Tulika Narayan and Anu Rangarajan Using Climate Finance Effectively: Five Recommendations

The recently formed Development Finance Corporation (DFC) aims to invest with private sector partners to finance solutions that address critical developmental challenges. The most pressing and challenging problem facing us is climate change caused by greenhouse gas (GHG) emissions. Efforts to curb (or mitigate) GHG emissions require governments to set and meet reduction targets by reducing dependence on fossil fuels in the face of challenges such as rising consumer and industrial energy demand, absence of climate change policies and programs, and problems implementing existing climate change policies and programs. Global actions to slow climate change are critical, and so is the need to bring a massive influx of funding to adapt to conditions that are now inevitable (Global Commission on Adaptation 2019).

The past decade has seen significant capital / Deploy a range of creative tools to expand bankable commitment to address climate change, focused climate opportunities. A big constraint in deploying primarily on mitigation actions in the energy climate finance, particularly debt and equity sector. Yet more needs to be done. First, sectors financing, is the lack of bankable investments. To beyond energy need more funding. Second, it is energize the pipeline of potential investments, the important to promote adaptation actions. Third, DFC can use results-based payments approaches due to past efforts and donor awareness, capital such as prize competitions for business plans with now exists to fund climate action. However, that defined parameters about expected financial returns capital often chases a weak pipeline of funding and climate goals that plans must demonstrate. opportunities, which needs to be energized. Finally, The DFC could define prize competitions separately larger investors and private sector players are more for different sectors, for different target countries, likely to benefit from climate finance interventions, and across mitigation and adaptation actions. This leaving out smaller players who might engage could be a natural way to energize opportunities in climate action that has deeper social impact. in relatively neglected domains and identify new Spurring investment opportunities and linking actors. The DFC could manage these challenges, them with investors calls for creativity. Under the outlining clear criteria that take into account new administration, the DFC can make a significant inputs from investors. The challenges can be run impact in achieving climate goals through the piecemeal, but could also have an open window or following actions: cyclical windows that focus on different topics.

DECEMBER 2020 > mathematica.org 1 Directing more climate finance toward mitigation these cases, a simple intervention that alleviates efforts in sectors beyond energy (such as informational constraints (matchmaking) might agriculture), and toward adaptation actions could be adequate. Further, even if private sector be facilitated by deploying investment platforms. investment occurs, it could be less than socially An investment platform could take several forms. desirable because the private investor might not For instance, it could be a development platform account for the additional climate benefit of the similar to the Sankalp Forum that includes summits investment. Quantifying this difference between and workshops related to key themes, and helps the financial and economic returns (accounting match investors with potential projects. Such for the climate impact) can identify the extent of a platform could specify investors’ needs and public funds that should be used to motivate the collate potential investment opportunities and flow of capital. could follow the business-plan prize competitions Other investments might not occur because of that identify viable business plans and investees. more fundamental market failures—namely, Another possibility is to structure an investment because the financial returns are negative even if platform similar to the co-creation workshops that the economic returns are positive (Quadrant II). the U.S. Agency for International Development These opportunities will not attract private capital (USAID) hosts to convene a vetted set of actors without public support to make the opportunity looking to develop solutions for problems that are financially attractive to private investors. If the either broadly or narrowly defined. Lastly, the DFC wedge between financial and economic returns could customize a platform similar to the Power of is significant, grants might be the ideal financing Nutrition to target climate adaptation activities. mechanism, and could be potential projects that Such a platform would mobilize funding to address come under purview of USAID or the Millennium adaptation (or other neglected sectors) by leveraging Challenge Corporation (MCC). financing and partnerships among the private sector, governments, various types of donors, and In other cases, investments can adversely affect implementing partners to scale up sustainable climate goals even if the financial returns are efforts in targeted countries. positive (Quadrant IV). These cases might require / Adopt a clear analytical framework to regulatory measures to limit such actions. classify, assess, and fund opportunities. However, without a climate impact analysis of Clearly articulating the nature and extent of all related investments, it is possible that public the market failures that limit private sector funds are invested in opportunities that fall in this investment in the opportunity must motivate quadrant, particularly if they meet other goals that the administration’s case for using public funds. are tracked (such as employment or job creation). The DFC can accomplish this by evaluating the Even if it is not practical to discontinue funding of potential financial and economic returns from opportunities in Quadrant IV, at the portfolio level, an investment and potential donor actions the DFC could strive for net positive economic (Figure 1). If a bankable idea exists that yields returns at the portfolio-level by routinely positive financial return and positive climate assessing the GHG impacts of all investments. goals, then a private investor would likely invest in it without any public intervention (Quadrant In summary, organizing the opportunities along I). However, informational constraints might this analytical framework that clarifies the nature impede such investments. For instance, investors of market failure would be an important step in might not be aware of promising opportunities ensuring public funding is at the right level, of in nascent markets. Similarly, they could have the right type, and is additional. That is, it leads limited knowledge of the risk profile to match to climate goals that would otherwise not have opportunities with different sources of capital. In been achieved.

DECEMBER 2020 > mathematica.org 2 Figure 1. Analytical Framework for Optimizing Climate Finance Investments

Quadrant IV: Quadrant I: Donor + Financial + Financial Donor options: - Economic + Economic options: Assess GHG Non-climate development Net DFC investment should Match making impact of all actions that increase GHG be no more than the Debt financing key actions emissions fall in this differenc between Equity financing category, which should be economic - financial return. Risk guarantee Regulations minimised. Donors should In some cases match assess GHG impact of its making to overcome entire portfolio and seek to informational constraints have a net positve impact may be adequate. on GHG reduction across its portfolio. Financial returns Financial Economic returns

Quadrant III: Quadrant II: Donor - Financial - Financial Donor options: - Economic + Economic options: No action No action necessary. Neither Donor's investment needed Grants needed private actors will be to offset the negative Blended finance interested in these financial returns. Therefore, Risk guarantee opportunities nor the donors. such opportunities will require blended finance or grants.

/ Achieve net zero emissions (or net reduction in zero emissions. Currently, it is unclear if these emissions) impact by focusing equally on the agencies’ investments—those focused on climate impacts of nonclimate investments. achieving climate goals, as well as those focused All GHG emissions are a result of activity that on other development impacts—achieve a net is funded by either private or public money. reduction in GHG emissions. Achieving ambitious Carefully assessing the GHG impacts of such climate goals requires such a foundational shift. investments—not just climate investments— / Improve measurement of success to establish could help identify significant mitigation additionality and reduce unintended negative opportunities. The DFC, USAID, and MCC impacts. Establishing the environmental can pledge to assess GHG impacts of all key and sustainability impact of an investment is investments. In particular, they can commit difficult but feasible. It is harder to establish to identifying whether a specific project leads additionality if the impact occurred as a result to a net positive or negative economic impact of the specific public funding commitment or to inform their investment portfolio in ways whether it would have occurred in any case (as that reduce GHG impacts and achieve net might happen with any investment that yields a

DECEMBER 2020 > mathematica.org 3 positive financial return and has an employment financing gaps, and away from areas where the and growth impact). Even in such cases in which prospect of high financial returns means that private investment might have occurred in the business-as-usual trends in investment will be absence of public funds, public funds could be sufficient or will yield a negative climate impact. used to increase the environmental impact of an / Improve measurement of resilience impacts. investment: for example, if the investment also As the administration expands its investment leads to protection of forests. It is essential that in adaptation actions, it will need to measure we measure and establish the additionality of its impact on climate resilience—the ability of new opportunities—both ex-ante (so we invest humans or natural systems to cope with and in the right opportunities at the right level) as recover from climate-related shocks. Measuring well as ex-post (so we can learn if the intended households’ and communities’ resilience results did occur). Ex-ante analysis can also help cost effectively requires innovation because identify the key assumptions or parameters resilience is a dynamic concept that relies on that drive results, and the project monitoring high-frequency data that can be costly to gather. framework can focus on capturing those specific Several efforts have demonstrated the use of indicators. A way forward to put this idea into high-frequency short surveys (for example, the operation is to use decision support tools (DSTs) World Food Programme) and indicators for which that project the financial costs and returns of we need information (Measuring Indicators investments; rigorously document the associated for Resilience Analysis). Pioneering approaches GHG, environmental, and social impacts; and in crowd-sourcing self-reported data from enable joint analyses of financial, economic, and communities can increase the spatial resolution social costs under distinct intervention scenarios. of resilience measurement and help understand As part of a USAID-supported consortium, communities’ adaptive capacity and climate Mathematica is developing such a DST to vulnerability. Templates and examples exist of inform the scaling-up of innovative sustainable projects that have successfully obtained self- agriculture technologies. This tool accounts for reported community data in other sectors, and the complex ways in which weather variability, the DFC can readily apply them to climate. Better soil health, and water availability influence accounting of investments’ impact on resilience agricultural productivity, while modeling the are also critical to targeting the administration’s agricultural technology’s impact on deforestation, resources to the right efforts. GHG emissions, biodiversity loss, and soil and water pollution. In so doing, it explicitly highlights Reference wedges between financial and economic returns (such as at agricultural frontiers, often Global Commission on Adaptation. “Adapt Now: A Global Call for Leadership on Climate Resilience.” Washington, characterized by pervasive land-use and land- DC: Global Center on Adaptation, World Resources cover change). Such tools can help policymakers Institute, 2019. channel existing resources toward meaningful, climate-smart agricultural technologies that face

Let’s Progress Together. For more information, please contact Tulika Narayan [email protected] or Anu Rangarajan [email protected].

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