economic rationale for high investments in the short-term(e.g., McKinsey 2020a), regional differences are significant highlighting the need for extensive cooperation and solidarity initiatives.

For many developing countries, the focus of debt sustainability discussions is on the negative effect of climate change on the future GDP and the uncertainty with regard to short-term effects of climate change and their economic implications ( ''high confidence'' ). With long-term economic impacts of climate change being in the focus of the modelling community, the volatility of GDP in the short term driven by shocks is more difficult to analyse and requires country-specific deep-dives. IPCC scenario data is often not sufficient to perform such analysis with additional assumptions being needed ( [[#Acevedo--2016|Acevedo 2016]] ). For debt sustainability analysis, these more short-term impacts are, however, a crucial driver with transparency being limited to the significance of climate-related revision of estimates. The latter might result in a continued overestimation of future GDP as happened in the past, increasing the vulnerability of highly indebted countries ( [[#Guzman--2016|Guzman 2016]] ; [[#Mallucci--2020|Mallucci 2020]] ). While climate change considerations have already impacted country ratings and debt sustainability assessments (and financing costs), it is unclear whether current GDP forecasts are realistic. The review of the IMF debt sustainability framework leads to a stronger focus on vulnerability rather than only income thresholds when deciding upon eligibility for debt relief and/or concessional resources ( [[#Mitchell--2015|Mitchell 2015]] ), which could become a mitigation factor for the challenge described before.

Debt levels globally but particularly in developing and vulnerable countries have significantly increased over the past years with current and expected climate change impacts further burdening debt sustainability ( ''high confidence'' ). For low- and middle-income countries, 2018 marked a new peak of debt levels amounting to 51% of GDP; between 2010 and 2018, external debt payments as a percentage of government budget grew by 83% in low- and middle-income countries, from an average of 6.71% in 2010 to an average of 12.56% in 2018 ( [[#Fresnillo--2020b|Fresnillo 2020b]] ). COVID-19 has further reduced the fiscal space of many developing governments and/or increased the likelihood of debt stress. With many vulnerable countries already being burdened with higher financing costs, this limited fiscal space further shrinks their ability to actively steer the required transformation ( [[#Buhr--2018|Buhr et al. 2018]] ). Limited progress in increasing debt transparency remains another burden ( [[#15.6.7|Section 15.6.7]] ).

Considering the need for responses to both short-term liquidity issues and long-term fiscal space, current G20/IMF/World Bank debt service suspension initiatives are focused on the liquidity issue rather than underlying problems of more structural nature of many low-income countries ( [[#Fresnillo--2020a|Fresnillo 2020a]] ). In order to ensure fiscal space for climate action in the coming decade, a mix between debt relief, deferrals of liabilities, extended debt levels and sustainable lending practices including new solidarity structures need to be considered in addition to higher levels of bilateral and multilateral lending to reduce dependency on capital markets and to bridge the availability of sustainably structured loans for highly vulnerable and indebted countries. More standardised debt-for-climate swaps, a higher share of GDP-linked bonds or structures ensuring (partial) debt cancellation in case countries are hit by physical climate change impacts/shocks appear possible. The ‘hurricane’ clause introduced by Grenada, or wider natural disaster clauses provide issuers with an option to defer payments of interest and principal in the event of a qualifying natural disaster and can reduce short-term debt stress (UN Addis Ababa Action Agenda Art. 102) ( [[#UN--2015a|]] [[#UN--2015|UN 2015]] a ). A mainstreaming of such clauses has been pushed by various international institutions. The collective action clause might be a good example of a loan/debt term which became market standard. Definition of triggers is likely the most complex challenge in this context.

The use of debt-for-nature and debt-for-climate-swaps is still very limited and not mainstreamed but offers significant potential if used correctly ( ''high'' ''confidence'' ) ''.''

An increasing number of debt-for-climate/nature swaps have been seen in recent years applied primarily in international climate cooperation and in bilateral contexts, however, not (yet) to an extent addressing severe and acute debt crises ( [[#Essers--2021|Essers et al. 2021]] ; [[#Volz--2021|Volz et al. 2021]] ) offering significant potential if used correctly ( [[#Warland--2015|Warland and Michaelowa 2015]] ). Significant lead times, needs-based structuring, transparency with regard to the additionality of financed climate action, uncertainty with regard to own resource constraints and ODA accountability remain as barriers for a massive scale-up needed to make transactions relevant ( [[#Mitchell--2015|Mitchell 2015]] ; [[#Fuller--2018|Fuller et al. 2018]] ; [[#Essers--2021|Essers et al. 2021]] ). At the same time, the limitation of the use of debt-based instruments as a response to climate-related disasters and counter-cyclical loans might be necessary ( [[#Griffith-Jones--2010|Griffith-Jones and Tyson 2010]] ).

Ensuring efficient debt restructuring and debt relief in events of extreme shocks and imminent over-indebtedness and sovereign debt default are further crucial elements with a joint responsibility of debtors and creditors ( [[#UN--2015a|]] [[#UN--2015|UN 2015]] a ). In this context, the Commonwealth Secretariat flagged that the diversification of the lender portfolio made debt restructuring more difficult with more and more heterogeneous stakeholders being involved ( [[#Mitchell--2015|Mitchell 2015]] ) and the UN AAAA raising concerns about non-cooperative creditors and disruption of timely completion of debt restructuring ( [[#UN--2015a|]] [[#UN--2015|UN 2015]] a ). This is a side effect of a stronger use of capital markets, which needs to be carefully considered in the context of sovereign bond issuances ( [[#15.6.7|Section 15.6.7]] ).

'''Stranded assets.''' The debate around stranded assets focuses strongly on the loss of value to financial assets for investors ( [[#15.6.1|Section 15.6.1]] ), however, stranded assets and resources in the context of the transition towards a low-emission economy ‘are expected to become a major economic burden for states and hence the tax payers’ ( ''high confidence'' ) ( [[#EEAC--2016|EEAC 2016]] ). Assets include not only financial assets but also infrastructure, equipment, contracts, know-how, jobs as well as stranded resources ( [[#Bos--2019|Bos and Gupta 2019]] ) '''.''' Besides financial investors and fiscal budgets, consumers remain vulnerable to stranded investments. Against the background of the frequent simultaneousness of losses occurring for financial investors on the one hand and negative employment effects as well as regional development and fiscal effects on the other hand, negotiations about compensations and public support to compensate for negative effects of phasing out of polluting technologies often remain interlinked and compensation mechanisms and related redistribution effects untransparent.

Recent phase-out deals tend to aim for (partial or full) compensation rather than no relief for losses. In contrast to the line of argument in the tobacco industry, the backward-looking approach and a resulting obligation of compensation by investors in polluting assets can be observed rarely with the forward-looking approach of compensations by future winners for current losers dominating – despite the high level of awareness about carbon externalities and resulting climate change impacts among polluters for many years ( [[#van%20der%20Ploeg--2020|van der Ploeg and Rezai 2020]] ). In particular, transactions in the energy sector show a high level of investor protection also against much needed climate action which is also well illustrated by the share of claims settled in favour of foreign investors under the Energy Charter Treaty and investor-state dispute settlement ( [[#Bos--2019|Bos and Gupta 2019]] ) '''.'''

Late government action can delay action and consequently strengthen the magnitude of action needed at a later point in time with implications for employment and economic development in impacted regions requiring higher level of fiscal burden ( ''high confidence'' ). This has also been considered in the context of global climate cooperation with prolonged support for polluting infrastructure resulting in heavy lock-in effects and higher economic costs in the long run ( [[#Bos--2019|Bos and Gupta 2019]] ) '''.''' Despite a significant share of fossil resources which need to become stranded in developing countries to reach the LTGG, REDD+ remains a singular example for international financial cooperation in the context of compensation for stranded resources.

<div id="15.6.4" class="h2-container"></div>

<span id="climate-risk-pooling-and-insurance-approaches"></span>

=== 15.6.4 Climate Risk Pooling and Insurance Approaches ===

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Since 2000, the world has been experiencing significant increase in economic losses and damages from natural disasters and weather perils such as tropical cyclones, earthquakes, flooding and drought. Total global estimate of damage is about USD4210 billion, 2000–2018 ( [[#Aon%20Benfield%20UCL%20Hazard%20Research%20Centre--2019|Aon Benfield UCL Hazard Research Centre 2019]] ). The largest portion of this is attributed to tropical cyclones (USD1253 billion), followed by flooding (USD914 billion), earthquakes (USD757 billion) and drought (approximately USD372 billion, or about USD20 billion yr –1 losses) ( [[#Aon%20Benfield%20UCL%20Hazard%20Research%20Centre--2019|Aon Benfield UCL Hazard Research Centre 2019]] ). In the period 2017–2018, natural catastrophe losses totalled approximately USD219 billion ( [[#Bevere--2019|Bevere 2019]] ). According to the National Oceanic and Atmospheric Administration, 14 weather and climate disasters cost USD91 billion in 2018 ( [[#NOAA%20NCEI--2019|NOAA NCEI 2019]] ). The European Environment Agency reports that ‘disasters caused by weather and climate-related extremes accounted for some 83% of the monetary losses over the period 1980–2017’ for EU Member States (EU-28) and that ‘weather and climate-related losses amounted to EUR426 billion (at 2017 values)’. For the EEA member countries (EEA-33), the ‘total reported economic losses caused by weather and climate-related extremes’ over the same period amounted to approximately EUR453 billion ( [[#EEA--2019|EEA 2019]] ). Asia Pacific and Oceania has been particularly impacted by typhoon and flooding (China, India, the Philippines) resulting in economic losses of USD58 billion, 2000–2017, and a combination of flooding, typhoon and drought totalling USD89 billion in 2018 (inclusive of loss by private insurers and government sponsored programmes ( [[#Aon%20Benfield%20UCL%20Hazard%20Research%20Centre--2019|Aon Benfield UCL Hazard Research Centre 2019]] ). Based on past historical analysis, a region such as the Caribbean, which has experienced climate-related losses equal to 1% of GDP each year since 1960, is expected to have significant increases in such losses in the future leading to possibly upwards of 8% of projected GDP in 2080 ( [[#Commonwealth%20Secretariat--2016|Commonwealth Secretariat 2016]] ). Similarly, Latin American countries, such as Argentina, El Salvador and Guatemala, experienced severe losses in agriculture totalling about USD6 billion due to drought in 2018 ( [[#Aon%20Benfield%20UCL%20Hazard%20Research%20Centre--2019|Aon Benfield UCL Hazard Research Centre 2019]] ). In the African region, where climate is projected to get significantly warmer, continuing severe drought in parts of East Africa, Tropical Cyclone Idai, had devastating economic impacts for Mozambique, Zimbabwe and Malawi ( [[#WMO--2019|WMO 2019]] ). According to Munich Re, loss from about 100 significant events in 2018 for Africa are estimated at USD1.4 billion (Munich Re 2019).

'''While there are questions about the sufficiency of insurance products to address the losses and damages of climate-related disasters, insurance can help to cover immediate needs directly, provide rapid response and transfer financial risk in times of extreme crisis (''' high confidence ''')''' '''( [[#GIZ--2015|GIZ 2015]] ; [[#Lucas--2015|Lucas 2015]] ; [[#Schoenmaker--2015|Schoenmaker and Zachmann 2015]] ; [[#Hermann--2016|Hermann et al. 2016]] ; [[#Wolfrom--2016|Wolfrom and Yokoi-Arai 2016]] ; [[#Kreft--2017|Kreft and Schäfer 2017]] ; [[#UNESCAP--2017|UNESCAP 2017]] ; [[#Matias--2018|Matias et al. 2018]] ; [[#UNECA--2018|UNECA 2018]] ; [[#Broberg--2019|Broberg and Hovani-Bue 2019]] ; [[#EEA--2019|EEA 2019]] ; [[#Martinez-Diaz--2019|Martinez-Diaz et al. 2019]] ). Commercial insurability is heavily driven by the predictability of losses and the resulting ability to calculate insurance premium levels properly. Climate change has become a major factor of increasing uncertainty. The previously strong reliance on historic data in calculation of premium levels may be but a starting point given the likely need for upward adjustment due to climate change and potential consequential economic damage. Different risk perceptions between policyholders and insurers will create contrary assessments on premium levels and consequently underinsurance. [[#McKinsey--2020b|McKinsey (2020b)]] also stresses the systemic effect of climate change on insurers’ business models and resulting availability of appropriate insu''' '''rance products.'''

The conventional approach to such protective or hedging position has been indemnity and other classical insurance micro-, meso- and macro-level schemes ( [[#Hermann--2016|Hermann et al. 2016]] ). These include micro insurance schemes such as index insurance and weather derivative approaches that cover individuals’ specific needs such as coverage for farm crops. Meso-level insurance schemes, which primarily benefit intermediary institutions, such as NGOs, credit unions, financial institutions and farmer credit entities, seek to reduce losses caused by credit default thereby ‘enhancing investment potential’, whereas macro-level insurance schemes ‘allow both insured and uninsured individuals to be compensated for damages caused by extreme weather events’ ( [[#Hermann--2016|Hermann et al. 2016]] ). These macro-level insurance schemes include catastrophe bonds and weather derivatives and so on, that transfer risk to capital markets ( [[#Hermann--2016|Hermann et al. 2016]] ). Over the last decades, there has been a trend towards weather-index insurance and other parametric insurance products based on predefined pay-out risk pooling instruments. It has gained favour with governments in developing regions such as Africa, the Caribbean and the Pacific because it provides certainty and predictability about funding – financial preparedness – for emergency actions and initial reconstruction and reduces moral hazard. This ‘financial resilience’ is also increasingly appealing to the business sector, particularly micro, small and medium enterprises (MSMEs), in developing countries ( [[#MEFIN%20Network%20and%20GI%20RFPI%20Asia--2016|MEFIN Network and GI RFPI Asia 2016]] ; [[#Woods--2016|Woods 2016]] ; [[#Schaer--2018|Schaer and Kuruppu 2018]] ).

To date, sovereign parametric climate risk pooling as a way of managing climate risk does not seem to have much traction in developed countries and does not appear to be attractive to actors in the G20 countries. No G20 members are yet party to any climate risk pooling initiative ( [[#Kreft--2017|Kreft and Schäfer 2017]] ). However, international bilateral donors such as the USAID and the UK Foreign, Commonwealth and Development Office (FCDO, formerly DFID), and the multilateral development banks are all, to different extent, supporters of the various climate risk pooling initiatives now operational in developing countries.

As noted also in IPCC AR5, risk sharing and risk transfer strategies provide ‘pre-disaster financing arrangements that shift economic risk from one party to another’ ( [[#IPCC--2012|IPCC 2012]] ). Risk pooling among countries and regions is relatively advantageous when compared to conventional insurance because of the effective subsidising of ‘affected regions’ using revenues from unaffected regions which involve pooling among a large subset of countries ( ''high confidence'' ) ( [[#Lucas--2015|Lucas 2015]] ). In general, the premiums are less costly than what an individual country or entity can achieve and disbursement is rapid and there are also fewer transaction costs ( [[#Lucas--2015|Lucas 2015]] ; [[#World%20Bank--2015|World Bank 2015]] ). The World Bank argues that the experience with the Pacific Catastrophe Risk Insurance Pilot (PCRIP) and Africa Risk Capacity risk pooling (ARC) show savings of 50% in obtaining insurance cover for pooled risk compared with purchasing comparable coverage individually ( [[#Lucas--2015|Lucas 2015]] ; [[#World%20Bank--2015|World Bank 2015]] ; [[#ARC--2016|ARC 2016]] ). However, it requires, as noted by UNESCAP, ‘extensive coordination across participating countries, and entities’ ( [[#Lucas--2015|Lucas 2015]] ).

At the same time, this approach has substantial basis risk (actual losses do not equal financial compensation) ( ''high confidence'' ) ( [[#Hermann--2016|Hermann et al. 2016]] ). With parametric insurance, pay-outs are pre-defined and based on risk modelling rather than on-the-ground damage assessment so may be less than, equal to, or greater than the actual damage. It does not cover actual losses and damage and therefore, may be insufficient to meet the cost of rehabilitation and reconstruction. It may also be ‘non-viable’ or damaging to livelihoods in the long run ( [[#UNFCCC--2008|UNFCCC 2008]] ; [[#Hellmuth--2009|Hellmuth et al. 2009]] ; [[#Hermann--2016|Hermann et al. 2016]] ). Additionally, if the required threshold is not met, there may be no pay-out, though a country may have experienced substantial damages from a climatic event. This occurred for the Solomon Islands in 2014 which discontinued its insurance with the Pacific Catastrophe Risk Insurance Pilot when neither its Santa Cruz earthquake nor the 2014 flash floods were eligible to receive a pay-out under the terms of the insurance ( [[#Lucas--2015|Lucas 2015]] ).

Increasingly, climate risk insurance schemes are being blended into disaster risk management as part of a comprehensive risk management approach ( ''high confidence'' ). The best-known example is the Caribbean Catastrophe Risk Insurance Facility ( [[#CCRIF%20SPC--2018|CCRIF SPC 2018]] ), which involves cooperation among Caribbean states, Japan, Canada, UK and France and international organisations such as the World Bank ( [[#UNESCAP--2017|UNESCAP 2017]] ). But there are growing platforms of such an approach mainly under the umbrella of the G7’s InsuResilience Initative ( [[#Deutsche%20Klimafinanzierung--2020|Deutsche Klimafinanzierung 2020]] ), including, the Pacific Catastrophe Risk Assessment and Financing Initiative for the Pacific Islands (PCRAFI), the African Risk Capacity (ARC Agency and its financial affiliate), and the African Risk Capacity Limited (ARC Ltd/ the ARC Group) ( [[#ARC--2016|ARC 2016]] ) and in the Asian region, the South East Asian Disaster Risk Insurance Facility (SEADRIF) and the ASEAN Disaster Risk Financing and Insurance Program (ADRFI), ( [[#SEADRIF--2018|SEADRIF 2018]] ; GIZ and World Bank 2019; [[#Martinez-Diaz--2019|Martinez-Diaz et al. 2019]] ; [[#Vyas--2019|Vyas et al. 2019]] ; [[#World%20Bank--2019a|World Bank 2019a]] ). The group of 20 vulnerable countries (V20) has also developed a Sustainable Insurance Facility (SIF), billed as a technical assistance facility for climate-smart [[#footnote-003|14]] insurance for MSMEs in 48 developing countries aswell as potentially to de-risk renewable energy in these countries and regions ( [[#ACT%20Alliance--2020|ACT Alliance 2020]] ; [[#V20--2020|V20 2020]] ; [[#V20--2021|V20 2021]] ).

However, as noted above, climate risk pooling is not a panacea. There are very obvious and significant challenges. According to [[#Kreft--2017|Kreft and Schäfer (2017)]] , limitations of insurance schemes include coordination challenges, limited scope, destabilisation due to exit of one or more members as premiums rise and inadequate attention to permanence ( [[#Schaeffer--2014|Schaeffer et al. 2014]] ). There are also challenges with risk diversification, replication, and scalability ( ''high confidence'' ). For example, CCRIF is extending both its membership and diversifying its geographic dimensions into Central America in seeking to lower covariate risk (similar shocks among cohorts such as droughts or floods). Under the SPC portfolio, CCRIF is able to segregate risk across the regions. Risk insurance does not obviate from the need to engage in capacity building to scale-up as well as having process for addressing systemic risk. Currently, risk pools have limited sectoral reach and may cover agriculture but not other important sectors such as fisheries and public utilities. Only recently (July 2019) has CCRIF initiated coverage of fisheries with the development of its Caribbean Oceans and Aquaculture Sustainability Facility (COAST) instrument ( [[#CCRIF%20SPC--2019|CCRIF SPC 2019]] ; [[#ACT%20Alliance--2020|ACT Alliance 2020]] ). Historically, risk pool mechanisms, like CCRIF and ARC, only cover a small subset of perils, such as tropical cyclones, earthquakes and excess rainfall but do not include other perils such as drought. Since 2016, ARC has increased its scope to cover drought and in 2019 launched ARC Replica, which not only covers drought but offers premiums and coverage to NGOs and the World Food Programme through the START Network and a pastoral drought product for protecting small farmers and ensuring food security. In some regions and countries, there may also be limited access to reinsurance ( [[#Schaeffer--2014|Schaeffer et al. 2014]] ; [[#Lucas--2015|Lucas 2015]] ). An important down-side of climate risk pooling is that it does not cover the actual cost of damage and losses. Though on the positive side, pay-out may exceed costs, but it may also be less than costs. Hence, the parametric approach is not a panacea and does not preclude having recourse to conventional indemnity insurance, which will cover full damage costs after a climate change event as it involves full on-the-ground assessment of factors such as the necessity and costs of repair versus, say, replacement value of damaged infrastructure. This may be important for governmental and publicly provided services such as schools, hospitals, roads, airports, communications equipment and water supply facilities. Given the growing popularity of parametric insurance and climate risk pooling, there are very ambitious attempts to expand this approach on several fronts ( [[#Scherer--2017|Scherer 2017]] ). [[#Schoenmaker--2015|Schoenmaker and Zachmann (2015)]] have proposed a global climate risk pool to help the most vulnerable countries. The pathway to this includes capacity building in underdeveloped financing sectors of developing countries. They argue that as climate extremes become more normalised, they will wipe out significant parts of the infrastructure and productive capacity of developing countries. This will have knock-on impact on fiscal capacity due to lowered tax revenue and high rebuilding costs. ‘Developing countries’, [[#Schoenmaker--2015|Schoenmaker and Zachmann (2015)]] argue, ‘cannot insure against such events on a market basis, nor would it be sensible to divert scarce fiscal resources away from infrastructure investment into accumulating a financial buffer for such situations’. In that context, [[#Schoenmaker--2015|Schoenmaker and Zachmann (2015)]] call for international risk pooling as ‘the only sensible strategy’, especially if it addresses the major gaps in climate risk insurance for poor and vulnerable communities by enhancing demand through ‘smart support instrument’ for premium support such as full or partial premium subsidies and investment in providing risk reduction ( [[#Schäfer--2016|Schäfer et al. 2016]] ; [[#Le%20Quesne--2017|Le Quesne et al. 2017]] ; [[#MCII--2018|MCII 2018]] ; [[#Vyas--2019|Vyas et al. 2019]] ). This, it is argued, may help to smoothen out the limited uptake of regional institutions such as ARC and CCRIF SPC, which are only in three regions of the world (with missing mechanism in South America) ( [[#Kreft--2017|Kreft and Schäfer 2017]] ). Existing regional mechanisms, while they may perform very well, only cover a portion of climatic hazards and tend to have limited subscribers. For example, across the key four sovereign risk pools (ARC, CRIFSPC, PCRAFI and SEADRIF), though there are 68 countries only one-third or 32% have purchased coverage in 2019 and 46% ‘did not deploy disaster risk financing instruments’ ( [[#ACT%20Alliance--2020|ACT Alliance 2020]] ).

Other gaps and challenges flagged by [[#Kreft--2017|Kreft and Schäfer (2017)]] include limited coverage of the full spectrum of contingency risks experienced by countries, inadequate role of risk management as a standard for all regional pools, though there are some emerging best practices in terms of data provision on weather-related risks, and incentivisation of risk reduction ( ''high confidence'' ). Here, they recognise the work of Africa Risk Capacity for not only providing the infrastructure to trigger disbursement but for also promoting national risk analysis. Another important gap in the landscape of climate risk pooling is lack of attention to financial institutions’ lending portfolios that are vulnerable to weather shocks. In this regard subsidies as part of innovative financing schemes facilitated by the donor community can encourage the uptake of meso-level climate risk insurance solutions ( [[#Kreft--2017|Kreft and Schäfer 2017]] ).

In the literature, there are two attempts at systematic evaluation or comprehensive assessment of regional climate risk pools: a comprehensive study by [[#Scherer--2017|Scherer (2017)]] and FCDO’s ten-year evaluation (2015–2024). Overall, neither of these studies draw adverse conclusions about regional climate risk pooling initiatives/mechanisms. According to Scherer, ‘it appears that insurances work in principle and there is certainly success’ and ‘initial experiences demonstrate regional climate risk insurances works’. The author cited the 28 pay-outs to 16 countries of USD106 millionarguing that it provides cash-starved countries with much needed cash ( [[#Scherer--2017|Scherer 2017]] , p. 4). The FCDO study ( [[#Scott--2017|Scott 2017]] ) examines the uptake of ARC and its impact on reducing vulnerability to disasters. It notes that there is scarce literature on disaster risk insurance mechanisms in terms of impacts. In its current sample of 20 countries as of November 2017, four are projected to experience food security crisis (IPC Level 3) but are not signatories to the ARC, which may signal that ARC is not attractive to all food insecure countries and that there is no overwhelming appetite for ARC among poorer countries. Additionally, [[#Panda--2020|Panda and Surminski (2020)]] research the importance of indicators and frameworks for monitoring the performance and impact of Coalition for Disaster Resilient Infrastructure (CDRI) but make no final assessment of any of the regional climate risk pool. However, they propose mechanisms to improve the transparency and accountability of the system. [[#Scherer--2017|Scherer (2017)]] , [[#Forest--2018|Forest (2018)]] and [[#Panda--2020|Panda and Surminski (2020)]] seem to indicate that there is ‘enthusiasm to support and scale-up regional climate risk insurance’ ( [[#Scherer--2017|Scherer 2017]] , p. 4) Examples of this support include: the Germany Ministry for Economic Cooperation and Development (BMZ) has provided USD5.9 million for the World Food Programme (WFP) to protect 1.2 million vulnerable African farmers with climate risk insurance, through ARC Replica, and the G7 InsuResilience Vision 2025, which has committed to ensuring 400–500 million poor persons are covered against disaster shock by pre-arranged finance and insurance mechanism by 2025; some of this will be through ARC ( [[#WFP--2020|WFP 2020]] ). Of course, this does not mean that risk pools are without challenges or are not failing on specific sets of metrics. [[#Forest--2018|Forest (2018)]] flags three failing areas: policy holder and hazard coverage, the cost of premium and risk transfer parameters, and the use of pay-out, which in most cases are up to the government. Here, ARC is flagged among the three regional risk pools, as the only one with contingency plan requirements that can support effective use of pay-outs. Other research exploring climate risk pooling and its impacts flag lack of transparency around pay-out, premium or risk transfer parameters. Ultimately, climate risk pools are not full insurance; they offer only limited coverage. Entities such as the U4 Anti-Corruption Help Desk are exploring how to mitigate potential corruption with regard to climate risk insurance.

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=== 15.6.5 Widen the Focus of Relevant Actors: Role of Communities, Cities and Subnational Levels ===

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There is an urgency and demand to meet the financial needs of the climate change actions not only at the national level but also at the subnational level, to achieve low-carbon and climate-resilient cities and communities ( ''high confidence'' ) ( [[#Barnard--2015|Barnard 2015]] ; [[#Moro--2018|Moro et al. 2018]] ). Scaling up subnational climate finance and investment is a necessary condition to achieve climate change mitigation and adaptation action ( [[#Ahmad--2019|Ahmad et al. 2019]] ).

'''The importance of exploring effective subnational climate finance.''' Stronger subnational climate action is indispensable to adapt cities to build more sustainable, climate-positive communities ( [[#Kuramochi--2020|Kuramochi et al. 2020]] ). It has transformative potential as a key enabler of inclusive urban economic development through the building of resilient communities ( ''high confidence'' ) ( [[#Floater--2017a|Floater et al. 2017a]] ; [[#Colenbrander--2018b|Colenbrander et al. 2018b]] ; [[#Ahmad--2019|Ahmad et al. 2019]] ). Yet the significant potential of subnational climate finance mechanisms remains unfulfilled. Policy frameworks, governance, and choices at higher levels underpin subnational climate investments ( [[#Colenbrander--2018b|Colenbrander et al. 2018b]] ; [[#Hadfield--2019|Hadfield and Cook 2019]] ). To scale climate investment, a systematicunderstanding of the preconditions to mobilising high-potential financing instruments at the national and subnational levels is necessary.

'''Subnational climate finance needs and flows.''' Subnational climate finance covers financing mechanisms reaching or utilising subnational actors to develop climate positive investment in urban areas. The fragility of interconnected national and subnational finances affects subnational finance flows, including the impact of the social-economic crisis ( [[#Canuto--2010|Canuto and Liu 2010]] ; [[#Ahrend--2013|Ahrend et al. 2013]] ). The effect of deficit in investment for global infrastructure towards the growing subnational-level debt also creates pressure on subnational finances and constrains future access to financing ( ''high confidence'' ) ( [[#Smoke--2019|Smoke 2019]] ).

The International Finance Corporation estimates a cumulative climate investment opportunity of USD29.4 trillion across six urban sectors (waste, renewable energy, public transportation, water, EVs, and green buildings) in emerging market cities, cities in developing countries with more than 500,000 population, to 2030 ( [[#IFC--2018|IFC 2018]] ). However, the State of Cities Climate Finance report estimated that an average of USD384 billion was invested in urban climate finance annually in 2017–2018 ( [[#Negreiros--2021|Negreiros et al. 2021]] ). The International Institute for Environment and Development estimates that out of the USD17.4 billion total investments in climate finance, less than 10% (USD1.5 billion) was approved for locally-focused climate change projects between 2003 and 2016 ( [[#Soanes--2017|Soanes et al. 2017]] ).

'''Subnational climate public and private finance.''' Urban climate finance and investment are prominent in the subnational climate finance landscape ( [[#CCFLA--2015|CCFLA 2015]] ; [[#Buchner--2019|Buchner et al. 2019]] ). Finance mechanisms that can support climate investment for the urban sector include public-private partnerships (PPPs); international finance; national investment vehicles; pricing, regulation, standards; land value capture; debt finance; and fiscal decentralisation ( [[#Granoff--2016|Granoff et al. 2016]] ; [[#Floater--2017b|Floater et al. 2017b]] ; [[#Gorelick--2018|Gorelick 2018]] ; [[#White--2019|White and Wahba 2019]] ). Among these mechanisms, PPPs, debt finance, and land value capture have the potential to mobilise private finance ( [[#Ahmad--2019|Ahmad et al. 2019]] ). Better standardisation in processes is needed, including those bearing on contracts and regulatory arrangement, to reflect local specificities ( [[#Bayliss--2018|Bayliss and Van Waeyenberge 2018]] ) ( [[#15.6.1|Section 15.6.1]] .1).

PPPs are particularly important in cities with mature financial systems as the effectiveness of PPPs depends on appropriate investment architecture at scale and government capacity ( ''high confidence'' ). Such cities can enable infrastructure such as renewable energy production and distribution, water networks, and building developments to generate consumer revenue streams that incentivise private investors to purchase equity as a long-term investment ( [[#Floater--2017b|Floater et al. 2017b]] ).

National-level investment vehicles can provide leadership for subnational climate financing and crowd in private finance by providing early-stage market support to technologies or evidence related to asset performance and costs-benefits ( ''high confidence'' ). The use of carbon pricing is increasing at the subnational level along with regulation and standards on negative externalities, such as pollution, to steer investment towards climate financing ( [[#World%20Bank%20Group--2019|World Bank Group 2019]] ).

Debt financing via subnational bonds and borrowing, including municipal bonds, is another potential tool for raising upfront capital, especially for rich cities ( ''high confidence'' ). The share of subnational, sub-sovereign, and sovereign bonds could grow over time, given efforts to expand the creditworthiness and ensure a sufficient supply of own-source revenue to reduce the default risk. As of now, subnational and sub-sovereign bonds are constrained by public finance limits and the fiscal capacities of governments. However, while green bonds have potential for growth at the subnational level and may result in a lower cost of capital in some cases, the market faces challenges related to scaling up and has been associated with limited measurable environmental impact to date ( [[#15.6.8|Section 15.6.8]] ). Further, bonds with lower credit ratings drive higher issuance costs for climate risk cities, for example, costs related to disclosure and reporting ( [[#Painter--2020|Painter 2020]] ).

'''Key challenges of subnational climate finance.''' Across all types of cities, five key challenges constrain the flow of subnational climate finance ( ''high confidence'' ): (i) difficulties in mobilising and scaling-up private financing ( [[#Granoff--2016|Granoff et al. 2016]] ); (ii) deficient existing architecture in providing investment on the scale and with the characteristics needed ( [[#Anguelovski--2011|Anguelovski and Carmin 2011]] ; [[#Brugmann--2012|Brugmann 2012]] ); (iii) political-economic uncertainties, primarily related to innovation and lock-in barriers that increase investment risks ( [[#Unruh--2002|Unruh 2002]] ; [[#Cook--2018|Cook and Chu 2018]] ; [[#White--2019|White and Wahba 2019]] ); (iv) the deficit in investment for global infrastructure affects the growing subnational-level debt ( [[#Canuto--2010|Canuto and Liu 2010]] ); and (v) insufficient positive value capture ( [[#Foxon--2015|Foxon et al. 2015]] ).

'''Different finance challenges between rich and poor cities.''' Access to capital markets has been one of the major sources for subnational financing and is generally limited to rich cities, and much of this occurs through loans ( ''high confidence'' ). Different challenges to accessing capital markets associated with wealthy and poorer cities are compounded into three main issues: (i) scarcity and access of financial resources ( [[#Bahl--2014|Bahl and Linn 2014]] ; [[#Colenbrander--2018b|Colenbrander et al. 2018b]] ; [[#Cook--2018|Cook and Chu 2018]] ; [[#Gorelick--2018|Gorelick 2018]] ); (ii) the level of implication from the existing distributional uncertainties to the current financing of infrastructural decarbonisation across carbon markets ( [[#Silver--2015|Silver 2015]] ); and (iii) the policy and jurisdictional ambiguity in urban public finance institutions ( [[#Padigala--2014|Padigala and Kraleti 2014]] ; [[#Cook--2018|Cook and Chu 2018]] ). In poorer cities, these differing features continue to be inhibited by contextual characteristics of subnational finance, including gaps in domestic and foreign capital ( [[#Meltzer--2016|Meltzer 2016]] ), the mismatch between investment needs and available finance ( [[#Gorelick--2018|Gorelick 2018]] ), weak financial autonomy, insufficient financial maturity, investment-grade credit ratings in local debt markets ( [[#Bahl--2014|Bahl and Linn 2014]] ), scarce diversified funding sources and stakeholders ( [[#Gorelick--2018|Gorelick 2018]] ; [[#Zhan--2018|Zhan et al. 2018]] ; [[#Zhan--2018|Zhan and de Jong 2018]] ) and weak enabling environments ( [[#Granoff--2016|Granoff et al. 2016]] ).

The depth and character of the local capital market also affect cities differently in generating bonds ( ''high confidence'' ). Challenges facing cities in developing countries include insufficient appropriate institutional arrangements, the issues of minimum size, and high transaction costs associated with green bonds ( [[#Banga--2019|Banga 2019]] ). Green projects and project pipelines are generally smaller in scale feasible for a bond market transaction ( [[#Saha--2017|Saha and D’Almeida 2017]] ; [[#DFID--2020|DFID 2020]] ). De-risking in the different phases of long-term project financing can be promoted to improve the appetite of capital markets (Section in 15.6.7).

'''Climate investment and finance for communities.''' There is insufficient evidence about which financing schemes contribute to climate change mitigation and adaptations at community level ( ''high confidence'' ). There is growing interest in the linkages between microfinance and adaptation in the agriculture sector ( [[#Agrawala--2010|Agrawala and Carraro 2010]] ; [[#Fenton--2015|Fenton et al. 2015]] ; [[#Chirambo--2016|Chirambo 2016]] ; [[#CIF--2018|CIF 2018]] ; [[#Dowla--2018|Dowla 2018]] ), the finance for community-based adaptation actions ( [[#Fenton--2014|Fenton et al. 2014]] ; [[#Sharma--2014|Sharma et al. 2014]] ), and the relations between remittances and adaptation ( [[#Le%20De--2013|Le De et al. 2013]] ). However, there is less discussion on community finance aside from the benefits of community finance and village funds in contributing to close investment gaps and community-based mitigation in the renewable energy and forest sectors ( [[#Ebers%20Broughel--2018|Ebers Broughel and Hampl 2018]] ; [[#Bauwens--2019|Bauwens 2019]] ; [[#Watts--2019|Watts et al. 2019]] ) The full potential and barriers of the community finance model are still unknown and research needs to expand understanding of favourable policy environments for community finance ( [[#Bauwens--2019|Bauwens 2019]] ; [[#Watts--2019|Watts et al. 2019]] ).

'''Implications for the transformation pathway.''' Cities often have capacity constraints on planning and preparing capital investment plans. Integrated urban capital investment planning is an option to develop cross-sectoral solutions that reduce investment needs, boost coordination capacity, and increase climate-smart impacts ( ''high confidence'' ) ( [[#Negreiros--2021|Negreiros et al. 2021]] ). In countries with weak and poorly functioning intergovernmental systems, alliances and networks may influence their organisational ability to translate adaptive capacity for transformation into actions ( [[#Leck--2015|Leck and Roberts 2015]] ; [[#Colenbrander--2018a|Colenbrander et al. 2018a]] ). Deepening understanding of country-specific enabling environment for mobilising urban climate finance among and within cities and communities, design of policy, institutional practices and intergovernmental systems are needed to reduce negative implications of transformation ( [[#Steele--2015|Steele et al. 2015]] ).

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=== 15.6.6 Innovative Financial Products ===

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Innovative financial products with increased transparency on climate risk have attracted investor demand, and can facilitate investor identification of low-carbon investments ( ''high confidence'' ). Innovative products may not necessarily increase financial flows for climate solutions in the near term, however they can help build capacity on climate risk and opportunities within institutions and companies to pave the way for increased flows over time.

'''Investor demand is driving developments in innovative financial products (''' high confidence ''').''' Since AR5, innovative financial products such as sustainability and green-labelled financial products have proliferated ( [[#15.3|Section 15.3]] ). These financial products are not necessarily ‘new’ in terms of financial design but are packaged or labelled in an innovative way to attract responsible and impact-oriented institutional investors.

The growth and diversity of the green bond market illustrates how innovative financial products can attract both public and private investors ( ''high confidence'' ). Demand for green financial products initially stemmed from public sector pension funds. Pension funds and insurance companies in OECD countries have traditionally favoured bonds as an asset class with lower risk ( [[#OECD%20and%20Bloomberg--2015|OECD and Bloomberg 2015]] ).

Since AR5, labelled green bonds have grown significantly, exceeding USD290 billion issued in 2020 with a total of USD1.1 trillion in outstanding bonds ( [[#CBI--2021a|]] [[#CBI--2021|CBI 2021]] a ) ( [[#15.6.7|Section 15.6.7]] ). Corporates, financial institutions and government-backed entities (for example in real estate, retail, manufacturing, energy utilities) issued the largest volumes, with use of proceeds focused primarily on GHG mitigation in energy, buildings and transport projects ( [[#CBI--2021a|]] [[#CBI--2021|CBI 2021]] a ). Given their focus on GHG mitigation, green bonds are also sometimes referred to as climate bonds, but the common market terminology is ‘green’. Municipal green bond issuance has also been growing ( [[#15.6.7|Section 15.6.7]] ). Beyond green bonds, additional products such as green loans, green commercial paper, green initial public offerings (IPOs), green commodities, and sustainability-linked bonds and loans have also been introduced in the market ( [[#CBI--2019a|CBI 2019a]] ) ( [[#15.6.7|Section 15.6.7]] ).

Investor demand for green bonds is evidenced by over-subscription of deals. Recent studies indicate an over-subscription for green-labelled bonds by an average of between three and five times, as compared to non-labelled bonds ( [[#Gore--2019|Gore and Berrospi 2019]] ; [[#Nauman--2020|Nauman 2020]] ). Results of a survey of global treasurers showed a higher demand for green bonds than non-labelled bonds for 70% of the respondents ( [[#CBI--2020a|CBI 2020a]] ).

The financial crisis associated with COVID-19 has put increased pressure on debt issuers, and the extent to which the increase in indebtedness for sovereigns and corporates has been financed via climate-related-labelled debt products is not known. Further, at this time there is no identified literature assessing the degree to which international versus domestic investors are financing sovereign green debt in developing countries ( [[#15.6.7|Section 15.6.7]] ) However, since the onset of the COVID-19 crisis, continued steady growth in issuance has been observed broadly across sustainable bonds (including green, social and sustainability bonds), with more significant growth in social bonds to support the COVID-19 recovery ( [[#Maltais--2020|Maltais and Nykvist 2020]] ; [[#CBI--2021a|]] [[#CBI--2021|CBI 2021]] a ).

Index providers and exchanges can also play a supporting role in transparency for identification of benchmarks and innovative financial products for climate action. Low-carbon indices have proliferated in recent years, with varying approaches including reduced exposure to fossil, best-in-class performers within a sector, and fossil-free (UN PRI 2018) (see discussion on ESG index performance that follows in this section). Indices can provide transparency on low-carbon opportunities, making it simpler for funds and investors to identify green investment options. Exchanges can also play a supporting role to the uptake of green financial products through transparent listings and requirements to improve credibility of green labelling. The number of green or sustainability bond listing segments tripled from five in 2016 to 15 in 2018 ( [[#SSE--2018|SSE 2018]] ). Green security listings can also be used to enhance local capital markets ( [[#15.6.7|Section 15.6.7]] ).

'''Significant potential exists for continued growth in innovative financial products, though some challenges remain (''' high confidence ''').''' Despite recent growth and diversification, green bonds face several challenges in scaling up. Issuance of green-labelled bonds constitutes approximately 1% of the global bond market issuance ( [[#ICMA--2020b|ICMA 2020b]] ; [[#CBI--2021a|]] [[#CBI--2021|CBI 2021]] a ) Potential exists to increase issuance amongst corporates, for instance, and across a broader regional scope (although subject to limitations of local capital markets). Yet there remain several challenges to growing the green bond market, including ''inter alia'' concerns about greenwashing and limitations in application to developing countries ( [[#Shishlov--2018|Shishlov et al. 2018]] ; [[#Banga--2019|Banga 2019]] ).

There is no globally accepted definition of green bonds, and varied definitions of eligible green activities are evolving across regional bond markets. Beyond the most commonly used green label, other related labels such as blue, sustainable, transition, sustainable development goal (SDG), social and environmental, social and governance (ESG) have some overlapping applications ( [[#Schumacher--2020|Schumacher 2020]] ). The degree to which these labels represent climate-relevant investments depends on underlying criteria and how they are applied ( [[#15.6.4|Section 15.6.4]] ).

There are several initiatives aimed at protecting the integrity of the green label. Guidance on use and management of proceeds established by the International Capital Markets Association’s Green Bond Principles (GBP) is followed on a voluntary basis, which notes eligible use of proceeds as primarily climate mitigation and adaptation projects. The GBP also recommend independent external reviews at the time of issuance, with 89% of green bond issuers in 2020 having external reviews at the time of issuance ( [[#CBI--2021a|]] [[#CBI--2021|CBI 2021]] a ). In addition to best practice based on voluntary principles, a further check on greenwashing, although insufficient on its own, is the fear of reputation risk on behalf of investors, issuers and intermediaries in the age of social media ( [[#Hoepner--2017|Hoepner et al. 2017]] ; [[#Deschryver--2020|Deschryver and de Mariz 2020]] ). A report on post-issuance green bond impact reporting notes that despite concerns ( [[#Shishlov--2018|Shishlov et al. 2018]] ), greenwashing incidence is rare, with 77% of green bond issuers reporting on allocation and 59% reporting on impact, but with significant variance in quality and consistency of impact reporting ( [[#CBI--2021b|]] [[#CBI--2021|CBI 2021]] b ).

Financial disclosure regulatory developments can help further align and specify definitions of green in the financial sector but are not a substitute for climate policy ( ''high confidence'' ). Developing a common basis for understanding a green label could further reduce uncertainty or concerns of greenwashing. Regulatory developments in some regions seek to further guard against greenwashing with more specific definitions. The EU sustainable finance package, including the EU Taxonomy and EU Green Bond Standard draft regulations, is the broadest reaching, but not the only, regional initiative focused on disclosure of climate risk ( [[#15.6.3|Section 15.6.3]] ). Taxonomies across regions are not always aligned on what can constitute a green project, for example with respect to transition activities ( [[#Pfaff--2021|Pfaff et al. 2021]] ) ( [[#15.6.7|Section 15.6.7]] ). While standardisation can help reduce uncertainty in markets with imperfect knowledge, the green bond market is currently developing and is expected to continue to reflect regional differences in economic governance approaches ( [[#Nedopil--2021|Nedopil et al. 2021]] ). Regulations may also have trade-offs in terms of transaction costs for green financial product issuers. Classification approaches can also face challenges, depending on how they are designed, in their ability to capture new technologies and social impacts ( [[#15.4|Section 15.4]] ).

Green bonds have been primarily targeting climate mitigation projects, with far fewer projects identified as adaptation. Green bonds mainly finance projects in the energy, buildings and transportation sectors, which constituted 85% of the use of proceeds of green bonds in 2020 ( [[#CBI--2020b|CBI 2020b]] , 2021a). Agriculture and forestry projects, including adaptation projects, have been less suited to be financed in a bond structure, which could be in part due to the more dispersed and smaller nature of the projects and in part due to project ‘bankability’ or ability to contribute steady streams of financing to pay back the terms of a bond. However, adaptation projects may not be identified as such as resiliency becomes more mainstreamed into infrastructure planning ( [[#15.3.2|Section 15.3.2]] ).

While green bonds have the potential to further support financial flows to developing countries, local capital markets can be at varying stages of development ( [[#Banga--2019|Banga 2019]] ) (Sections 15.6.2 and 15.6.7). While multilateral and bilateral development finance institutions have been active in the green bond market, global issuance in 2020 in the top 10 countries included only one developing country ( [[#CBI--2021a|]] [[#CBI--2021|CBI 2021]] a ). Targeting international investors can be enhanced via de-risking activities (15.6.4).

'''Identifying green financial products can increase uptake and may result in a lower cost of capital in certain parts of the market (''' high confidence ''').''' Investors face a systematic underpricing of climate risk in financial markets ( [[#Krogstrup--2019|Krogstrup and Oman 2019]] ; [[#Kumar--2019|Kumar et al. 2019]] ). Transparent identification of financial products can make it easier for investors to include low-carbon products in their portfolios. Investors with mandates that include or are focused on climate change are showing an interest in green-labelled financial products. Investors that identify themselves as green constitute approximately 53% of the investor base for green bonds in the first half of 2019 ( [[#CBI--2019b|CBI 2019b]] ).

There is some evidence of a premium, or an acceptance of lower yields by the investor, for green bonds ( ''medium confidence'' ). A survey of recent literature finds some consensus of the existence of a green premium in 56% of the studies on the primary markets (with a wide variance of premium amount), and 70% of the studies on the secondary market (with an average premium of –1 to –9 basis points), particularly for government issued, investment grade and green bonds that follow defined governance and reporting practices ( [[#MacAskill--2021|MacAskill et al. 2021]] ). In the US municipal bond market, as credit quality for green-labelled bonds has increased in the past few years, some studies show a positive premium for green bonds is arising ( [[#Baker--2018|Baker et al. 2018]] ; [[#Karpf--2018|Karpf and Mandel 2018]] ), or appearing only in the secondary market ( [[#Partridge--2020|Partridge and Medda 2020]] ), while others find no evidence of a premium ( [[#Hyun--2019|Hyun et al. 2019]] ; [[#Larcker--2020|Larcker and Watts 2020]] ). Several studies also show a recent emergence of a premium and oversubscription for some green-labelled bonds denominated in EUR ( [[#CBI--2019b|CBI 2019b]] ), in some cases for both USD or EUR green bonds ( [[#Ehlers--2017|Ehlers and Packer 2017]] ), with a wide variation in the range of the observed difference in basis points focusing on the secondary market ( [[#Gianfrate--2019|Gianfrate and Peri 2019]] ; [[#Nanayakkara--2019|Nanayakkara and Colombage 2019]] ; [[#Zerbib--2019|Zerbib 2019]] ), with financial institution and corporate green bonds exhibiting a marginal premium compared with their non-green comparisons ( [[#Hachenberg--2018|Hachenberg and Schiereck 2018]] ; [[#Kempa--2021|Kempa et al. 2021]] ).

Spillover effects of green bonds may also impact equity markets and other financing conditions. Stock prices have been shown to positively respond to green bond issuance ( [[#Tang--2020|Tang and Zhang 2020]] ). One study linked enhanced credit quality induced by issuing green-labelled bonds to a lower cost of capital for corporate issuers ( [[#Agliardi--2019|Agliardi and Agliardi 2019]] ). Issuers’ reputation and use of third-party verification can also improve financing conditions for green bonds ( [[#Bachelet--2019|Bachelet et al. 2019]] ). Green bonds are strongly dependent on fixed income market movements and are impacted by significant price spillover from the corporate and treasury bond markets ( [[#Reboredo--2018|Reboredo 2018]] ). A simulation of future green sovereign bond issuances shows that this can promote green finance via firm’s expectations and the credit market ( [[#Monasterolo--2018|Monasterolo and Raberto 2018]] ).

'''Financial flows via these instruments have limited measurable environmental impact to date, however they can support capacity building on climate risk and opportunities within institutions to realise future impacts (''' high confidence ''').''' There is a lack of evidence to date that green and sustainable financial products have significant impacts in terms of climate change mitigation and adaptation Box 15.7). Further, new products must be coupled with tightened climate policy and a reduction in investments associated with GHG-emitting activities to make a difference on the climate ( [[#15.3.3|Section 15.3.3]] .2).

It is challenging to link specific emission reductions with specific instruments that mainly target climate activities such as green bonds. Data challenges point to an inability to link emission reductions, including Scope 3 GHG emissions, at the organisation or firm level with green bond use-of-proceeds issuance ( [[#Ehlers--2020|Ehlers et al. 2020]] ; [[#Tuhkanen--2020|Tuhkanen and Vulturius 2020]] ). However one study found evidence of a signalling effect of issuing green bonds resulting in emission reductions at the corporate level following issuance ( [[#Flammer--2020|Flammer 2020]] ), and another study characterised the lifecycle emissions of renewable energy financed by green bonds, indicating potentially substantive avoided emissions but with variance up to a factor of 12 across bonds depending on underlying assumptions ( [[#Gibon--2020|Gibon et al. 2020]] ). There is also a lack of impact reporting requirements and consistency in the green bond market. Impact reporting is not typically required for green bond listings on specific exchanges, nor are there any requirements for independent reviews of impact reporting, however this could change in future if investors apply pressure.

Green-labelled products may not necessarily result in increased financial flows to climate projects, although there can be benefits from capacity building with issuing institutions. Green bonds can be used to finance new climate projects or refinance existing climate projects, and thus do not necessarily result in finance for new climate projects constituting additional GHG reductions (a framing used in the Clean Development Mechanism). The labelling process itself may not necessarily lead to additional financing ( [[#Dupre--2018|Dupre et al. 2018]] ; [[#Nicol--2018b|Nicol et al. 2018b]] ). However, the labelling process has merit in contributing to building capacity within issuing institutions on climate change ( [[#Schneeweiss--2019|Schneeweiss 2019]] ), which could support identification of new green projects in the pipeline.

Climate risk disclosure initiatives, some of which are voluntary in nature, may have a limited direct climate impact. Transparency on climate risk may not change investor decisions nor result in divestment, especially in the emerging economies, as support and clear direction from regulatory and policy mechanisms are required to drive institutional investors at large ( [[#Ameli--2021b|Ameli et al. 2021b]] ). On the other hand, there is evidence of reduced fossil fuel investments following mandatory climate risk disclosure requirements, indicating a broader signalling effect of transparency ( [[#Mésonnier--2021|Mésonnier and Nguyen 2021]] ).

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<span id="box-15.7-impact-of-esg-and-sustainable-finance-products-and-strategies"></span>
=== Box 15.7 | Impact of ESG and Sustainable Finance Products and Strategies ===

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While scaling up climate finance remains a challenge ( [[#15.3.2|Section 15.3.2]] ),there is consensus that investments that are managed taking into account broader sustainability criteria have increased consistently and ESG integration into sustainable investment is increasingly being mainstreamed by the financial sector over recent years ( [[#Maiti--2021|Maiti 2021]] ). The United Nations Principles for Responsible Investment (PRI) grew to over 3000 signatories in 2020, representing over USD100 trillion in assets under management ( [[#UN%20PRI--2020|UN PRI 2020]] ). And according to the 2018 biennial assessment by Global Sustainable Investment Alliance, [[#footnote-002|15]] sustainable investments in five major developed economies grew by 34% in the two-year period following the 2016 assessment. The primary ESG approaches leveraged were exclusion criteria and ESG integration, which together amounted to over USD37 trillion, accounting for two-thirds of the assessed sustainable investments, with novel strategies such as best-in class screening and sustainability-themed investing showing significant growth, although together they accounted for around 6% of these investments ( [[#GSIA--2019|GSIA 2019]] ). Shareholder activism or corporate engagement is the other key approach, which has been well established and continued to grow to nearly USD10 trillion ( [[#GSIA--2019|GSIA 2019]] ).

However, research indicates that ESG strategies by themselves do not yield meaningful social or environmental outcomes ( [[#Kölbel--2020|Kölbel et al. 2020]] ). When it comes to the tangible impact of the financial sector on addressing climate change and sustainable development, there remains ambiguity. There is a growing need for more robust assessment of ESG scores, including establishing higher standardisation of scoring processes and a common understanding of the different ESG criteria and their tangible impact on addressing climate change. The issue was highlighted in an assessment of six of the leading ESG rating agencies’ company ratings under the MIT Aggregate Confusion Project, which found the correlation among them to be 0.61, leading them to conclude that available ESG data was ‘noisy and unreliable’ ( [[#Berg--2020|Berg et al. 2020]] ). This need is reaffirmed by [[#Drempetic--2020|Drempetic et al. (2020)]] , who claim that a thorough investigation of ESG scores remains a relatively neglected topic, with extraneous factors, such as firm size, influencing the score ( [[#Drempetic--2020|Drempetic et al. 2020]] ).

There continues to be a research gap in assessing the direct impact of ESG and sustainable investments on climate change indicators, with most existing studies assessing the co-relation between either the factors driving the sustainable finance trends and the impact on sustainable investments, or sustainable investments and the impact on corporate financial performance. Nevertheless, since the post-SDG adoption period, there has been a notable uptake on research linking sustainable business practices and financial performance ( [[#Muhmad--2020|Muhmad and Muhamad 2020]] ). This research shows that there is a growing business case for ESG investing, with evidence increasingly indicating a non-negative co-relation between ESG, SDG adoption and corporate financial performance ( [[#Friede--2015|Friede et al. 2015]] ; [[#Muhmad--2020|Muhmad and Muhamad 2020]] ), and ESG performance having a positive relation with stock returns ( [[#Consolandi--2020|Consolandi et al. 2020]] ). Research focused on developed economies also indicates towards a positive relation between ESG criteria and disclosure, and economic sustainability of a firm ( [[#Giese--2019|Giese et al. 2019]] ; [[#Alsayegh--2020|Alsayegh et al. 2020]] ) and allays investor fears by showing that sustainable finance initiatives, such as divestment, do not adversely impact investment portfolio performance ( [[#Henriques--2018|Henriques and Sadorsky 2018]] ; [[#Trinks--2018|Trinks et al. 2018]] ). It should be reiterated that this research assesses the co-relation between ESG criteria and corporate financial performance, with the researchers in some cases, such as [[#Friede--2015|Friede et al. (2015)]] , including disclaimers of the results being inconclusive and highlighting the need for a deeper assessment for linking ESG criteria with impact on financial performance.

On the other hand, there is growing evidence for a sustainable investment lens having a broader positive impact on creating an enabling environment and strengthening the case for such investments. For instance, corporate social responsibility (CSR) activities and investments on the environment dimension, specifically in the areas of emission and resource reduction, were found to be profitable and a predictor of future abnormal returns in the longer term, from additional cash flow and additional demand ( [[#Dorfleitner--2018|Dorfleitner et al. 2018]] ). These factors could be contributing to the increasing trend of sustainable and green investments, and can be said to be further reiterated by the spate of investor-led collaborative initiatives and recent announcements by leading finance institutes in the developed economies, which is well recorded in a range of recent grey literature, including new climate-aligned investment strategies and ambition towards net zero targets.

Yet there is also a risk of companies announcing projected sustainability or net zerotargets and claiming the associated positive reputational impact, while having no clear action plan in place to achieve these. The lack of mandatory reporting frameworks, which results in an over-reliance on self-reported carbon data by companies for ESG assessments, can be a primary contributor ( [[#In--2021|In and Schumacher 2021]] ).

While there is a lack of research on the impactof sustainable finance products, divestment impact has been assessed in more detail. Although the research here also points towards the ambiguous direct impact of divestment on reducing GHG emissions or on the financial performance of fossil fuel companies, its indirect impact on framing the narrative around sustainable finance decisions (Bergman 2018), and the inherent potential of the divestment movement for building awareness and mobilising broader public support for effective climate policies, have been better researched and could be considered to be the more relevant outcomes ( [[#Braungardt--2019|Braungardt et al. 2019]] ). Arguments against divestment point to its largely symbolic nature, but [[#Braungardt--2019|Braungardt et al. (2019)]] elaborate on the broader positive impacts of divestment, which include its ability to spur climate action as a moral imperative and stigmatise and reduce the power of the fossil fuel lobby, and the potential of the approach to mitigate systemic financial risks arising due to climate change and address the legal responsibilities of investors merging in this regard.

Challenges remain with regards to overlapping definitions of sustainable and ESG investment opportunities, which also vary depending on social norms and pathways. There is also a general need for more extensive ESG disclosure at a corporate level, against the background of emerging mandatory impact reporting for asset managers in some regions. A movement is building towards sustainable investment strategies and increased sustainable development awareness in the financial sector ( [[#Muhmad--2020|Muhmad and Muhamad 2020]] ; [[#Maiti--2021|Maiti 2021]] ), which points to the ability of civil society movements, such as divestment campaigns, to have some influence on investor behaviour, although there are other influences such as climate risk disclosure initiatives and regulations.

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<span id="development-of-local-capital-markets"></span>

=== 15.6.7 Development of Local Capital Markets ===

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'''International situational context.''' Developing countries make up two-thirds of the world’s population and carry carbon-intensive economies where 70% of investments (see Chapter 3) need to be conducted to limit warming to 2°C. The focus for climate investments has been on China, USA, Europe, India and the G20 ( [[#UNEP--2019|UNEP 2019]] ) but studies highlight Paris and SDG attention should be devoted to Africa, LDCs and SIDS ( [[#African%20Union%20Commission--2015|African Union Commission 2015]] ; [[#Feindouno--2020|Feindouno et al. 2020]] ; [[#GCA-AAI--2020|GCA-AAI 2020]] ; [[#Warner--2020|Warner 2020]] ; [[#AOSIS--2021|AOSIS 2021]] ). The ‘special needs, circumstances and vulnerability’ of African, LDC and SIDS nations are recognised under UNFCCC and UN agreements ( [[#UN--2009|UN 2009]] , 2015a,b,c; [[#UNFCCC--2010|UNFCCC 2010]] , 2015; [[#Pauw--2019|Pauw et al. 2019]] ). These nations currently contribute very little to global emissions. Developing countries with their growing economies, including the vast African continent roughly the size of China, Europe, USA, and India combined ( [[#IEA--2014b|IEA 2014b]] , p. 20) with a 1 billion population expected to double by 2050, growing reliance on fossil fuels and ‘cheap’ biomass (charcoal use and deforestation) amid rising urbanisation and industrialisation ambitions – collectively these nations hold large leap-frog potential for the energy transition as well as risks of infrastructure lock-in. Accelerated international cooperation is a critical enabler ( [[#IPCC--2018|IPCC 2018]] ) in recognising this potential. This could mobilise global savings, scale up development of local capital markets for accelerated low-carbon investment and adaptation in low- and lower-middle-income countries as well as tackle illicit finance including tax avoidance leakages that deprive developing countries of valuable resources ( [[#US%20DoJ--2009|US DoJ 2009]] ; [[#Hearson--2014|Hearson 2014]] ; [[#Hanlon--2017|Hanlon 2017]] ; [[#US%20DoJ--2019|US DoJ 2019]] ; [[#IATFD--2021|IATFD 2021]] ). Diversifying funding sources is important at a time hard-currency Eurobond issuances reach records ( [[#Panizza--2020|Panizza and Taddei 2020]] ; [[#Moody’s%20Investors%20Service--2021|Moody’s Investors Service 2021]] ). Otherwise, the structure of voluntary, nationally oriented, and financially fragmented arrangements under the Paris Agreement (Chapter 17) could lead to ‘regional rivalry’ (SSP 3) pathways ( [[#IPCC--2018|IPCC 2018]] ; [[#Gazzotti--2021|Gazzotti et al. 2021]] ). The benefits are many times greater than apparent costs in terms of expected decline in global GHG emissions and attaining SDGs. These could even generate large ‘win-win’ opportunities back in capital source countries which will benefit from a flow back in import demand ( [[#Hourcade--2021a|Hourcade et al. 2021a]] ).

'''Lessons from literature on policy options in mobilising capital for Paris and SDGs in developing countries can be summarised as follows:'''

1. development of national just transition strategies meet the USD100 billion commitment on a grant-equivalent basis to support NDCs that integrate policies on COVID-19 recovery, climate action, sustainable development and equity;

2. increase the leverage of public funds on diverse sources of private capital through de-risking investments and public-private partnerships involving location-based entities with AAA-rated players and institutional investors;

3. coordination of project preparation and development of project pipelines by infrastructure coordinator agencies, one-stop structuring and financing shops, project risk facilities provided by entities such as cities’ development banks, green banks, a world climate bank, global guarantee mechanism, and global infrastructure investment platform;

4. development of local currency bond markets backed by cross-border guarantees, technical assistance, remediation assets, especially by regional and national players whose mandates include nurturing local capital markets to support bond yield curve development and exchange listing options;

5. adopting advances in science-based assessment methods to foster accountability;

(a) for project assessment, measuring, reporting and verifying, and certification,

(b) for disclosures in climate, fossil fuels, SDGs, debt transparency and debt sustainability, and

(c) for progress on UN systems of national accounts particularly for public sector finance statistics.

'''Whole-of-''' '''society approach to mobilising diverse capital.''' There’s no shortage of money globally: it is simply that it has yet to travel to where it’s most needed. One challenge is unlocking unencumbered endowments to contribute to Paris and SDGs ( ''high confidence'' ) ''.'' The aggregate global wealth figures exceed USD200 trillion ( [[#Davies--2016|Davies et al. 2016]] ; [[#UBS--2017|UBS 2017]] ; [[#Credit%20Suisse--2020|Credit Suisse 2020]] ; [[#Heredia--2020|Heredia et al. 2020]] ). Some developing countries have run pilots for investing in government bonds capitalising on fintech growth discussed ( [[#The%20Economist--2017|The Economist 2017]] ; [[#Akwagyiram--2021|Akwagyiram and Ohuocha 2021]] ) ( [[#15.6.6|Section 15.6.6]] ). Others are developing green products to encourage uptake by middle class retail investors ( [[#Eurosif--2018|Eurosif 2018]] ; UK DMO 2021). Millennial-aged inheritors expected to receive intergenerational transfers mobilised by global citizen activism (Chapter 2) invest in green retail and tech products ( [[#Morgan%20Stanley--2017|Morgan Stanley 2017]] ; [[#UBS--2017|UBS 2017]] ; [[#Capgemini--2021|Capgemini 2021]] ). Historic inequity and diaspora-related private and public resources pledged and debated during the COVID-19 pandemic might have potential to contribute towards Paris and SDGs ( [[#Olusoga--2015|Olusoga 2015]] ; [[#Glueck--2020|Glueck and Friedman 2020]] ; [[#Hall--2020|Hall 2020]] ; [[#Piketty--2020|Piketty 2020]] ; [[#Timsit--2020|Timsit 2020]] ; [[#Goldman%20Sachs--2021|Goldman Sachs 2021]] ; [[#Guthrie--2021|Guthrie 2021]] ; [[#Mieu--2021|Mieu 2021]] ; [[#Wagner--2021|Wagner 2021]] ). Philanthropic institutions use grants, debt, equity, guarantees and issue investment grade bonds in using unencumbered endowments ( [[#Manilla--2018|Manilla 2018]] ; [[#Covington--2020|Covington 2020]] ; [[#Moody’s%20Investors%20Service--2020|Moody’s Investors Service 2020]] ) but only about 2% of their resources are dedicated to climate action (Williams T., 2015; [[#Kramer--2017|Kramer 2017]] ; [[#Morena--2018|Morena 2018]] ; [[#Delanoë--2021|Delanoë et al. 2021]] ). The pandemic exemplified the unprecedented collaboration and mobilisation of multilateral and scientific communities supported by the COVAX risk sharing mechanism for COVID-19 vaccines with pooling of financial and scientific resources ( [[#OECD--2021d|OECD 2021d]] ). This momentum in international cooperation can be harnessed to galvanise resources, including for teaching of sciences in developing countries important in tackling society challenges, alleviating poverty ( [[#TWAS--2021|TWAS 2021]] ) and inequity legacies compounded by climate impacts debated by many ( [[#Henochsberg--2016|Henochsberg 2016]] ; [[#Obregon--2018|Obregon 2018]] ; [[#Fernandez--2021|Fernandez et al. 2021]] ; [[#The%20Economist--2021|The Economist 2021]] ). Suggestions towards equitable models include ‘global adaptation funding approaches’ ( [[#Chancel--2015|Chancel and Piketty 2015]] ), a ‘world climate bank’ to finance climate investments through long-term bonds ( [[#Foley--2009|Foley 2009]] ; [[#Broome--2012|Broome 2012]] ; [[#Broome--2016|Broome and Foley 2016]] ), a ‘cities development bank’ ( [[#Alexander--2019|Alexander et al. 2019]] ), and ‘public debt financing models’ ( [[#Rendall--2021|Rendall 2021]] ) for generations to share the burden which has precedence in history ( [[#Draper--2007|Draper 2007]] ; [[#Fowler--2015|Fowler 2015]] ).

'''Local financial institutions with local markets knowledge could benefit from technical assistance and partnership to scale up their potential with institutional investors better mobilised''' ( ''high confidence'' ) ''.'' The Global South has some 260 public development banks/PDBs representing USD5 trillion in assets with a worldwide PDB capacity to provide more than USD400 billion yr –1 of climate finance (IDFC and GCF 2020). Case studies discuss the potential for diaspora bond issuance being deployed for climate investments including securitisation of remittances as collateral for infrastructure bonds ( [[#Ketkar--2010|Ketkar and Ratha 2010]] ; [[#Akkoyunlu--2012|Akkoyunlu and Stern 2012]] ; [[#Gelb--2021|Gelb et al. 2021]] ). Such instruments could help harness diaspora remittances, whose flows rose from under USD 100 billion to USD530 billion during 1990–2018 (World Bank 2019c). PDBs could benefit from technical partnership with multilaterals and other local banks ( [[#Torres--2016|Torres and Zeidan 2016]] ). Their knowledge of local markets, can help build project pipelines (Figure 15.7) to channel local, domestic and international capital ( [[#Griffith-Jones--2020|Griffith-Jones et al. 2020]] ). Institutional domestic and international investors have growing assets estimated to exceed USD100 trillion ( ''high confidence'' ) ( [[#Willis%20Towers%20Watson--2020|Willis Towers Watson 2020]] ; [[#UN%20PRI--2020|UN PRI 2020]] ; [[#Halland--2021|Halland et al. 2021]] ; [[#Heredia--2021|Heredia et al. 2021]] ; [[#Inderst--2021|Inderst 2021]] ) and could be better mobilised. Some 36% of total assets under management (AUM) by the 100 largest asset owners come from pensions and sovereign wealth funds in the Asia Pacific region, with the remainder split almost evenly across Europe, the Middle East, Africa and North America. The largest pension fund in South Africa held about USD130 billion AUM in 2019 and African institutional investors held USD1.8 trillion in 2020 ( [[#PwC--2015|PwC 2015]] ; [[#GEPF--2019|GEPF 2019]] ; [[#Bagus--2020|Bagus et al. 2020]] ; GCA 2021a). UK NGO War on Want’s (2016) analysis of 101 fossil fuel and mining companies on the London Stock Exchange estimates these as holding USD1 trillion assets inside Africa. The Latin America and Caribbean region holds just about USD1 trillion AUM ( [[#Curtis--2016|Curtis 2016]] ; [[#Serebrisky--2015|Serebrisky et al. 2015]] ; [[#Cavallo--2019|Cavallo and Powell 2019]] ).

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[[File:53cbb7a421725f1a3c51148f1aa47ecc IPCC_AR6_WGIII_Figure_15_7.png]]

'''Figure 15.7 | Bond refinancing mobilises institutional investors in mature project phase.''' '''De-risk early-stage infrastructure projects.''' Source: adapted from [[#PIDG--2019|PIDG (2019)]] .

'''Investors with accumulated private capital are reported as looking for climate investments to ensure Just Transition, alignment with Paris and SDGs. However, progress remains pilot, slow and piecemeal''' ( ''high confidence'' ). Global investors have published statements on their possible contribution, with recommendations to governments on de-risking to accelerate private sector investment to support Paris-aligned NDCs in developing countries ( [[#IIGCC--2015|IIGCC 2015]] ; IIGCC 2017; Global Investor Statement 2018; IIGCC 2018; [[#Global%20Investor%20Statement--2019|Global Investor Statement 2019]] ; IIGCC 2020). In March 2020, the UN Principles for Responsible Investment (PRI), had 3038 members representing USD103 trillion ( [[#UN%20PRI--2020|UN PRI 2020]] ); another coalition of investors published COVID-19 recovery plans ( [[#Investor%20Agenda--2020|Investor Agenda 2020]] ) and the Net Zero Asset Managers initiative was launched in December 2020 ( [[#NZAM--2020|NZAM 2020]] ). However, it is still unclear how these pronouncements will be transformed to adequate financial flows and volumes of investment pipelines ( [[#IEA--2021d|IEA 2021d]] ) (Chapter 3). [[#Rempel--2020|Rempel and Gupta (2020)]] posit that a proportion of institutional holding is in fossil fuels. Clean energy transition minerals raise ESG questions around inclusive development for indigenous populations and require changes to supply chains exploiting child labour ( [[#Herrington--2021|Herrington 2021]] ; [[#IEA--2021a|IEA 2021a]] ; [[#IEA--2021f|IEA 2021f]] ).

Options to mobilise institutional investors currently remain small pilots, relative to Paris and SDG ambitions ( ''high confidence'' ). In terms of examples: in the ''women of colour-led arena'' , a Chicago pension fund invested in a developing country using a ''private equity fund'' ; ( [[#Langhorne--2021|Langhorne 2021]] , USAID 2021). Institutional BlackRock’s blended finance vehicle with OECD MDB partners focuses on developing countries ( [[#BlackRock--2021|BlackRock 2021]] ). In regional AAA MDB partnerships, the African Development Bank (AfDB) collaborates with African nations through a ''regional infrastructure fund'' (Africa50 2019); the Asian Development Bank (ADB) collaborates with a Philippines state-owned pension fund and Dutch pension fund in using a ''private equity fund'' to catalyse private sector investment ( [[#ADB--2012|ADB 2012]] ). A UN entity with several pooled public-private investment platforms includes an SDG blended finance vehicle ( [[#UN%20CDF--2020a|UN CDF 2020a]] ; 2020b). A multilateral International Finance Corporation (IFC) blended finance fund, supported by a sovereign guarantee from Sweden’s SIDA, and separately a USD1 billion green bond fund by IFC and Europe’s Amundi asset manager buy green securities issued by developing country banks financing local currency climate investments ( [[#IFC--2018|IFC 2018]] , 2021; [[#Amundi%20and%20IFC--2019|Amundi and IFC 2019]] ). The key parameter is the ''investment multiplier,'' the ''ratio of private investment mobilised by a given amount of public fund'' s which varies by product type. IFC’s portfolio of blended finance investments point to a self-reported range of 3 to 15 times for project debt and even higher levels (10 to 30) for debt finance provided on concessional terms ( [[#IFC--2021|IFC 2021]] a). Although an AAA-rated IFC blended finance fund was established in 2013, most investors joined in 2017 with insurers AXA and Swiss Re investing USD500 million each to bring the fund to USD7 billion raised from eight global investors ( [[#Attridge--2021|Attridge and Gouett 2021]] ). Critics of blended finance mechanisms point to lack of data transparency hampering independent assessment on (i) value for public money and costs of blending versus other financial mechanisms, (ii) risks and benefits of de-risking private capital to collateralising climate-vulnerable Global South populations, (iii) lack of partnership with local players, and (iv) complex structures ( [[#Akyüz--2017|Akyüz 2017]] ; [[#Mawdsley--2018|Mawdsley 2018]] ; [[#Convergence--2020|Convergence 2020]] ; [[#Attridge--2021|Attridge and Gouett 2021]] ; [[#Gabor--2021|Gabor 2021]] ). Whilst blended finance transactions (BFTF 2018) are quite common in mature regulated markets with mandatory reporting requirements ( [[#Morse--2015|Morse 2015]] ; [[#ICAEW--2021|ICAEW 2021]] ), the additional finance mobilised and their developmental impact remain unknown due to poor reporting that hammpers evidence-based policy making ( [[#Attridge--2021|Attridge and Gouett 2021]] ). Projects that are aligned with blended finance principles in the UN Addis Agenda ( [[#UN--2015a|]] [[#UN--2015|UN 2015]] a ), and take account of local contexts by partnering with local actors, are much more likely to have sustainable impacts.

'''De-risking tools to lower capital costs and mobilise diverse investors''' . Paris-aligned NDCs that integrate policies on COVID-19 pandemic recovery, climate action, sustainable development, just transition and equity can harness co-benefits including contribution to ''Invisible UN SDG 7 energy poverty sectors'' ( ''high confidence'' ) ''.'' Developing countries require access to affordable finance for projects ranging from clean cooking solutions ( [[#Accenture--2018|Accenture 2018]] ; World Bank et al. 2021); decentralised energy systems, intra-country power stations and regionally shared power pools with their associated energy distribution networks ( [[#IEA--2020d|IEA 2020d]] ; [[#IRENA--2020c|IRENA 2020c]] ). Close to 3 billion people in Africa and developing Asia have no access to clean cooking. For sub-Saharan Africa, the acute lack of electricity access lags behind all regions on SDG 7 indicators, impacting mostly women and children ( [[#IEA--2014b|IEA 2014b]] ; [[#IRENA--2020b|IRENA 2020b]] ,c; [[#IEA--2021|IEA et al. 2021]] ; ESMAP 2020; [[#Zhang--2021|Zhang 2021]] ) (Box 6.1). These dire statistics remind of compounding tensions: historical inequities and the associated ‘first comer’ exploiting African resources for development elsewhere, the local climate change, ‘latecomer’ capacity development and technology transfer challenges, illicit mining finance and stranded assets ( [[#Curtis--2016|Curtis 2016]] ; [[#Bos--2019|Bos and Gupta 2019]] ; [[#UNU-INRA--2019|UNU-INRA 2019]] ; [[#Arezki--2021|Arezki 2021]] ). The COVID-19 pandemic exacerbates this tension with more people pushed below the poverty line ( [[#Sumner--2020|Sumner et al. 2020]] ) (section 15.6.4, Box 15.6 on post-COVID). Recent analysis points to the 60 largest banks providing USD3.8 trillion to fossil fuel companies since 2016, includinginside Africa (Rainforest Action Network et al. 2021). IMF estimated fossil fuel subsidies totalling USD5.2 trillion or 6.5% of global GDP in 2017 ( [[#Coady--2019|Coady et al. 2019]] ) to be compared with the USD2.4 trillion yr –1 energy investments over the next decade to limit global warming to 1.5°C ( [[#IPCC--2018|IPCC 2018]] ). Analysts point to models in improvements to resources husbandry that include (i) developing strong minerals sector governance through sovereign wealth funds for domestic development ( [[#Wills--2016|Wills et al. 2016]] ) and (ii) compensation for Africa ( [[#Walsh--2021|Walsh et al. 2021]] ) leaving fossil fuels underground ( [[#McGlade--2015|McGlade and Ekins 2015]] ) in the ''Just Transition'' ( [[#15.2.4|Section 15.2.4]] ) and ''Right to Develop'' debates as assets continue to be mined ( [[#IEA--2019c|IEA 2019c]] ). In many developing regions, some of the world’s best renewable energy sources remain out of reach due to high costs which can be up to seven times those in developed countries ( [[#IEA--2021d|IEA 2021d]] ). Shifting some risks through financial de-risking approaches could be instrumental ( [[#Schmidt--2014|Schmidt 2014]] ; [[#Sweerts--2019|Sweerts et al. 2019]] ; [[#Drumheller--2020|Drumheller et al. 2020]] ; [[#Matthäus--2020|Matthäus and Mehling 2020]] ).

'''Combining approaches: (i) developed countries meeting UNFCCC USD100 billion commitment on a grant-equivalent basis, (ii) stepped up technical assistance, (iii) infrastructure coordination, (iv) knowledge sharing by project preparation entities, and (iv) harnessing project risk facilities such as guarantees could be instrumental for scaling climate finance for Paris-SDGs''' ( ''high confidence'' ) ''.'' Figure 15.7 illustrates the interplay between infrastructure project financing phases, bond refinancing and opportunities for developing bond yield curve benchmarks in nurturing local capital markets and mobilising diverse investors. These project financing phases have varying risk-return profiles and different benchmarks to track performance are often required by investors for different securities that might be created ( [[#Ketterer--2018|Ketterer and Powell 2018]] ).

An [[#ODI--2018|ODI (2018)]] survey of private and public project preparation facilities internationally showed high failure rates in ''early project preparation phases'' with recommendations on ‘ ''one-stop-shops'' ’ and knowledge sharing on effective approaches. During the very high-risk ''concept phase'' (Figure 15.7) ''–'' grants and technical assistance de-risk with design concepts, project proposals and feasibility studies completed to ‘kick-start’ the right projects. The early-stage developmental phase is characterised by short-term debt in the two to five years phase to complete construction enabled by concession finance. Bank loans are paid back by issuing bonds once the construction phase is completed. Such bond refinancing over say, 15–25 years, in the low-risk ''mature project phase'' can provide a lower cost of capital. Market-making to develop a pipeline of investment opportunities uses a complimentary mix of high-risk capital options in the form of grants, guarantees, equity, and mezzanine financing that can help ( [[#Attridge--2021|Attridge and Gouett 2021]] ): (i) reduce up-front risks in the early phases, (ii) allow banks to recycle loans to new projects, and (iii) galvanise multilateral technical assistance for building bond yield curve benchmarks and de-risking local currency bond issuance of long tenors such as green bonds/resilience bonds ( [[#Berensmann--2015|Berensmann et al. 2015]] ; [[#CBI--2015|CBI 2015]] ; [[#Mercer--2018|Mercer 2018]] ; [[#Dasgupta--2019|Dasgupta et al. 2019]] ; [[#PIDG--2019|PIDG 2019]] ; [[#Braga--2021|Braga et al. 2021]] ; CBI et al. 2021; [[#Hourcade--2021a|Hourcade et al. 2021a]] ,b). [[#Convergence--2019|Convergence (2019)]] points to investment from commercial banks with commercial debt of 11–15 years maturity being covered by guarantees. To achieve scale, some have issued special purpose vehicle (SPV) green infrastructure project bonds combining tenors up to 15 years with credit ratings assigned to mobilise investors with community trusts for local participation ( [[#Kaminker--2012|Kaminker and Stewart 2012]] ; [[#Mathews--2012|Mathews and Kidney 2012]] ; [[#Mbeng%20Mezui--2013|Mbeng Mezui and Hundal 2013]] ; [[#Essers--2016|Essers et al. 2016]] ; [[#Moody’s%20Investors%20Service--2016|Moody’s Investors Service 2016]] ; [[#Ng--2016|Ng and Tao 2016]] ; [[#Harber--2017|Harber 2017]] ). Bond refinancing could be facilitated through standardised national infrastructure style bonds, national infrastructure funds ( [[#Amonya--2009|Amonya 2009]] ; [[#Ketterer--2018|Ketterer and Powell 2018]] ) and country SPV infrastructure funds issuing bonds ( [[#Cavallo--2019|Cavallo and Powell 2019]] ) embedding MDBs.

'''Existing project risk facilities including guarantees could benefit from coordination, scaling and better reporting frameworks''' ( ''high confidence'' ) ''.'' Individual and clubs of developed and developing countries currently provide public guarantees ( [[#ADB--2015|ADB 2015]] , 2018; [[#IIGCC--2015|IIGCC 2015]] ; [[#Pereira%20Dos%20Santos--2018|Pereira Dos Santos 2018]] ; [[#GGGI--2019|GGGI 2019]] ; [[#Garbacz--2021|Garbacz et al. 2021]] ). However MDB business models impose limitations on use of guarantees and collaboration with other MDBs ( [[#Gropp--2014|Gropp et al. 2014]] ; [[#Schiff--2017|Schiff and Dithrich 2017]] ; [[#Lee--2018|Lee et al. 2018]] ; [[#Pereira%20dos%20Santos--2018|Pereira dos Santos and Kearney 2018]] ). Loans continue to dominate as the financial instrument of choice by MDBs and DFIs, with guarantees mobilising the most private finance for OECD reported data, even if their use remains limited ( [[#IATFD--2020|IATFD 2020]] ; [[#OECD--2020c|OECD 2020c]] ; [[#Attridge--2021|Attridge and Gouett 2021]] ). Ramping up the use of guarantees to mobilise private investment raises questions around understanding efficacy in the design as there is no one size that fits all and more research is required to better understand this aspect ( [[#Convergence--2019|Convergence 2019]] ). Sample guarantee forms in literature: (i) single-country Sweden and USA DFI forms (SIDA 2016, DCA 2018), (ii) multilateral institution offerings ( [[#Pereira%20Dos%20Santos--2018|Pereira Dos Santos 2018]] ; [[#IRENA--2020e|IRENA 2020e]] ), (iii) multi-sovereign guarantees one-stop platforms such as those on the PIDG/GuarantCo ( [[#PIDG--2019|PIDG 2019]] ) and Africa Guarantee Fund owned by DFIs, including the African Development Bank (AfDB), the French Development Agency (AFD), the Nordic Development Fund (NDF), and the KfW Development Bank ( [[#AGF--2020|AGF 2020]] ), (iv) MIGA, established to provide political risk guarantees (enhanced green MIGA) ( [[#Déau--2018|Déau and Touati 2018]] ), (v) multilateral partnerships with developing nations via infrastructure funds ( [[#15.6.7|Section 15.6.7]] .2) and green infrastructure options ( [[#de%20Gouvello--2010|de Gouvello and Zelenko 2010]] ; Studart and Gallagher 2015), (vi) guarantees embedded in project risk facilities such as currency fund TCX established by 22 DFIs ( [[#TCX--2020|TCX 2020]] ), and (vii) ASEAN and African multi-sovereign regional local currency bond guarantee funds and a co-guarantee platform ( [[#GGGI--2019|GGGI 2019]] ; [[#Garbacz--2021|Garbacz et al. 2021]] ). Fossil fuels currently benefit from de-risking tools from export credit agencies ( [[#Lawrence--2021|Lawrence and Archer 2021]] ), with questions around sustainable development ( [[#Wright--2011|Wright 2011]] ); [[#Gupta--2020|Gupta et al. (2020)]] argue that these could be deployed for renewable energy. Sample project facilities reflecting the diverse project types across developing country regions can include i) UNEP Seed Capital ii) C40 Cities Facility iii) Blue Natural Capital Facility ( [[#IUCN--2021|IUCN 2021]] ); iv) Clean Cooking Fund ( [[#ESMAP--2021|ESMAP 2021]] ) v) opportunities for guarantees in LDCs ( [[#Garbacz--2021|Garbacz et al. 2021]] ) vi) World Bank’s Renewables Risk Mitigation ( [[#GCF--2021|GCF 2021]] ) and World Bank’s Global Infrastructure Facility ( [[#GGGI--2019|GGGI 2019]] ).. Multilaterals offer credit enhancement to manage both actual and perceived risks: in India’s corporate sector, renewable energy SPV project bonds have been guaranteed jointly by ADB and an infrastructure company raising the credit rating from sub-investment grade to investment grade to lower borrowing costs ( [[#ADB--2018|ADB 2018]] ; [[#Agarwal--2018|Agarwal and Singh 2018]] ; [[#Carrasco--2018|Carrasco 2018]] ).

Investment vehicles into green infrastructure come in various forms ( ''high confidence'' ) and can include indirect corporate investment such as bonds; semi-direct investment funds via pooled vehicles such as infrastructure funds and private equity funds and project investment (direct) in green projects through equity and debt including loans, project bonds and green bonds. For pension funds in Australia and Canada, direct investment in infrastructure is about 5% of total AUM ( [[#Inderst--2013|Inderst and Della Croce 2013]] ) whilst less than 1% for OECD pension funds goes to green infrastructure ( [[#Kaminker--2013|Kaminker et al. 2013]] ). Some regional developing country institutional investors use a variety of investment vehicles that span SPVs, private equity, domestic and regional local currency bond markets with statutory level mandates to address historic inequities ( [[#GEPF--2019|GEPF 2019]] ). Cross-border collaboration in regional power markets such as Europe’s Nordpool; for developing countries could be led by repository of technical partnership from infrastructure funds and multilaterals ( [[#Oseni--2016|Oseni and Pollitt 2016]] ; [[#Juvonen--2019|Juvonen et al. 2019]] ; [[#Chen--2020|Chen et al. 2020]] ; [[#Nordpool--2021|Nordpool 2021]] ). Barriers to investments include non-standardised investment vehicles of scale and lack of national infrastructure road maps to give investor confidence in government commitment. Some have set up infrastructure coordinating entities embedding local science and engineering R&amp;D ( [[#IPA--2021|IPA 2021]] ; National Infrastructure Commission 2021). [[#Arezki--2016|Arezki et al. (2016)]] argue that coordination within existing platforms could create a global infrastructure investment platform for de-risking through guarantees and securitisation; Matthäus and (Mehling (2020) point to a global guarantee mechanism. Such AAA multilateral approaches create credibility-enhancing effects in developing capital markets. [[#Hourcade--2021a|Hourcade et al. (2021a)]] suggest that the overall economic efficiency could be higher with guarantees calibrated per tonne on an agreed ''‘social, economic, and environmental value of mitigation actions [and] their co-benefits’'' (Article 108, Paris Agreement) basis, which would operate as a notional carbon price ( [[#High-Level%20Commission%20on%20Carbon%20Prices--2017|High-Level Commission on Carbon Prices 2017]] ). The grant equivalent of guarantees and induced equity inflows could be far beyond the USD100 billion promise. Such cooperative solutions in adopting development of local capital markets would end the drawbacks of the current plethora of low-scale fragmented project-by-project and ‘special-purpose’ pilots and programmes.

'''Harnessing existing bond markets and securities exchanges in nascent markets''' . The G20 has an action plan to support strengthening local currency bond markets and development of local capital markets is also part of the option for financing UN SDGs in developing countries ( [[#UN--2015a|]] [[#UN--2015|UN 2015]] a , 2019, 2020; [[#IATFD--2016|IATFD 2016]] , 2021). Primers are available on bond market development to support policy choices ( [[#World%20Bank%20and%20IMF--2001|World Bank and IMF 2001]] ; [[#Silva--2020|Silva et al. 2020]] ; [[#World%20Bank--2020|World Bank 2020]] ; Adrian et al 2021; [[#IMF%20and%20World%20Bank--2021|IMF and]] [[#World%20Bank--2021|]] [[#World%20Bank--2021|World Bank 2021]] ). Developing government bond yield curves with different maturities can be an important policy objective ( ''high confidence'' ) '''.''' This can support pricing discovery, liquidity ( [[#Wooldridge--2001|Wooldridge 2001]] ) and can be achieved through step by step tranches from shorter to longer maturities to boost confidence and encourage municipals and other quasi-sovereigns. Money market instruments (such as, green commercial paper) anchor the short end of the yield curve with bonds of varying maturity issued by sovereign/quasi-sovereign entities (national treasuries, SOEs, municipalities) to mobilise investors ( [[#Goodfriend--2011|Goodfriend 2011]] ; [[#LSEG--2018|LSEG 2018]] ; [[#Tolliver--2019|Tolliver et al. 2019]] ). A variety of bonds are being used for developing countries including green ( [[#Ketterer--2019|Ketterer et al. 2019]] ), blue-water ( [[#Roth--2019|Roth et al. 2019]] ), transition, SDG/social, biodiversity bonds ( [[#Aglionby--2019|Aglionby 2019]] ), green/resilience bonds (AAC 2021); gender bonds ( [[#Andrade--2020|Andrade and Prado 2020]] ) diaspora ( [[#LSEG--2017|LSEG 2017]] ) and infrastructure project bonds (CBK 2021). Local policymakers would gain from technical and financial assistance in building green yield curves, for example with support from multilaterals ( [[#EIB--2012|EIB 2012]] ; [[#IATFD--2016|IATFD 2016]] ; [[#Shi--2017|Shi 2017]] ; [[#EIB--2018|EIB 2018]] ; Impact Investing Institute 2021). Green bonds are one of the most readily accessible to help fund Paris goals ( [[#Tolliver--2019|Tolliver et al. 2019]] ; [[#Tuhkanen--2020|Tuhkanen and Vulturius 2020]] ). [[#15.3.2|Section 15.3.2]] refers to the growth in labelled bond markets ( [[#CBI--2021a|]] [[#CBI--2021|CBI 2021]] a ), low borrowing costs and yield curve building in Europe ( [[#Bahceli--2020|Bahceli 2020]] ; [[#Serenelli--2021|Serenelli 2021]] ; [[#Stubbington--2021|Stubbington 2021]] ; UK DMO 2021). For developing countries, labelled bonds have mostly been in hard currency (e.g. [[#Smith--2021|Smith 2021]] ) despite local currency markets making up more than 80% total debt stock ( [[#IMF%20and%20World%20Bank--2016|IMF and]] [[#World%20Bank--2016|World Bank 2016]] ; [[#Silva--2020|Silva et al. 2020]] ; Adrian et al 2021; [[#Inderst--2021|Inderst 2021]] ). The labelled bonds issuance by multilaterals do not currently mobilise the trillion levels needed. Research studies show that participating in green bond markets in part depends on a country having credible NDCs ( [[#Tolliver--2020a|Tolliver et al. 2020a]] ; [[#Tolliver--2020b|Tolliver et al. 2020b]] ) and highlights diverse approaches working together to support local bond market development ( [[#Amacker--2021|Amacker and Donovan 2021]] ; [[#ICMA--2021|ICMA 2021]] ; [[#IMF%20and%20World%20Bank--2021|IMF and]] [[#World%20Bank--2021|]] [[#World%20Bank--2021|World Bank 2021]] ).

'''Technical assistance options would benefit from coordination. Labelled bond costs remain high. Developing countries are using fiscal incentives, grants, and guarantees to support nascent bond markets with most taxonomies under development''' ( ''high confidence'' ). Technical assistance requirements to improve the investment climate and bond market development will vary across national capacities. These would benefit from the USD100 billion UNFCCC grant equivalent basis to develop (i) regulatory and policy frameworks; (ii) UN national statistical systems ( [[#Singh--2016|Singh et al. 2016]] ; [[#MacFeely--2017|MacFeely and Barnat 2017]] ; [[#Paris21--2018|Paris21 2018]] ; [[#Bleeker%20and%20Abdulkadri--2020|Bleeker and Abdulkadri 2020]] ); (iii) credible NDC and SDG investment plans; (iv) project assessment certification and taxonomies; (v) bond market guidelines; and (vi) public finance management ( [[#US%20DoJ--2009|US DoJ 2009]] ; [[#US%20DoJ--2019|US DoJ 2019]] ). Other technical assistance channels include diaspora entities, universities and learned societies ( [[#ICEAW--2012|ICEAW 2012]] ; [[#UNFCCC--2021|UNFCCC 2021]] ). LDCs supported by humanitarian entities are least likely to have active capital markets (ICRC 2020; [[#IDFC--2020|IDFC 2020]] ; [[#Cao--2021|Cao et al. 2021]] b). Clubs of LDCs are partnering with AAA MDBs in aggregation approaches ( [[#AfDB--2020|AfDB 2020]] ; [[#GCF--2020b|GCF 2020b]] ). Some UN entities provide technical assistance on municipal aggregation of projects ( [[#UN%20CDF--2021a|UN CDF 2021a]] ) ''',''' with Africa, LDC, SIDS nations and cities accessing green technical facilities and listings for labelled bonds ( [[#C40%20Cities%20Climate%20Leadership%20Group--2016|C40 Cities Climate Leadership Group 2016]] ; [[#Gorelick--2018|Gorelick 2018]] ; [[#Jackson--2019|Jackson 2019]] ; FSD Africa and CBI 2020; [[#Gorelick--2020|Gorelick and Walmsley 2020]] ; MoE Fiji 2020; [[#IFC--2021|IFC 2021]] c). Elevated climate risks imperil developing country ability to repay debts ( [[#Schmidt--2014|Schmidt 2014]] ; [[#Buhr--2018|Buhr et al. 2018]] ; [[#Volz--2020|Volz et al. 2020]] ; [[#Dibley--2021|Dibley et al. 2021]] ). To lower overall costs and achieve more, entities have accessed technical assistance, listed local currency labelled bonds, and used credit enhancing bond guarantees, regulatory treatments and philanthropy schemes ( [[#Europe%202020%20Project%20Bond%20Initiative--2012|Europe 2020 Project Bond Initiative 2012]] ; [[#SBN--2018|SBN 2018]] ; [[#Agliardi--2019|Agliardi and Agliardi 2019]] ; [[#Banga--2019|Banga 2019]] ). In the regions, China issued guidelines for stock exchanges and regulatory support for green bonds (Cao and Ma 2021), India issued regulations for local issuance of green bonds ( [[#CBI--2019a|CBI 2019a]] ), while in the Latin America and Caribbean region, both plain vanilla and labelled bonds use the same authority ( [[#Ketterer--2019|Ketterer et al. 2019]] ). African, LDC and SIDS nations are reviewing ways to harness local exchanges ( [[#SSE--2018|SSE 2018]] ; [[#GCF--2019|GCF 2019]] ; World Bank et al. 2021b; [[#UN%20CDF--2021b|UN CDF 2021b]] ). For taxonomies, the differences reflect the multitude of local Just Transition pathways, some with a purely environmental focus and others incorporating livelihood improvements ( [[#ICMA--2021|ICMA 2021]] ). The sustainable bond market has been expanding as transition bonds become listed in anticipation of future developments ( [[#Roos--2021|Roos 2021]] ).

'''Progress towards transparency using scientific-based methods to build trust and accountability.''' After 60 years of development finance, critics underline limits coming from i) multilaterals model, lack of transparency around aid and debt ( [[#Mkandawire--2010|Mkandawire 2010]] ; Lee 2017; PWYF 2019; Bradlow 2021; Gianfagna et al. 2021) ii) illicit finance ( [[#Plank--1993|Plank 1993]] ; [[#Sachs--2001|Sachs and Warner 2001]] ; Hanlon 2016; [[#US%20DoJ--2019|US DoJ 2019]] ) ) iii) lack of developed country commitment to pledges ( [[#Nhamo--2016|Nhamo and Nhamo 2016]] ) iv) unregulated players as financial intermediaries in blended finance ( [[#Pereira--2017|Pereira 2017]] ; [[#Donaldson--2018|Donaldson and Hawkes 2018]] ; [[#Attridge--2019|Attridge and Engen 2019]] ; [[#Tan--2019|Tan 2019]] ) v) weak accountability reflected in soft SDG data and vi) burden of responsibility in mobilising Paris and SDG resources to countries with historically soft institutional capacity ( [[#Hickel--2015|Hickel 2015]] ; [[#Donald--2016|Donald and Way 2016]] ; [[#Scheyvens--2016|Scheyvens et al. 2016]] ; [[#Liverman--2018|Liverman 2018]] ). Literature around trust in blended finance pinpoints four progress areas in accountability. First, debt transparency through public debt registries, centralised UN legacy debt restructuring and science-centred UN national statistical systems ( [[#Donaldson--2018|Donaldson and Hawkes 2018]] ; [[#Jubilee%20Debt%20Campaign--2019|Jubilee Debt Campaign 2019]] ; [[#Stiglitz--2020|Stiglitz and Rashid 2020]] ). Second, international reporting bell-weathers could be called upon to produce harmonised mandatory reporting frameworks that capitalise on TCFD to capture climate, debt sustainability ( [[#15.6.7|Section 15.6.7]] .3), SDG and fossil fuels ( [[#GISD--2020|GISD 2020]] ). Third, standardisation of assessment by third parties of the quantity and values of carbon saved by green projects ( [[#Hourcade--2012|Hourcade et al. 2012]] ) and of their contribution to quantified performance biodiversity targets ( [[#Finance%20for%20Biodiversity%20Initiative--2021|Finance for Biodiversity Initiative 2021]] ) to facilitate their bundling, securitisation and repackaging in standardised liquid products and bonds ( [[#Arezki--2016|Arezki et al. 2016]] ; [[#Blended%20Finance%20Taskforce--2018a|Blended Finance Taskforce 2018a]] ).

<div id="15.6.8" class="h2-container"></div>

<span id="facilitating-thedevelopment-of-new-business-models-and-financing-approaches"></span>
=== 15.6.8 Facilitating theDevelopment of New Business Models and Financing Approaches ===

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New and innovative business models and financing approaches have emerged to help overcome barriers related to transactions costs by aggregating and/or transferring financing needs and establishing supply of finance for stakeholder groups lacking financial inclusion ( ''hi'' ''gh confidence'' ).

<div id="15.6.8.1" class="h3-container"></div>

<span id="service-based-business-models-in-the-energy-and-transport-sectors"></span>
==== 15.6.8.1 Service-based Business Models in the Energy and Transport Sectors ====

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'''Energy as a service (EaaS)''' is a business model whereby customers pay for an energy service without having to make any upfront capital investment ( [[#PwC--2014|PwC 2014]] ; [[#Hamwi--2017|Hamwi and Lizarralde 2017]] ; [[#Cleary--2019|Cleary and Palmer 2019]] ). EaaS performance-based contracts can also be a form of ‘creative financing; for capital improvement that makes it possible to fund energy upgrades from cost reductions and deployment of decentralised renewable energy ( [[#KPMG--2015|KPMG 2015]] ; [[#Moles-Grueso--2021|Moles-Grueso et al. 2021]] ). Innovation in EaaS has started at the household level, where smart meters using real-time data are used to predict peak demand levels and optimise electricity dispatch ( [[#Chasin--2020|Chasin et al. 2020]] ; [[#Government%20of%20UK--2016|Government of UK 2016]] ; [[#Smart%20Energy%20International--2018|Smart Energy International 2018]] ).

'''Aggregators.''' An aggregator is a grouping of agents in a power system to act as a single entity when engaging in power system markets ( [[#MIT--2016|MIT 2016]] ). Aggregators can use operation optimisation platforms to provide real-time operating reserve capacity and a range of balancing services to integrate higher shares of variable renewable energy ( [[#Zancanella--2016|Zancanella et al. 2016]] ; [[#Ma--2017|Ma et al. 2017]] ; [[#Enbala--2018|Enbala 2018]] ; [[#Research%20and%20Markets--2017|Research and Markets 2017]] ; [[#IRENA--2019b|IRENA 2019b]] ). This makes a business case for deferred investments in grid infrastructure ( ''medium confidence'' ). Aggregating and managing demand-response of heat systems (micro CHP and heat pumps) has shown reduction in peak demand ( [[#TNO--2016|TNO 2016]] ).

'''Peer-to-peer (P2P) electricity trading''' . Producers and consumers can directly trade electricity with other consumers in an online marketplace to avoid the relatively high tariffs and the relatively low buy-back rates of traditional utilities ( [[#Liu--2019|Liu et al. 2019]] ; [[#IRENA--2020f|IRENA 2020f]] ). P2P models trading with distributed energy resources reduce transmission losses and congestion ( [[#Mengelkamp--2018|Mengelkamp et al. 2018]] ; [[#SEDA--2020|SEDA 2020]] ; [[#Lumenaza--2020|Lumenaza 2020]] ; [[#Sonnen--2020|Sonnen 2020]] ; [[#UNFCCC--2020|UNFCCC 2020]] ).

'''Community ownership models''' . Community ownership models refer to the collective ownership and management of energy-related assets with lower levels of investment, usually distributed renewable energy resources but also recently in heating systems and energy services (e.g., storage and charging) ( [[#Gall--2018|Gall 2018]] ; [[#IRENA--2018|IRENA 2018]] ; [[#Kelly--2019|Kelly and Hanna 2019]] ; [[#Singh--2019|Singh et al. 2019]] ; [[#Bisello--2021|Bisello et al. 2021]] ; Maclurcan and Hinton 2021). Community ownership projects may need significant upfront investments, and the ability of communities to raise the required financing might prove insufficient, which can be supported by microcredits in the initial stages of the projects ( [[#Aitken--2013|Aitken 2013]] ; [[#Federici--2014|Federici 2014]] ; [[#REN21--2016|REN21 2016]] ; Rescoop 2020).

'''Payment method: Pay-as-you-go (PayGo).''' PayGo business models emerged to address the energy access challenge and provide chiefly solar energy at affordable prices, using mobile telecommunication to facilitate payment through instalments; [[#Yadav--2019|Yadav et al. 2019]] ). However, PayGo has the technology and product risk, requires a financially viable and large customer base, and the system supplier must provide a significant portion of the finance and requires substantial equity and working capital ( [[#C40%20Cities%20Climate%20Leadership%20Group--2018|C40 Cities Climate Leadership Group 2018]] ).

'''Transport sector business models''' . Analog to EaaS, mobility as a service (MaaS) offers a business model whereby customers pay for a mobility service without making any upfront capital investment (e.g., buying a car). MaaS tends to deliver significant urban benefits (e.g., cleaner air) and brings in efficiency gains in the use of resources ( ''high confidence'' ). However, the switch to MaaS hardly improves the carbon footprint and further tempted on-demand mobility is likely to nurture carbon emissions ( [[#Suatmadi--2019|Suatmadi et al. 2019]] ). Therefore, to support climate change mitigation, MaaS must be integrated with the deployment of smart charging of electric (autonomous) vehicles coupled to renewable energy sources ( [[#IRENA--2019d|IRENA 2019d]] ; [[#Jones--2019|Jones and Leibowicz 2019]] ).

'''Financial technology applications to climate change.''' Financial technology, abbreviated as ‘fintech’, applies to data-driven technological solutions that aim to improve financial services ( [[#Dorfleitner--2017|Dorfleitner et al. 2017]] ; [[#Lee--2018|Lee and Shin 2018]] ; [[#Schueffel--2018|Schueffel 2018]] ). Fintech can enhance climate investment in innovative financial products and build trust through data, but also presents some challenges including potentially significant emissions from increased energy use with distributed transactions ( [[#Lei--2021|Lei et al. 2021]] ). Blockchain is a key fintech that secures individual transactions in a distributed system, which can have many applications with high impact potential but is also associated with uncertainty ( [[#OECD--2019c|OECD 2019c]] ; [[#World%20Energy%20Council--2019|World Energy Council 2019]] ). Fintech applications with climate change mitigation potential have been growing recently, including tracking payment or asset history for credit scoring in AFOLU activities ( [[#Nassiry--2018|Nassiry 2018]] ; [[#Davidovic--2019|Davidovic et al. 2019]] ), blockchain supported grid transactions ( [[#Livingston--2018|Livingston et al. 2018]] ), carbon accounting throughout value chains ( [[#World%20Bank--2018b|World Bank 2018b]] ), or transparency and verification mechanisms for green financial instrument investors ( [[#Kyriakou--2017|Kyriakou et al. 2017]] ; [[#Stockholm%20Green%20Digital%20Finance--2017|Stockholm Green Digital Finance 2017]] ). Generally, blockchain and digital currency applications are not well covered by governance systems ( [[#Tapscott--2016|Tapscott and Kirkland 2016]] ; [[#Nassiry--2018|Nassiry 2018]] ), which could lead to problems with security ( [[#Davidovic--2019|Davidovic et al. 2019]] ), and some licensing and prudential supervision frameworks are in flux.

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==== 15.6.8.2 Nature-Based Solutions Including REDD+ ====

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Nature-based solutions are ‘actions to protect, sustainably manage and restore natural or modified ecosystems that address societal challenges effectively and adaptively, simultaneously providing human well-being and biodiversity benefits’ ( [[#Cohen-Shacham--2016|Cohen-Shacham et al. 2016]] ). Nature-based solutions consist of a wide range of measures including ecosystem-based mitigation and adaptation.

The studies on investment and finance for nature-based solutions is still limited. However, frameworks and schemes to incentivise the implementation of nature-based solutions, such as reducing emissions from deforestation and forest degradation and the role of conservation, sustainable management of forests and enhancement of forest carbon stocks in developing countries (REDD+), which contributes to climate change mitigation, has been actively discussed under the UNFCCC, with lessons from finance for REDD+ being available.

If effectively implemented, nature-based solutions can be cost-effective measures and able to provide multiple benefits, such as enhanced climate resilience, enhanced climate change mitigation, biodiversity habitat, water filtration, soil health, and amenity values ( ''high confidence'' ) ( [[#Griscom--2017|Griscom et al. 2017]] ; [[#Keesstra--2018|Keesstra et al. 2018]] ; [[#OECD--2019d|OECD 2019d]] ; Griscom et al. 2020; [[#Dasgupta--2021|Dasgupta 2021]] ).

Nature-based solutions have large potential to address climate change and other sustainable development issues ( ''high confidence'' ). Nature-based solutions are undercapitalised and the limited investment and finance, especially limited private capital, is widely recognised as one of the main barriers to the implementation and monitoring of the nature-based solutions ( [[#Seddon--2020|Seddon et al. 2020]] ; [[#Toxopeus--2021|Toxopeus and Polzin 2021]] ; [[#UNEP--2021|UNEP et al. 2021]] ) Finance and investment models that generate their own revenues or consistently save costs are necessary to reduce dependency on grants ( [[#Schäfer--2019|Schäfer et al. 2019]] ; [[#Wamsler--2020|Wamsler et al. 2020]] ).

'''REDD+.''' REDD+ can significantly contribute to climate change mitigation and also produce other co-benefits like climate change adaptation, biodiversity conservation, and poverty reduction, if well-implemented ( ''high confidence'' ) ( [[#Milbank--2018|Milbank et al. 2018]] ; [[#Morita--2018|Morita and Matsumoto 2018]] ). We use the term REDD+ broadly, not limited to REDD+ implemented under the UNFCCC decisions, including Warsaw Framework for REDD+ (Chapter 14), but include voluntary REDD+ projects, such as projects which utilise voluntary carbon markets. Finance is a core element that incentivises and implements REDD+ activities. Various financial sources are financing REDD+ activities, including bilateral and multilateral, public and private, and international and domestic sources, with linking with several finance approaches/mechanisms including results-based finance and voluntary carbon markets ( [[#FAO--2018|FAO 2018]] ). However, there is lack of sufficient finance for REDD+ ( [[#Lujan--2018|Lujan and Silva-Chávez 2018]] ; [[#Maguire--2021|Maguire et al. 2021]] ). REDD+ under the UNFCCC is implemented in three phases: readiness, implementation, and results-based payment phases. The Ecosystem Marketplace identified that at least USD5.4 billion in REDD+ in three phases funding has been committed through multiple development finance institutions so far ( [[#Maguire--2021|Maguire et al. 2021]] ), and public funds are main sources that are supporting three phases, and most of the REDD+ finance was spent on the readiness phase ( [[#Atmadja--2018|Atmadja et al. 2018]] ; [[#Lujan--2018|Lujan and Silva-Chávez 2018]] ; [[#Watson--2021|Watson and Schalatek 2021]] ). There is a significant gap between the existing finance and finance needs of REDD+ in each phase ( [[#Lujan--2018|Lujan and Silva-Chávez 2018]] ). Furthermore, private sector contributions to REDD+ are currently limited mostly to the project-scale payments for carbon offsets/units through voluntary carbon markets ( [[#McFarland--2015|McFarland 2015]] ; [[#Lujan--2018|Lujan and Silva-Chávez 2018]] ).

Current main challenges of REDD+ finance include the uncertainty of compliance carbon markets (which allow regulated entities to obtain and surrender emissions allowances or offsets to meet regulatory emissions reduction targets) ( [[#Maguire--2021|Maguire et al. 2021]] ), as well as limited engagement of the private sector in REDD+ finance ( ''high confidence'' ). With regard to the compliance carbon markets, at the international level, integrating climate cooperation through carbon markets into Article 6 of the Paris Agreement and including REDD+ has potential to enable emission reduction in more cost-effective ways, while the links between carbon markets and REDD+ under Article 6 is under discussion at the UNFCCC ( [[#Environmental%20Defense%20Fund--2019|Environmental Defense Fund 2019]] ; [[#Maguire--2021|Maguire et al. 2021]] ) (Chapter 14). At the national and subnational levels, although compliance carbon markets such as in New Zealand, Australia and Colombia allow forest carbon units, how REDD+ will be dealt in the national and subnational government-led compliance carbon markets is uncertain ( [[#Streck--2020|Streck 2020]] ; [[#Maguire--2021|Maguire et al. 2021]] ). As for limited engagement of the private sector in REDD+ finance, there are various reasons why mobilising more private finance in REDD+ is difficult ( [[#Dixon--2015|Dixon and Challies 2015]] ; [[#Laing--2016|Laing et al. 2016]] ; [[#Golub--2018|Golub et al. 2018]] ; [[#Ehara--2019|Ehara et al. 2019]] ; [[#Streck--2020|Streck 2020]] ). The challenges include the needs of a clear understanding of carbon rights and transparent regulation on who can benefit from national REDD+ ( [[#Streck--2020|Streck 2020]] ); a clear regulatory framework and market certainty ( [[#Dixon--2015|Dixon and Challies 2015]] ; [[#Laing--2016|Laing et al. 2016]] ; [[#Golub--2018|Golub et al. 2018]] ; [[#Ehara--2019|Ehara et al. 2019]] ); strong forest governance ( [[#Streck--2020|Streck 2020]] ), and implementation of REDD+ activities at national and subnational levels. Other challenges are associated with the nature of forest-based mitigation activities, the costs and complexity of monitoring, reporting and verification of REDD+ activities, because of the need to consider the risks of permanence, carbon leakage, and precisely determine and monitor the forest carbon sinks ( [[#van%20der%20Gaast--2018|van der Gaast et al. 2018]] ; [[#Yanai--2020|Yanai et al. 2020]] ). Although REDD+ has many challenges to mobilise more private finance, there is discussion on exploring other finance opportunities for the forest sector, such as building new blended finance models combining different funding sources like public and private finance ( [[#Streck--2016|Streck 2016]] ; [[#Rode--2019|Rode et al. 2019]] ), and developing enhanced bonds for forest-based mitigation activities ( [[#World%20Bank--2017|World Bank 2017]] ).

'''Private finance opportunities for nature-based solutions.''' The development of nature-based solutions faces barriers that relate to the value proposition, value delivery and value capture of nature-based solutions business models and sustainable sources of public/private finance to tap into ( ''high confidence'' ) (Toxopeus and [[#Polzin--2017|Polzin 2017]] ; [[#Mok--2021|Mok et al. 2021]] ) ''.'' However, the demand for establishing new finance and business models to attract both public and private finance to nature-based solutions is increasing in a wide range of topics such as urban areas, forestry and agriculture sectors, and blue natural capital including mangroves and coral reefs (Toxopeus and [[#Polzin--2017|Polzin 2017]] ; [[#EIB--2019|EIB 2019]] ; [[#Cziesielski--2021|Cziesielski et al. 2021]] ; [[#Mok--2021|Mok et al. 2021]] ; [[#Thiele--2021|Thiele et al. 2021]] ; [[#UNEP--2021|UNEP et al. 2021]] ). Furthermore, the recognition of the needs of financial institutions to identify the physical, transition and reputational risks resulting from not only climate change but also loss of biodiversity is gradually increasing (De Nederlandsche Bank and PBL Netherlands Environmental Assessment Agency 2020; [[#Dasgupta--2021|Dasgupta 2021]] ; [[#TNFD--2021|TNFD 2021]] ). Development of finance and business models for nature-based solutions needs to be explored, for example through utilising a wide range of financial instruments (e.g., equity, loans, bonds, and insurance), and creating standard metrics, baselines and common characteristics for nature-based solutions to promote the creation of a new asset class ( [[#Thiele--2021|Thiele et al. 2021]] ; [[#UNEP--2021|UNEP et al. 2021]] ).

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==== 15.6.8.3 Exploring Gender-responsive Climate Finance ====

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Global and national recognition of the lack of finance for women has led to increasing emphasis on financial inclusion for women ( ''high confidence'' ). Currently, it is estimated that 980 million women are excluded from formal financial system ( [[#Miles--2018|Miles and Wiedmaier-Pfister 2018]] ); and there is a 9% gender gap in financial access across developing countries ( [[#Demirguc-Kunt--2018|Demirguc-Kunt et al. 2018]] ). This gender gap is the percentage difference between men and women with bank accounts as measured and reported in the Global Financial Inclusion (Global Findex) database. Policies and frameworks to expand and enhance financial inclusion also extend to the area of climate finance ( ''high confidence'' ). Since AR5, there remain many questions and not enough evidence on the gender, distribution and allocative effectiveness of climate finance in the context of gender equality and women’s empowerment (Williams M., 2015; [[#Chan--2018|Chan et al. 2018]] ; [[#Wong--2019|Wong et al. 2019]] ). Nonetheless, the existing global policy framework (entry points, policy priorities, etc.) of climate funds is gradually improving in order to support women’s financial inclusion in both the public and the private dimensions of climate finance/investment ( [[#Schalatek--2015|Schalatek 2015]] ; [[#Chan--2018|Chan et al. 2018]] ; [[#Schalatek--2020|Schalatek 2020]] ). At the level of public multilateral climate funds, there have been significant improvements in integrating gender equality and women’s empowerment issues in the governance structures, policies, project approval and implementation processes of existing multilateral climate funds such as the UNFCCC’s funds managed by the Global Environment Facility, the Green Climate Fund and the World Bank’s CIFs ( ''high confidence'' ) ( [[#Schalatek--2015|Schalatek 2015]] ; Williams M., 2015; [[#Sellers--2016|Sellers 2016]] ; [[#GCF--2017|GCF 2017]] ). But according to a recent evaluation report, the integration of gender into operational policies and programmes is fragmented and there is lack of an ‘adequate, systematic and comprehensive gender equality approach for the allocation and distribution of funds for projects and programmes on the ground’ ( [[#GEF%20Independent%20Evaluation%20Office--2017|GEF Independent Evaluation Office 2017]] ; [[#Schalatek--2018|Schalatek 2018]] ). The review found that ‘almost half of the analysed sample of 70 climate projects were judged to be largely gender-blind, and only 5% considered to have successfully mainstreamed gender, including in two Least Developed Countries Fund adaptation projects’ ( [[#GEF%20Independent%20Evaluation%20Office--2017|GEF Independent Evaluation Office 2017]] ; [[#Schalatek--2018|Schalatek 2018]] ). While the GCF requires funding proposals to consider gender impact as part of their investment framework, [[#footnote-001|16]] the fund does not have its own funding stream targeted to women’s project on the ground, nor is there as yet an evaluation as to how entities are actually implementing gender action plan in the projects. In the case of the CIFs, as noted by [[#Schalatek--2018|Schalatek (2018)]] , ‘gender is not included in the operational principles of the Pilot Program on Climate Resilience (PPCR), which funds programmatic adaptation portfolios in a few developing countries, although most pilot countries have included some gender dimensions’. And, ‘gender is not integrated into the operations of the Clean Technology Fund (CTF), which finances large-scale mitigation in large economies and accounts for 70% of the CIFs’ pledged funding portfolio of 8.2 billion USD’ ( [[#Schalatek--2018|Schalatek 2018]] ). However, both the Forest Investment Program (FIP) and the Scaling-Up Renewable Energy in Low-Income Countries Program (SREP) have integrated gender equality as either a co-benefit or core criteria of these programmes ( [[#Schalatek--2018|Schalatek 2018]] ).

Overall, efforts to promote gender responsive/sensitive climate finance, at national and local levels, both in the public and private dimensions and more specifically in mitigation-oriented sectors such as clean and renewable energy, remain deficient ( ''high confidence'' ). Recent developments in the capital markets in the areas of social bond are focused around gender bonds – debt instruments targeted to activities and behaviours that are relevant to gender equality and women’s empowerment. These bonds are aligned with Sustainability-linked Bonds as well as Social Bonds Principles of the International Capital Market Association. Issuances of gender-labelled bonds are increasing in the Asia Pacific region (the most comprehensive initiative is the Impact Investment Exchange’s (IIX) multi-country USD150 million Women’s Livelihood Bond [[#footnote-000|17]] ) and in Latin America, Colombia, Mexico and Panama each have gender bond issuances). Additionally, a few developing countries, such as Pakistan (May 2021) and Morocco (March 2021) have issued gender bond guidelines for financial market participants.

'''Linkage to sectoral climate change issues and gender and climate finance.''' Subsets of actions designed to enhance women’s more formal integration into climate policies, programmes and actions by the global private sector include: investment in clean energy, redirecting funds to support women and vulnerable regions as a component of social and green bonds as well as insurance for climate risk management. In the latter context, insurance providers are arguing that ‘given the fact that women are disproportionately affected by climate change, there could be new finance innovations to address this gap’.( [[#Miles--2018|Miles and Wiedmaier-Pfister 2018]] ). AXA and IFC estimate that the global women’s insurance market has the opportunity to grow to three times its current size, to UDS1.7 trillion by 2030 (AXA Group et al. 2015; GIZ et al. 2017). However, across the board, and in particular with regard to public funds, despite improvements in the substantive gender sensitisation and operational gender responsiveness of multilateral and bilateral climate finance funds operations, current flows of public and climate finance do not seem to be going to women and local communities in significant amounts ( [[#Chan--2018|Chan et al. 2018]] ; [[#Schalatek--2020|Schalatek 2020]] ). At the same time, evaluations of the effectiveness of climate finance show that equitable flow of climate finance can play an important role in levelling the playing field and in enabling women and men to successfully respond to climate change and to enable the success and sustainability of local response in ensuring effective and sustainable climate strategies that can contribute to the global goals of the Paris Agreement ( [[#Minniti--2010|Minniti and Naudé 2010]] ; [[#Bird--2013|Bird et al. 2013]] ; [[#Barrett--2014|Barrett 2014]] ; [[#Eastin--2018|Eastin 2018]] ). This is particularly, so in the case of female-owned MSMEs, who, the literature increasingly shows, are key to promoting resilience at micro and macro scale in many developing countries ( [[#Omolo--2017|Omolo et al. 2017]] ; [[#Atela--2018|Atela et al. 2018]] ; Crick, F. et al. 2018).

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