The Challenges of Climate Finance in Emerging Markets
While multilateral development banks (MDBs) like the World Bank and the International Monetary Fund have been the primary source of finance for climate initiatives in emerging markets, their efforts alone are insufficient for the global challenge of climate change. The 2023 Bridgetown Declaration underscores the need for a paradigm shift in how MDBs approach development finance. But what is keeping the private sector, with its vast reservoirs of capital, from fully engaging to provide the climate finance so critical to these markets? Five major challenges can be identified that have presently hindered funding in adaptation and mitigation projects within emerging markets.
These include the following:
1. Currency risk: Investing in emerging markets means confronting currency volatility. Fluctuations in local currencies against major global currencies can erode returns for foreign investors. This uncertainty can deter potential investors from committing funds.
2. Lack of data and local knowledge: Comprehensive, reliable data is the bedrock of informed investment decisions. In many emerging markets, there is a dearth of such data, especially concerning climate-related projects. Without this, it is challenging to assess risks and potential returns accurately.
3. Liquidity risk and high transaction costs: Underdeveloped markets can lack the liquidity seen in more mature markets. This illiquidity, combined with sometimes exorbitant transaction costs, can make it difficult for investors to enter or exit positions without incurring significant costs.
4. Political and legal risks: Emerging markets can have unstable political landscapes or legal systems that foreign investors might find hard to navigate. Regulatory changes, political upheaval, or legal disputes can jeopardize investments.
5. Misalignment on deal size, time horizons, and returns: Emerging market projects might not always align with the scale and scope that large investors are accustomed to. Differences in expected time horizons and anticipated returns can further widen this gap.
These challenges intersect and create a difficult environment for facilitating capital where it is needed the most. In addition, the current state of affairs results in a higher cost of capital for projects in emerging markets, as illustrated by the International Energy Agency’s cost of capital observatory. These inefficiencies not only hamper the clean energy transition but also impede sustainable development.
The promise of smart contracts
Enter smart contracts. These self-executing contracts with the terms of agreement directly written into code lines can revolutionize climate finance in emerging markets. The World Economic Forum has highlighted the potential of blockchain and smart contracts in enhancing security and facilitating capital flow to accelerate low-carbon transitions in emerging markets.
There are a number of ways that smart contracts can help tackle some of the challenges of bringing private sector climate finance into emerging markets.
These include the following:
1. Mitigating currency risk: Smart contracts can incorporate automated currency hedging mechanisms or use stablecoins (cryptocurrencies pegged to stable assets like the US dollar) to minimize currency risk.
2. Bridging the data gap: Blockchain, the underlying technology of smart contracts, offers a transparent and immutable ledger. This can serve as a repository of reliable data, with every transaction and its details recorded.
3. Reducing transaction costs: By eliminating intermediaries and automating processes, smart contracts can drastically reduce transaction costs, making investments more lucrative.
4. Navigating political and legal landscapes: Smart contracts are borderless and operate based on predefined rules, offering a level of insulation from local political or legal upheavals.
5. Aligning investments: Smart contracts can be customized to align with specific deal sizes, time horizons, and expected returns, making them more adaptable to diverse investment needs.
While smart contracts present a promising solution, they alone cannot solve the challenges associated with climate finance. Accelerating the flow of private sector climate finance also will require policy changes, improved data availability, a rethinking of risk assessment processes, and an active and continuing role for MDBs. However, by enhancing transparency, security, and risk management, smart contracts can indeed play a transformative role in channelling much-needed adaptation and mitigation funding into emerging markets.
By: David Carlin, Senior Advisor to the United Nations Environment Programme – Finance Initiative