Paving the Way for Green Investment in Emerging Market and Developing Economies

As the world looks to recover from the economic crisis induced by COVID-19, there is an enormous opportunity to choose a “green” recovery—one that sets the stage for sustainable growth over the medium and long term. While the eventual benefits to this economic reset are now well-documented, it is also clear that an upfront investment is needed in sustainable infrastructure and renewable energy sources. The challenge of mobilizing private climate finance is not just substantial, but also hugely urgent, with the bulk of expenditures having to be undertaken by about 2030 in order to meet the temperature pathway under the Paris Agreement. The richest nations, notably China and those in the European Union, are putting in place a regulatory and supervisory framework to encourage and track sustainable finance. Yet the need for investment is global, with a critical role being played by emerging market and developing economies (EMDEs). Great hope has been put in private financing fueling green investment, helping to reset the development paradigm in the years to come.

Today we publish a paper that assesses the capacity of the current global financial structures to encourage green capital flows to EDMEs and finds they are inadequate. Aimed primarily at encouraging green investment in advanced economies, the frameworks need to recognize the realities of EDME investment, as well as the often-poor capacity of EDMEs, in order to adopt the complex institutional constraints needed to direct investment to truly green products. In fact, climate investment in most EDMEs is predominantly domestically financed and private green capital flows play a tiny part in overall financing. Cross-border investment could be attractive to institutional investors looking to promote a green recovery, but the scale and scope of projects in EDMEs are as yet insufficient to attract large amounts of green capital from abroad. And even if funds were ready to flow, investors would need considerably more information to be assured that they were in fact supporting viable projects that qualified as “green” under their own investment standards.

So what needs to be done to pave the way for future cross-border green investment in EDMEs? We see five areas of action that need to be pursued in parallel:

• Accelerate capacity building within banks in EDMEs, through financial and technical assistance from multilateral development banks and development finance institutions. In the end, most climate finance is going to have to be in local currency and offer long-term maturities. Both local and international bond markets will not offer the kind of patient capital on the scale that is needed for sustainable investment to be made and to mature. Well-regulated and supervised local financial institutions could be instrumental in accelerating such development.
• Establish and/or upgrade national sustainable development finance principles in EDMEs and enhance surveillance and enforcement of those standards. There is considerable work to be done to develop standards in each EDME that clearly articulates its vision of sustainable investment, consistent with its Nationally Determined Contribution (NDC) to the Paris Agreement. Standards and principles for local financial markets should also be consonant with international standards for green investment, although the existing multiplicity of standards makes this a challenge. And articulation of standards must be followed by monitoring and enforcement and preclude “greenwashing”—a tall challenge for many EDMEs. Again, assistance from the MDBs and DFIs will be critical to boost this capacity.
• Standards that are set in the large advanced economies for green finance should be mindful not to implicitly or explicitly exclude cross-border investment in EDMEs. This will require that EDMEs be “at the table” as standards are developed and differences among the big players, particularly the EU and China, are hashed out (or not). One important element will be establishing principles for project investment taxonomies that are rigorous but flexible enough to reflect cross-border differences in priorities and regulatory capacities. The International Platform on Sustainable Finance (IPSF), set up by the EU in 2019, provides one possible venue where EDMEs already have a voice at the table, although this could be expanded (see also our detailed thoughts here in a piece from Bruegel).
• Continued efforts by MDBs and DFIs to finance and co-finance green projects in EDMEs, first with local investors and, in due course, with international investors. A variety of so-called blended finance schemes (guarantees, concessional debt, and equity contributions) have developed over the last few years by publicly funded institutions. While there is a danger of unduly subsidizing what should be purely private sector investments, the underdevelopment of green investment “markets” in EDMEs and the global public goods nature of green investment argues for MDBs and DFIs to play a market-development role to bring green investment to scale, with a parallel development of the regulatory framework through technical assistance. They can provide the small-cap, patient, longer-term, risk-taking international investment that would deter many international institutional investors. International investors willing to encourage such activities could contribute through the use of a stretch fund, as my CGD colleague Nancy Lee has proposed.
• Enhanced surveillance and advice from the IMF and World Bank for EDME green investment financial frameworks and plans. While there are many international efforts to frame and encourage the greening of financial markets, the World Bank and the IMF have a unique role to play in helping countries understand the complex tradeoffs among development objectives (mostly the Bank) and advising on financial regulation and long-term national and systemic risk. Their expertise is valuable not just on a country-by-country basis but also on a systemic basis, recognizing that resilience of the global financial system in the long term will be only as strong as its weakest link. This will require both institutions to develop new expertise and new tools, but without their global view, the whole risks being undermined by the parts.

As the developing economies prepare to update their commitments ahead of the 2021 UN climate summit, there is a clear need to strengthen the framework for private climate finance, both within local financial markets, and as it affects cross-border capital flows. The strong standards for climate finance that have emerged over the past years in some advanced economies will now need to be reflected in more EMDEs, taking into account local capacity and priorities.