Blended Finance — A Much Needed Climate Finance Catalyst
Emerging markets and developing countries are caught in the crosshairs of climate upheavals. An important solution is blended finance.
The problem
Developing countries are facing a whopping $1.8 trillion annual gap to meet the climate ambitions. They’re home to two-thirds of global greenhouse gas emissions and to the regions most vulnerable to climate hazards. At the same time, they’re aiming to kick their growth into high gear, but this growth needs to be green to not exacerbate the climate problem. They need rapid and ambitious solutions for climate mitigation and adaptation.
To solve this, public or philanthropic money won’t be enough. The private sector will need to be mobilized, which means overcoming concerns like high risk profiles or below-market return expectations for climate projects. That’s where blended finance comes in.
What is blended finance?
Blended finance combines public or philanthropic funds with private sector capital to back projects with environmental or social benefits in emerging markets. It achieves this by reducing investment risks and boosting potential returns, either through direct capital inputs (debt, equity, or grants), credit enhancements (like first-loss capital or guarantees), or enabling investments (like advance market commitments).
Consider this example: A private investor contemplates setting up a major wind power facility in a developing country. Such a venture confronts unique risks — think political instability or currency devaluation — not prevalent in developed markets. While the project promises considerable returns, they might not sufficiently offset these elevated risks. This gap is precisely what blended finance’s array of tools can bridge.
Blended finance’s arsenal
Blended finance isn’t just talk; it’s got some legit tools available. Here are some examples.
Green bonds: Financial instruments stamped with Mother Earth’s approval; they’re investment vehicles earmarked climate initiatives. These instruments can draw in institutional investors like pension funds, particularly when public entities chip in with concessional (better-than-market terms) capital. Bloomberg noted a 22% rise in green bond sales in the first half of 2023, hitting a record $352M. In our wind farm example, such a bond could be raised at a below-market rate if public investors provide concessional funds alongside regular institutional investors.
First loss capital: Public or philanthropic inventors can step in to absorb early losses, be it through grants or accepting a lower-ranking investment position, thus improving the expected risk-adjusted return. A great example is BlackRock’s $673M Climate Finance Partnership for emerging markets, which includes a first-loss tranche from governments and philanthropies. For our wind farm scenario, raising public or philanthropic first-loss capital can help the investor raise at a lower cost of capital from its other capital providers.
Guarantees and insurance: These tools protect against unforeseen investment risks. Take political risk insurance; it’s a shield against volatile political scenarios, covering issues like expropriation or political violence, offered by providers like the World Bank’s MIGA. For capex-intensive ventures, like renewable energy projects, this assurance can be pivotal to ensure favorable interest rates from private debt investors.
Advance market commitments: Pre-buying products to stimulate market supply. This is an established practice in the healthcare industry, especially in vaccine procurement, but is increasingly used for other sustainable development purposes including climate. A recent example: Just a few weeks ago at the Africa Climate Summit, the African Carbon Markets Initiative raised almost half a billion USD in advance commitments to boost Africa’s carbon credit production.
The bottom line
Emerging markets have their work cut out for them on the climate front. With vital cash needed for green transformations and climate resilience, the blended finance toolkit will be critical in mobilizing both private and public investors in the quest for a sustainable and prosperous future.
