International Climate Finance and support to national climate policy processes in emerging markets – literature review

The German Institute for Economic Research – DIW Berlin | July 2021

Programme: Strengthen National Climate Policy Implementation: Comparative Empirical Learning & Creating Linkage to Climate Finance – SNAPFI

Financial support:
The International Climate Initiative (IKI), Federal Ministry for the Environment, Nature Conservation and Nuclear Safety (BMU)

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Chapter 2. Literature review

Authors: Imad Ahmed, Julian Payne, Cor Majlis

The chapter
– provides an overview of climate policies, including their benefits and limitations
– presents the challenges to adopting these climate policies
– discusses a range of climate finance instruments and how they support climate policy development
– identifies factors for the success of climate finance in supporting policy development
– undertakes a deep dive into the factors that enable and prevent cooperation between development partners and recipient governments

2.1 Climate policies

Addressing climate change at the domestic level entails integrating economic, social, and environmental objectives, and implementing cost-efficient measures to attain them. Relevant sectors include energy production and use in buildings, transport and industry; waste; and land use, particularly forestry and agriculture. Cost-effective mitigation can be spurred by measures to reduce greenhouse gases (GHGs). In turn, this may require changes in the existing infrastructure, as well as social, technical, and behavioural innovation. Therefore, an iterative, responsive policy framework is needed; one which aims to enhance resource efficiency, environmental and economic performance, and social objectives over time.

There are several taxonomies of climate policies to choose from. Vivid Economics (2020) offers an alternative taxonomy of eight climate ‘levers’, some of which go beyond policy instruments, such as project-based financing and innovation. Bhandary at al (2021) identify nine climate policies, but some of these are climate finance instruments rather than policies.Instead of these, a taxonomy developed by the Intergovernmental Panel on Climate Change (IPCC) was selected.

The IPCC’s climate policy taxonomy covers the universe of real and potential climate policies while avoiding double-counting (IPCC, 2007, 2014,). Among the IPCC’s economic instruments are taxes (to which we add fines because they also penalise undesirable activities), tradeable allowances, subsidies, and among the non-economic instruments are regulations, information programmes, government provision of public goods or services, and voluntary actions. These are described below in Table 1.

Table 1 Climate-related policies to spur mitigation and adaptation

Climate-related policiesDescription
Economic instrumentsTaxes and finesTaxes act as levies on undesirable activities and generate revenues that go to the government; for example, carbon taxes impose a fee on the emissions of GHGs.
Tradable  allowancesTradable allowances establish a limit on aggregate emissions by specified sources. They require emitters to hold permits equal to actual emissions and allow permits to be traded among sources.
SubsidiesSubsidies include direct payments, tax reductions or price support from a government to a private entity for implementing a practice or performing a specified action.
RegulationsGovernment regulation acts as rules or directives aimed at reducing emissions. These can specify abatement technologies or set performance standards for reducing emissions.
Information programmesInformation programs are public disclosures of environmentally related information for customers. They address barriers to investment/purchase where there is limited information and can take the form of labelling, rating, certification, or other public disclosures. 
Direct provision of public goods or servicesThe government can address the under-provision of public goods by maintaining and delivering them directly. This policy arm includes procurement.
Voluntary actions Voluntary actions are agreements between government authorities and private parties to improve environmental performance beyond compliance/ regulation. Examples include labelling, management systems, standards, and education campaigns.

Source:        Vivid Economics; IPCC, 2007; IPCC, 2014

Table 2 illustrates how each of these climate policies can be applied to the energy and transport sectors. Tradable allowances have been observed to have been most successful when applied to the energy sector because of the mature technologies that allow diversification from carbon-emitting sources of power generation (Cullenward and Victor, 2020). Subsidies also help introduce new low-carbon technologies such as carbon capture, usage and storage (BEIS, 2020) which add costs to power generation and are not yet price competitive against facilities without carbon capture and storage even when carbon is priced. Subsidised feed-in-tariffs have been successful in mobilising household investment into rooftop solar, if not been economically efficient (Bhandary, Gallagher and Zhang, 2021). The taxonomy can also be applied to other sectors of the economy.

Table 2 These policies can be applied across sectors to address climate change at the domestic-level

Climate-related policiesEnergyTransport
Economic instrumentsTaxesCarbon taxes
Tax credits
Fuel taxes; Congestion charges, vehicle registration fees, road tolls; vehicle taxes
Tradable  allowancesEmissions trading (e.g., EU ETS); Emission credits under the Kyoto Protocol’s Clean Development Mechanism (CDM); Tradable Green Certificates  Fuel standards (sometimes incorporate market-like features including trading among suppliers)
SubsidiesFossil fuel subsidy removal; Feed-in-tariffs for renewable energy; Capital subsidies and insurance for Carbon Capture and Storage (CCS)  Biofuel subsidies; Vehicle purchase subsidies; Feebates  
RegulationEfficiency or environmental performance standards; Renewable portfolio standards for renewable energy; Legal status of long-term CO2 storage Fuel economy performance standards; Fuel quality standards; GHG emission performance standards; Restriction on use of vehicles in certain areas; Urban planning and zoning restrictions 
Information programmesUtility informationFuel labelling; Vehicle efficiency labelling  
Direct provision of public goods or servicesResearch and development; Infrastructure expansionInvestment in transit and human powered transport   
Voluntary actions Energy management systemsProduct eco-labelling  

Source:  Vivid Economics; IPCC, 2007; IPCC, 2014

2.2 The benefits of climate policies

The impact of climate-related policies depend on the details of policy design, characteristics of the local market, country conditions (including macroeconomic conditions, institutional structures, and the maturity of the country’s financial system). Other factors include the cost of and familiarity with the technologies that are being deployed in that country (Bhandary, Gallagher and Zhang, 2021).

Regulation provides the foundations for climate action; other climate policies are additive. Amongst economic instruments, subsidies, credits and feed-in-tariffs for the development and proliferation of low-emissions technologies such as in the energy sector seem to have been most effective, followed by carbon taxes and then tradable allowances. Tradable allowances are most effective where they are focused on particular sectors, such as energy, where technologies are mature and economic risks are well known. Information programmes are low-cost and improve outcomes. Direct government provision of public goods and services can be necessary to rectify market failures.

Figure 1     The benefits of adopting climate-related policies vary from policy to policy

Source:  Vivid Economics

To evaluate each of the climate-related policies identified in the previous chapter, their benefits and limitations were assessed. This covers the mobilisation effectiveness, economic efficiency, environmental integrity, and equity assessments of climate policies that Bhandary et al (2021) identified. As their categorisation of climate policy instruments did not perfectly match the IPCC taxonomy, which is more exhaustive and mutually exclusive, other literature that provided additional insight to assess instruments was consulted. For each of the policies identified in Table 1, the benefits, limitations, and a series of real-world examples are identified below.

Taxes can be effective at reducing undesirable activities if set at appropriate levels but can prove politically contentious. Like tradable allowances, taxes price carbon for consumers and producers so that they are economically incentivised to reduce their activities in ways that reduce greenhouse gas emissions.

  • Benefits: Taxes reduce the extent to which unsustainable production and consumption impose externalised costs. If set within a stable economic environment, they provide price certainty on this cost, unlike tradable allowances (Nordhaus, 2015).
  • Limitations: Their efficacy depends on whether they are set at a rate that induces behavioural change (IPCC, 2007). Since they are charged on activities, they are regressive, though the impact can be ameliorated with revenue recycling (IPCC, 2007). Taxes are often politically unpopular. Piketty critiques the French government’s introduction of carbon taxes that induced the gilets jaunes protests because only 20% of revenues were recycled into ecological programmes while a portion of the rest was used to cut taxes for the wealthy rather than to recycle the taxes to poorer citizens and thereby address the regressivity of the taxes (Piketty, 2020).
  • Examples: Climate taxes can be levied on carbon, fossil fuels, vehicles, waste, fertiliser, urban sprawl etc. to disincentivise undesirable behaviour and activities (IPCC, 2014).

Tradable allowances create certainty in the volume of emissions associated within an economy’s sectors, but are most suited to less trade-sensitive sectors which have mature technologies for greenhouse gas abatement . Also known as marketable permits and cap-and-trade, allowances can either by auctioned, in which case initially generated revenues go to the government, or allocated to industry incumbents, in which case new market entrants are disadvantaged (Nordhaus, 2015).

  • Benefits: Like taxes, tradable allowances, provide a price signal to consumers and producers on the environmental cost of goods and services, and so reduce the extent to which unsustainable production and consumption impose externalised costs (Nordhaus, 2015). Unlike taxes, they provide certainty over the maximum emissions that can be expected from sectors of the economy that trade in emissions allowances (Vivid Economics, 2019). There is scope for cross-border links(Vivid Economics, 2019).
  • Limitations: ILow and volatile carbon prices disincentivise investment in low-carbon, carbon-resilient (LCCR) solutions (Nordhaus, 2015; Cullenward and Victor, 2020; Vivid Economics, 2020b). For carbon markets to be effective, the sector for which carbon is traded should not be trade sensitive, voters should not be highly aware and abatement technologies should be relatively mature (Cullenward and Victor, 2020). This means the sectors for which carbon markets can be effective are few beyond electricity utilities. The scope for cross-border links is limited. It works in the EU because the EU is like a single market with a single regulator, and member states that see losses from climate policy have multiple institutional opportunities to negotiate for compensation and gains in other areas, including trade policy and intra-EU fiscal decisions (Cullenward and Victor, 2020). Sub-national efforts like those of the Western Climate Initiative involving US and Canadian states and Regional Greenhouse Gas Initiative involving US east-coast states lack the authority to sign treaties that make their joint agreements enforceable and credible (Cullenward and Victor, 2020). Like tax credits (below under subsidies), there is no way of checking whether credits under the Clean Development Mechanism induced a change in behaviour  (Nordhaus, 2015).
  • Examples: Examples of tradeable allowance schemes include the EU Emissions Trading System, emission credits under the Kyoto Protocol’s Clean Development Mechanism (CDM), Tradable Green Certificates,, tradable certificates for energy efficiency improvements (white certificates), Tradable Green Certificates, compliance schemes outside Kyoto protocol (national schemes), voluntary carbon markets, and Urban-scale Cap and Trade (IPCC, 2014).

The success of subsidies depends on programme design; poorly targeted subsidies can have perverse effects. Unlike taxes and tradable allowances, subsidies demand public funds. They are intended to help low emitting products and technologies replace high emitters. Two effective types of subsidies include tax credits and feed-in-tariffs. Perverse subsidies lower the prices of fossil fuels or activities that increase emissions, and so where these exist, subsidy reduction or removal would have positive effects for climate change and public revenues (IPCC, 2014).

  • Benefits: Subsidies in the form of climate tax credits can facilitate private research and development investment into precompetitive innovative low-carbon or climate resilient technologies (LCCR), so that they cross the “Valley of Death for Innovations” to the “jungle of the marketplace” from the “ivory tower” where they were conceived (Nordhaus, 2015). Bhandary et al (2021) found tax credits to be medium-high in terms of environmental integrity if climate-friendly sectors are targeted. They find them medium-high in terms of equitable outcomes because theoretically all can access them, though those with the highest tax burdens have the most to benefit from them.Subsidies in the form of feed-in-tariffs are highly effective in mobilising capital and promoting environmental integrity.Feed-in-tariffs are popular among investors and household consumers of solar rooftop PV (Bhandary, Gallagher and Zhang, 2021). In the USA, they have helped avoid 50 million cumulative metric tons of carbon dioxide since 2010 (Bhandary, Gallagher and Zhang, 2021).
  • Limitations: The environmental effectiveness and cost-effectiveness of subsidies depends on programme design (IPCC, 2007). They can be captured by politically favoured but inefficient targets, such as the use of ethanol as a fuel which on a lifecycle assessment basis, where the use of fertiliser used to grow the crops from which it is extracted, and the extraction process end up making it as damaging as fossil fuels (Nordhaus, 2015). Tax credits are middle-ranking in terms of mobilising capital and low ranking in terms of economic efficiency because of the potential free riders who would have pursued socially beneficial activities in the absence of the support scheme which represents foregone tax revenues (Bhandary, Gallagher and Zhang, 2021). Feed-in-tariffs can lead to higher costs due to the lack of price competition(Bhandary, Gallagher and Zhang, 2021).They are medium in distributional equity and low in economic efficiency (Bhandary, Gallagher and Zhang, 2021).
  • Examples: Climate subsidies can be direct payments, tax reductions and price-supports and take the form of feed-in-tariffs for renewable energy, capital subsidies and insurance for first generation GHG Capture and Storage (CCS), feebates, tax exemptions or subsidies for investment in efficient buildings, retrofits and products, subsidies on loans for green activities or technologies, credit lines for low carbon agriculture, sustainable forestry. They can be for electric vehicle purchases, energy audits, fuel switching, special improvement or redevelopment. 

While regulation lays the foundation for climate action, the literature lays out caveats to its efficacy. Regulations and standards’ cost efficacy and distributional equity depends on design. They are popular with regulators in countries with weakly functioning markets (IPCC, 2007). On the one hand, they can provide some degree of certainty of outcomes, do the bulk of controlling pollution and are politically durable. On the other, they can be relatively cost inefficient.

  • Benefits: Regulations are more politically durable than price-based policy, i.e. more difficult to roll-back than taxes. The costs of regulation and other forms of industrial policy are less visible to voters. Extensive regulation makes it easier to shift costs and benefits as needed to address political opposition. Regulations do the bulk of the work of controlling climate pollution (Cullenward and Victor, 2020). Regulatory standards can be tailored to sectors. There is a direct connection between the regulatory requirement and the environmental outcome, which can provide some degree of certainty (IPCC, 2007).
  •  Limitations: Because it is difficulty for regulators to determine the amount of change that is possible at a reasonable economic cost, regulation is generally more expensive per unit of emissions reduction than a price-based policy; unlikely to achieve ambitious targets except in some sectors; and can be overly stringent at other times. It is difficult for policymakers to select the most appropriate regulations; they often opt for expensive or counterproductive regulations (Jaffe, Newell and Stavins, 2003; IPCC, 2007; Nordhaus, 2015). Finally, regulations also do not economically incentivise polluters to strive to exceed the mandated reductions in pollution  (Jaffe, Newell and Stavins, 2003; Sterner, 2003; IPCC, 2007).
  • Examples: Regulatory standards can cover fuel efficiency, fuel quality, greenhouse gas emissions limits, resilient design requirements for infrastructure, restrictions on use of vehicles in certain areas, urban planning and zoning restrictions, building energy efficiency, equipment and appliances, energy management systems, labelling, public procurement, land use protection (IPCC, 2014).

Information programmes motivate firms to become less carbon-intense in their operations. Lack of relevant information constrains firms, investors and consumers’ ability to make environmentally conscious decisions. Disclosure of high-quality information enables them to hold firms to account for their processes through their production and consumption decisions (Krarup and Russell, 2005; IPCC, 2014).  

  • Benefits: Information policies can effectively address barriers to investment where there is limited awareness of technologies and their future benefits, even when accounting for carbon costs. This may for example be the case with energy efficient appliances and heating solutions with relatively uninformed consumers, in industrial processes where technological advancements are rapid and markets are less mature, and in infrastructure investment decisions facing limited information around the future physical impacts of climate change. Information programmes can be low cost (IPCC, 2007) and should be simple to implement (Bhandary, Gallagher and Zhang, 2021). Disclosures can lower the cost of capital, unless they show that emissions intensity is high, in which case they increase the cost of debt and negatively impact shareholder value (Bhandary, Gallagher and Zhang, 2021). In the longer term, disclosure may motivate firms to invest in cleaner projects (Bhandary, Gallagher and Zhang, 2021).
  • Limitations: However, there is lack of standardisation and enforcement across companies and countries in information programmes (Bhandary, Gallagher and Zhang, 2021).
  • Examples: Information programmes include labelling, energy audits, fuel labelling, vehicle efficiency labelling, EPC ratings for houses, energy advice programmes, certification schemes for sustainable forest practices and policies to support REDD+ including monitoring, reporting and verification (IPCC, 2014).   

Government provision of public goods can achieve socially optimal outcomes; government procurement policies influence private sector investment decisions. A changing climate will typically be a ‘public bad’ and actions and programmes by governments to counteract or prevent climate change can thus be seen as ‘public goods’ (IPCC, 2014).

  • Benefits: Where markets are unable to meet the needs of society in an environmentally efficient manner because of lack of captured value through prices, long time horizons and lumpy and indivisible investments, the government steps-in to provide or maintain the socially optimal supply (Frischmann, 2013). As the largest purchaser in a country, government procurement policies focused on carbon efficient goods and services affect market decisions.
  • Limitations: Direct provision of services is not required in all instances where there are market barriers. Instead, the government can address the market imperfections to enable market provision of the required goods and services (Pauw et al., 2021). For example, stronger IP laws can address positive externalities, information programmes can address incomplete information, and insurance and guarantees can address risks that investors are unable to manage (Pauw et al., 2021).
  • Examples: Examples of public provision include research and development and infrastructure expansion in district heating/cooling in the energy sector; investment in transit, in alternative fuel infrastructure and in low emission vehicle procurement; procurement of efficient buildings and appliances; training and education and brokering industrial cooperation; protection of natural capital and investment in improvement and diffusion of innovative technologies in agriculture; provision of parks and trails; the removal of institutional and legal barriers that preclude mitigation (IPCC, 2014).

Firms can be motivated to engage in voluntary agreements with governments over climate actions to avoid future mandatory alternatives. Voluntary actions refer to actions taken by firms, NGOs, and other actors beyond regulatory requirement.  Voluntary agreements are in most cases the consequence of an explicit negotiation process between the regulator and the polluter (IPCC, 2014). Their environmental efficacy depends on the targets set, third-party involvement in design and involvement in monitoring (IPCC, 2007). Their cost efficacy depends on the extent of government incentives and penalties (IPCC, 2007).

  • Benefits: They are often politically popular (IPCC, 2007). A voluntary agreement can result in higher abatement and net social benefits than regulation if the probability of private enforcement and accompanying costs are high and the probability of agency enforcement is low (Langpap, 2015).
  • Limitations: They require significant administrative staff in the government (IPCC, 2007). Polluters see them as a means to avoiding future mandatory alternatives from the regulator (Metz, 2010; IPCC, 2014). If this is so, they could subvert the introduction of necessary sector-wide regulation. Evaluation of the early use of these agreements in the 1990s found that the targets set were too easy to achieve (Croci, 2003). Further, if the regulator does not have statutory authority to provide regulatory relief, the voluntary agreements can leave the polluter more vulnerable to legal challenges through citizen lawsuits (Langpap, 2015).
  • Examples: Examples include labelling, adoption by industry of energy management system and resource efficiency targets  (IPCC, 2007). 

2.3 Challenges to adopting climate policies

The main barriers to the adoption of climate-related policies are those related to i) political economy challenges, ii) market failures, and iii) enabling environment challenges (Vivid Economics et al., 2020). Political economic barriers are those which impact the distribution of national resources: the interests of powerful actors within the economy conflict with aggregate societal utility, as well as abstract phenomena such as path dependence and accountability that impact government allocation of resources. Market failures are institutional shortcomings of the marketplace to allocate resources efficiently. Enabling environment challenges are other structural economic weaknesses. Figure 2 presents some of (but not all) of the main barriers that fall into these broad categories.

Figure 2 Barriers to adoption of climate-related policies

Source:        Vivid Economics

2.3.1        Political economy barriers

In many countries surveyed, the lack of strong and tangible commitments by governments to support green sectors and markets is a major disincentive to the adoption of climate-related policies (GCF, 2017; CPI, 2020). This lack of commitment is further compounded by a historical dependence on carbon intensive industries in many countries, alongside a host of other political economy barriers, as illustrated in Figure 2.

Growth and climate-consciousness are often seen as standing in opposition. Countries that a) rely on fossil fuels revenues for public expenditure and b) have large existing investments in fossil fuel energy and industry, such as China, India, Indonesia, and South Africa, perceive trade-offs between a strong focus on economic growth and greening finance and green investment, particularly in the context of post-COVID-19 stimuli that predominantly favour brown sectors in all regions[JP1] [IA2] . This acts in opposition to the clean growth that the green financial system has seen in recent years (GCF, 2017; HM Government Prosperity Fund, 2018).

Historical dependence on carbon intensive industries leads to institutional inertia. Decision-making inertia favours the use of incumbent brown technologies such as fossil fuels. Fiscal policies, such as subsidies to fossil fuel energy sources at either the producer or consumer end, exist in all regions and are a disincentive to reform and investment.

Strong relationships between government and dirty industries can dilute and delay sectoral reform as regulatory agencies become dominated by the interests of industry they are charged with regulating. Regulators can be susceptible to lobbying from both industry as well as down-stream beneficiaries of brown industry support, such as employees (as in China and Algeria) or disadvantaged groups dependent on subsidised fossil fuels (as in South America) (Vivid Economics et al., 2020).

Lack of accountability can lead to state capture. Beyond the regulatory capture that happens when well-meaning regulators who become blinkered to the wider social benefits by focusing on the benefits to narrow interest groups, politicians can be influenced by coercive actions or through corruption to make decisions that are societally suboptimal. Ongoing investigations into state capture of ANC high official’s under South African President Zuma’s administration illustrate this (Climate Action Tracker, 2019).Robust civil society, robust journalism, and institutional checks and balances between the government, legislative body and judiciary help ensure that politicians have to explain their decisions in terms of the benefits to society.

Countries endowed with large economic deposits of dirty resources or pristine carbon sinks can be reluctant to leave them untouched (Cullenward and Victor, 2020). To economically incentivise them to leave those resources, they need to be paid compensation covering their opportunity cost.

Strong policies and regulatory frameworks help mobilise climate finance. Cohesive sectoral policies, national development banks and sector-specific incentives help mobilise capital finance. Examples of sector-specific incentives include access to land rights, risk guarantees, power purchase agreements, auctions, and feed-in tariffs (Bhandary, Gallagher and Zhang, 2021). Strong capacity within Ministries of Finance and sector ministries in setting strategies and agenda, establishing public–private partnerships (PPPs), or launching blended finance mechanisms can help achieve greening the financial sector and supporting investment in green sectors. Institutional capacity to implement carbon pricing instruments, or to substitute one-size-fits-all consumption subsidies with targeted cash programmes to vulnerable groups helps attract climate finance (Vivid Economics et al., 2020). Central banks’ and financial regulators’ knowledge and capacity to address and oversee the green financial sector, manage risks and address resilience also attracts climate finance (GCF, 2017).Lack of a green financing strategy does not incentivise green investment. The lack of a long-term, coherent, transparent, and straightforward strategic plan for greening finance and green investment fail to mobilise  necessary commitments (HM Government Prosperity Fund, 2018; CPI, 2020). Unclear financial sectoral regulation, particularly around credit risk and environmental and social reporting, also fail to mobilise capital (GCF, 2017). In China and South Africa, for example, there is a lack of clarity about banks’ responsibilities in tracking environmental and social risks, and in India the lack of a common government position on green investment is a deterrent to investment (IIGF, 2017; CPI, 2020).

Low government creditworthiness is associated with high political and investment risk. Due to the low creditworthiness of government ministries and regulators, particularly in the energy sector, Brazil, India, South Africa, and Southeast Asia have high political and investment risk in international capital markets, which leads to either high cost of capital or non-investment (Vivid Economics et al., 2020).

2.3.2        Market failure barriers

Market failures such as lack of information, externalised costs and benefits and limited technical capacity prevent firms from allocating resources in a socially efficient manner.

Investors are largely unaware of the risks of stranded assets and thus make suboptimal business decisions. Markets have so far failed to adequately understand and value the risks and costs of climate change and thus failed to adjust the cost of capital (Carbon Tracker, 2020). There is a lack of standardised frameworks between ministries of finance, central banks, financial regulators, financial institutions, and corporates for understanding a) the risks that climate change poses to financial institutions and carbon-intensive businesses and b) the risks these institutions and their assets pose to national economies. Risks may appear in policy, legal, market, technology, and physical domains and relate to climate proofing in the context of a changing climate as well as the less productive and stranded assets in low-carbon transitions (UNEP, 2016; TCFD, 2017; NGFS, 2019).

Mispriced or unpriced greenhouse gases lead to the perpetuation of externalised costs on society. Unpriced or mispriced GHG emissions and/or weak carbon pricing instruments lead to the perpetuation of fossil-fuel based energy systems and economies, and to a large role of fossil fuels in the provision of government revenues and public services like power and transport (GSI, 2019; Cullenward and Victor, 2020; Vivid Economics et al., 2020).

Limited technical capacity within industry limits firms’ ability to diversify away from carbon-intensive technologies. Labour markets in the focus areas may lack the number of suitably trained workers needed to deliver the green transition (ILO, 2019).  Project developers’ corporate governance and accounting standards and skills in preparing investible projects may be lacking, which diminishes the size of the investible pipeline, as, for example, in India (GCF, 2017; CPI, 2020). Amongst financial institutions, there is a lack of knowledge and skills around the benefits and risks of investment in green sectors, of suitable financial products that can achieve scale, and of how to measure and report on environmental, social, and governance risks (Vivid Economics et al., 2020).

Interventions could cause unintended perverse market distortions.  Subsidies, for example, to fossil and biofuels contribute to climate change. Unilateral regulations and carbon pricing could disadvantage local industry if international competitors are not facing the same conditions. Carbon credits for projects that would have been invested in without them cause economic inefficiencies (Nordhaus, 2015). An understanding of local barriers and the enabling environment is critical for introducing policy that is effective and minimises perverse market distortions.

Positive externalities explain why firms underinvest in clean technologies. Positive externalities occur when private investments generate public goods: benefits to society that do not necessarily generate additional cash flows and hence are not captured by the financial return (Varian, 2010; Pauw et al., 2021). It is important to address positive externalities because investors might be held back when public good provision is not reflected by their return on investment (Tompkins and Eakin, 2012; Pauw et al., 2021). Positive externalities can be addressed through, for example, public financial support or risk sharing (Pauw et al., 2021).

2.3.3        Enabling environment

Unstable economic climates, low policymaking capacity and low donor coordination make adoption of consistent policy regarding the climate challenging.

Unstable economic climates are not conducive to green investment. Difficulty in enforcing contracts, poor investor rights and protections and inadequate foreign investment and repatriation laws deter necessary investment. The loosening of barriers to foreign investment and repatriation can cause domestic political tension (GCF, 2017).

Low policymaking capacity hinders adoption of climate policy. Governments are often unable to select the appropriate policy for lack of capacity and allow for inconsistencies (Nordhaus, 2015). Policy inconsistency regarding fossil fuel subsidies and carbon pricing instruments is pervasive. China, for instance, is sending mixed signals on the role of coal in its energy system (Vivid Economics et al., 2020).

Low donor coordination is a barrier to climate finance adoption. Effective bilateral, multilateral and philanthropic donor coordination helps sustain viable country partnerships,  avoid programme duplication and promotes long-term reform (Vivid Economics et al., 2020).This is discussed further below.


A lack of coordination amongst development partners, and between development partner and
recipient country government makes climate policy less effective.
Typical barriers relating to a lack of coordination include mismatched priorities, high levels of bureaucratic or administration burden, and inefficient resource allocation (including both duplication and policy gaps). Coordination barriers can lead to severe restraints on the rate of uptake and effective implementation of climate policies.

Fragmented sources of political support and financing can pose a significant administrative
burden on partner governments and result in suboptimal outcomes.
Climate support and its
funding is delivered through a range of institutions including multilateral funds (like the Green Climate Fund (GCF)), national development and aid agencies, development banks as well as monitoring bodies such as the Intergovernmental Panel on Climate Change or the United Nations Framework Convention on Climate Change’s (UNFCCC) Standing Committee on Finance. This wide range of sources results in a complex web of actors, a proliferation of norms, and significant administrative burden for countries seeking to demonstrate compliance. The complexity involved in managing multiple sources of information, assistance and financing may reduce transparency, result in inequitable funding, or deter recipient governments from accessing support (Pickering et al., 2017). Additionally, the multiplicity of implementation channels and differing donor priorities can cause resources to be spread too thin, or across competing objectives (Lundsgaarde et al., 2018). This may translate to a lack of resources for policy implementation.

Limited bilateral communication between donor agencies or government ministries can also
inhibit the effectiveness of resource allocation
. Lack of donor coordination results in duplication
and missed opportunities to identify synergies across initiatives (OECD, 2016). Additionally, inconsistent messages and practices from development partners impose administrative costs on partner governments (OECD, 2003). A lack of clarity may dull the effectiveness of policy solutions. Limited coordination amongst domestic actors also creates similar issues. Taking the energy sector as an example, implementing climate policy can require coordination across government roles including regulatory, planning, and financial departments (Lundsgaarde et al., 2018). Lack of effective cooperation can therefore generate severe delays and inefficiencies in these processes.

2.4 Climate finance instruments and mechanisms to support climate policy

International public climate finance has evolved since international climate negotiations and support started in 1994 with the United Nations Framework Convention on Climate Change (UNFCCC) entering into force. International public climate finance – the flows of finance from developed to developing countries to support climate action – increased over the early 2000s, then remained stable through 2007. From the mid-2000s onwards there was a parallel increase in carbon market funding for climate action through market-based mechanisms under the Kyoto protocol. However, unlike the increases in international climate finance, carbon market funding peaked in 2010 and decreased substantially towards and following the end of the Protocol’s first commitment period in 2012, with limited transaction volumes from 2015 onwards. International public climate finance increased alongside carbon market finance in the late 2000s, and then accelerated from 2009 onwards, with large increases leading up to and following the negotiation of the Paris Agreement in 2015 (Vivid Economics, 2020b).

Climate finance can support climate policy if the relevant stakeholders are engaged in ways that impact attitude, behaviour, procedures, leverage financial commitments and if the finance instruments help develop policy content. Working together with civil society, political leaders, recipient governments and investors on developing policy, improving procedures and securing additional commitments, international climate donors’ financial instruments can influence the behaviour and attitudes of voters and emitting industries in the adoption of climate policies.

Figure 3  The evolution of climate finance and carbon market flows since 2000

Note:           MDB and bilateral international public climate finance apportioned to mitigation and adaptation objectives based on the total amount of the project and the relative value of mitigation and adaptation finance in that project. Finance from multilateral climate funds tagged as “multiple foci” is apportioned to adaptation and mitigation finance based on the relative value of climate finance of each type in a given year. The Kyoto Protocol introduced three market-based mechanisms for the purchase of emissions reductions or allotted emissions units. Kyoto carbon market finance includes financial flows to selected countries (see Appendix for full list) for emissions credits under the Clean development mechanism (CDM), Joint implementation (JI) and Emissions trading (ET).

Source:        Vivid Economics, based on OECD, 2018; ODI, 2019; UNEP DTU Partnership, 2019; World Bank, 2018

2.4.1      Types of climate finance instruments

Clearly defining and delineating different types of climate finance is necessary to understand how certain types of climate finance can be transformative by influencing policy. The transformational goal of international climate finance is to reduce greenhouse gas emissions, shift to a low-carbon development path, and increase the climate resilience of developing countries (Vivid Economics, 2020a).International public finance is provided by developed countries to developing countries at market or at below market rates for mitigation and/or adaptation activities. Climate finance comes in two forms (OECD, 2019d):

  1. dedicated climate finance climate as finance specifically and primarily focused on climate outcomes (provided by specialized multilateral and bilateral climate funds), and
  2. climate-related development finance as finance that offers a blend of development and climate outcomes (provided by multilateral and bilateral organisations).

The composition by theme (mitigation, resilience/adaptation) and their geographic focus is similar in both categories.

The literature is mixed on whether climate finance should be separated from overseas development assistance. On the one hand, Selin argues that developing countries fear that rich countries will cannibalise resources already committed to development assistance, and that climate finance should therefore be additional to ODA (Selin, 2015, 2016). On the other hand, Eyckmans et al (2016) anticipate that a separation of ODA and climate finance would diminish the recipient country’s ability to allocate resources between mitigation, adaptation and consumption to achieve welfare maximisation. Separation would increase the funds’ efficiency in terms of how much the donor would like to see spent on mitigation and adaptation (Eyckmans, Fankhauser and Kverndokk, 2016). The UNFCCC includes provisions related to the tracking of public finance provided and private finance mobilised for climate action in developing countries, but currently there are no requirements to track broader financial flows (Bhattacharya et al., 2020).

A range of widely used, as well as currently less-used, climate finance instruments are needed to support transformative climate policy. These finance instruments include approaches that are well known, particularly grants to support investments and climate projects, and instruments that have been less frequently used, including blended finance approaches. However, even widely used instruments may need to be deployed in new ways to support transformative change. Table 3 sets out nine different climate finance instruments considered in this analysis.

Table 3 Nine types of climate finance instruments to support climate action

Climate finance instrumentsDescription
Investment financingEquityThe provision of public finance in the form of equity stake/shareholder investment to support an enterprise or one of a series of discrete projects. Typically provided on terms not available from private capital providers and often intended to mobilize private capital.
Investment loansThe provision of public finance in the form of loans to government projects, an enterprise or a series of discrete projects. Typically provided on terms not available from private capital providers and often with the intention of mobilizing private capital.
Investment grantsThe provision of public finance in the form of cash, goods or services, for which no repayment is required. May be used to support government projects, infrastructure or the provision of goods/services in the private sector (e.g. enterprise support), public sector (e.g. infrastructure investment), or civil society/academic sectors (e.g. climate services provision).
GuaranteesThe provision of support by a public actor to transfer certain risks from investors or national governments to the public actor. Guarantees can help recipients manage financing, policy or climate physical risks that they cannot absorb.
Intermediated financingThe provision of financial support through intermediaries such as banks, microfinance institutions or other actors, rather than providing funding to end recipients directly. Examples include credit lines or fund capitalisation for re-granting/investing.
Results-based financingThe provision of funds to a recipient is linked to the achievement and independent verification of a pre-agreed set of results from an investment or policy. This includes prizes and competitions and payments for investment and policy outcomes.
Policy-based financingThe provision of public finance conditional on the borrower fulfilling their policy commitments. Such public finance is typically fungible in the borrower’s budget (budget support).
Trade financeThe provision of finance to bridge the gap in time between import payment and export receipt of payment, mitigating risk on the part of both the buyer and the seller by providing credit, payment guarantees and/or insurance for transactions. This typically takes the form of credit for either buyers or sellers between companies, or a bank intermediated guarantee.
Technical assistanceThe provision of finance in the form of grants or non-financial assistance provided by specialists, to finance or provide support in the form of information sharing, expertise, skills training, knowledge/best practice sharing or other consultation services.

Source:        Vivid Economics

Most climate finance has been project-based and been made in the form of market-rate loans for renewable energy projects. Most climate finance was project based and came in the form of debt, followed by equity. A small portion of investment came in the form of grants. Additional information on the prevalence of different types of financing is collected below by the Climate Policy Initiative. The figures below account for domestic, bilateral and multilateral public funds, differing from the bilateral public funds from DAC nations highlighted in Figure 3:

  • Debt accounted for USD 380 billion, or 66%, of total climate finance. 83% of this was provided at market rate (i.e. 55% of total tracked climate finance was market-rate debt) (CPI, 2019).
    • Most of this debt was provided at the project level (CPI, 2019). Market-rate project debt financing increased by 10% from 2015/16 to 2017/18. The most popular projects have been renewable energy (CPI, 2019).
    • Surprisingly, public institutions (multilaterals and national development finance institutions (DFIs)) provided 66% of project-level market rate debt in 2017/18 which suggests that they could be crowding-out private finance. Unsurprisingly, 98% of below market rate project debt was provided by public institutions (CPI, 2019).
  • Equity investments constituted USD 169 billion, or 29%, of climate finance flows in 2017/2018, 26% of which was at the project-level. The remainder was placed directly on investors’ balance sheets (CPI, 2019).  
  • Grants constituted USD 29 billion, or 5%, of total climate finance flows in 2017/2018. Almost three-fifths of grants were made internationally. 35% of international grants went to the more commercially challenging sectors agriculture, forestry and other land use (AFOLU) and natural resources management. 71% of this was used for adaptation or had dual benefits. 42% went to Sub-Saharan Africa, where these sectors only account for 10% of total international flows (CPI, 2019).
  • Guarantee and insurance commitments of USD 1.5 billion in 2017/2018 helped mobilise 39% of USD 38.2 billion of private financing, over a third of which was in energy. These instruments typically take the form of political risk insurance, off-taker guarantees and first-loss coverage. Renewable energy has been the main sectoral focus for these instruments, but there has been an increase use in energy efficiency, land use and transport (CPI, 2019). Grants are excluded from the flows reported to avoid over-estimation of risk.

Climate finance must look beyond investments and projects and towards other instruments to make a broader impact. Project-based financingcan be constrained by capital requirements, may not align with national development priorities and may distort markets, especially with the use of market-rate loans from public institutions (CPI, 2019; Vivid Economics, 2020b). Technical assistance, results-based financing, policy-based financing and trade finance are further instruments that can help achieve climate policy objectives.

The combined impact of technical assistance and direct financial support may be multiplicative rather than additive. This is because it ensures that financial support is adequately embedded in national action, reaches its full potential to be effective, and therefore can be scaled up and replicated beyond a single project (Vivid Economics, 2020b).

Results-based financing (RBF) can support multiple climate levers by supporting direct action, incentivising new approaches, and laying the ground for carbon pricing. RBF is a proven effective tool to support a programme of changes that cuts across multiple climate levers. Within projects and programmes, an approach of unlocking financing upon achievement of pre-agreed results can be effectively linked to creating policy and incentive frameworks with a far greater reach than enabling immediate investments within that project or programme (Vivid Economics, 2020b).

Policy-based financing and trade financing tend to have a narrower focus on certain climate levers. However, they have the potential to be geared towards new areas and support action in policy areas where it has not yet broadly been applied (Vivid Economics, 2020b).

2.4.2        Mechanisms through which international climate finance influences policy

There is currently no clear framework or theory of change for how international climate finance instrument impact climate-related policies. DIW Berlin conducted a literature review in which they found that the effectiveness of climate finance on the development of national climate and development policy frameworks can only be assessed if a deeper analysis of transformational change processes of developing countries is conducted. They found that such comprehensive analyses had not yet been conducted in a systematic manner and that the main analytical units and related analytical frameworks are not yet available if the analysis is to exceed project levels and instead consider national settings (DIW Berlin, 2020).

While providing a theory of change that maps instruments to climate-related policies is beyond the scope of this research, an indicative approach can be outlined. Such an approach would build on existing literature related to the (a) mechanisms by which climate finance influences policy, (b) institutional factors through which stakeholders interact with climate policy, and (c) the way in which stakeholders interact with climate policy.

The mechanism by which climate finance enables climate-related policy in many ways depends on the form of climate finance and the type of policy. An effective theory of change must map the precise mechanisms by which climate finance enables policy. ODI (2011) identifies several broad dimensions used to evaluate policy influence that provide an indicative sense of the causal pathways discussed above. These are presented below:

  • Attitudinal change: raising awareness and framing debates, changing the attitudes or perceptions of key stakeholders and getting the issue on to the political agenda
  • Securing commitment: encouraging discursive commitments, for example promoting the endorsement of international declarations
  • Procedural change: securing change in the process for policy decision-making, such as opening new spaces for policy dialogue
  • Policy content: delivering legislative change
  • Behavioural change: influencing behaviour change among key stakeholders to ensure meaningful and sustainable implementation.

In terms of its transformative potential, the degree of success of climate finance will hinge upon how well the mechanisms influence actors. Climate finance should enable depth of change, scale of change and the change should be sustainable. To achieve depth, the mechanism should address root causes. To achieve scale, changes must go beyond the boundaries of the intervention itself (World Bank, 2016). These can come through catalytic effects, demonstration effects, replication of innovation or positive externalities (World Bank, 2016). To achieve sustainability, the changes effected through the mechanisms should not harm the prospects of long-term economic growth (World Bank, 2016).

One approach to assessing how key stakeholders interact with climate policy is provided by Cullenward and Victor (2020). Stakeholders interact through two main institutional factors:

  • Adoption rules: The creation of market-based policy involves the creation of new structures which frequently require legislation (Cullenward and Victor, 2020) and the creation of interventions which require financing. As such, requiring adoption demands the following questions to be answered:
    • What kind of vote or action is required to make the policy become legally binding (Cullenward and Victor, 2020) and mobilise required public funds?
    • What sort of financial structure will help leverage private capital?
  • Administrative capacity: When organised interests mobilise for state action, the interests must look at the rules for adopting the action and at the skills of the state in putting that action into practice.  Managing pollution markets is often complex and requires different skills from those traditionally found in environmental agencies (Cullenward and Victor, 2020). 

International climate donors play an important role in financing countries’ climate-related infrastructure but can also play an important role in facilitating domestic climate-related policies. International climate donors can offer financing at below market rates to both governments and the private sector to reduce the pressure on budget-constrained governments who would otherwise not be able to provide concessional finance needed to enable action. When used strategically, this finance in turn can enhance the possibility of crowding in private finance (OECD, 2015; Vivid Economics, 2020b). Investment instruments have broader potential than just investment opportunities, and this is where non-project financing instruments come in.

Climate finance can support climate policy if the relevant stakeholders are engaged in ways that impact attitude, behaviour, procedures, leverage financial commitments and if the finance instruments help develop policy content. Working together with civil society, political leaders, recipient governments and investors on developing policy, improving procedures and securing additional commitments, international climate donors’ financial instruments can influence the behaviour and attitudes of voters and emitting industries in the adoption of climate policies. Below we provide one way in which this framework could be illustrated.

Figure 4   Theory of change for how climate finance impacts climate policies

Source:        Vivid Economics

Climate financing effects attitudinal change helps secure financial commitments. Investments into funds or institutions may attract co-financing and spur recurring fiscal commitments to those vehicles or institutions from among (a) recipient governments, in the form of subsidies or direct provision of public goods or services, and (b) investors as they lower the cost of capital by de-risking projects and programmes through guarantees or through their concessional financing, and through demonstrative effects.

Results-based financing can help effect procedural and behavioural changes among recipients, including civil society organisations, financial institutions (a subclass of investors), and recipient government entities. It can also incentivise emitting industries to transition to lower carbon intensity activity. Through CSOs, RBF can effect behavioural and attitudinal change among the broader public and firms seeking funding. Through intermediated finance, RBF can effect behavioural and attitudinal change among indirectly financed firms.

Policy-based financing and technical assistance can help effect procedural changes, deliver policy content and effect behavioural change among recipient government entities and political leaders. PBF can be used to address capacity constraints and improve information efficiency and, can help in the design of new sector policies. It can help stabilise the regulatory and policy environment with which political leaders have to contend and create a more conducive environment for investment in innovation.

Trade finance can help secure commitments from export credit agencies in developing standards that align with climate action goals.

Technical assistance can help recipient government entities with the design and implementation of economic instruments and policies. These include regulation, information programmes, the policies behind the provision of public goods and services, and voluntary actions.Technical assistance also:

  • Provides governments with information, expertise and best practice when designing reforms;
  • Supports implementation of sector-specific policies by knowledge and best-practice sharing as well as help to overcome political resistance;
  • Provides market intelligence to set up efficient innovation policies and supports the private sector by providing regulatory and strategic advice.

Mapping the causal process and interplay between climate finance and policy involves input from international climate donors and outputs from recipient governments. This is a key area for additional research and should be a focus for the SNAPFI consortium going forward.

2.5 Factors that support the success of climate finance

There are four factors that contribute to (or prevent) the successful delivery of climate finance
and support policy development.
These include (a) the structure of climate finance, (b) host country conditions, (c) the capacity of implementing entities, and (d) the strength of cooperation. The structure of climate finance relates to the type of climate finance provided and the process for selecting projects. Host country conditions are the political, economic, and social factors that will determine how well climate initiatives are adopted. The capacity of implementing entities relates to the strength of national and sub-national institutions, as well as institutional transparency and ability more broadly. Conditions that enable cooperation relate to both internal and external coordination between development partners and recipient government.

These factors help determine the successful uptake of climate finance instruments and their
corresponding impact on climate policy.
The right choice of instruments and the right appraisal tools will help to effectively secure financial commitments in the most transformative and demonstrative opportunities. Host country conditions, ranging from engagement with civil society to integration of climate change in national plans, inform the successful implementation of climate finance instruments and policies. The capacity of implementing entities to plan, monitor and evaluate and learn from experience also play an important role in supporting the adoption of these policies. Finally, ensuring cooperation between different stakeholders is a key enabling factor, with extensive research undertaken on the drivers of success in this area.

Figure 5 Factors affecting the successful adoption of climate finance instruments

Source:        Vivid Economics

2.5.1        Structure of climate finance

The appraisal processes and structure of international climate finance will help determine whether the finance responsively addresses needs and whether or not the private sector co-invests. Adoption of climate finance pertains not only to the adoption by partner governments to help them implement their climate policies, but also to the successful mobilisation of private capital.

Continued donor support and successful adoption depends on the quality of processes and tools for selecting financed projects that are responsive to the needs of the country. Donors and governments should have transparent processes and robust ex-ante appraisal tools for estimating interventions’ environmental, social, economic and financial benefits, as well as trade-offs, in order to prioritise resources for the most transformative and demonstrative opportunities (OECD and IEA, 2013). Processes and tools should strike the right balance between rigour and administrative costs and allow for data availability constraints. Such tools could include marginal abatement cost curve analysis, options analysis, impact assessments, cost-benefit analysis, and multi-criteria analysis (OECD and IEA, 2013).

Climate finance should be successful at leveraging private capital. Meeting the investment levels required for mitigation and adaptation place a heavy burden on political will. As of 2014, the public sector dominated investment in infrastructure, a key sector for climate finance, accounting for more than 75% infrastructure spending in developing countries and closer to 90% in International Development Association countries  (ODI, 2014). This burden can be reduced if concessional finance can mobilise private capital (OECD and IEA, 2013). While some investors have integrated sustainability considerations, a key requirement for effective private engagement is maximising risk-adjusted returns.

The right types of finance should be selected for the right purpose. Climate funds need to consider the full suite of financial options to incentivise investors to engage in new areas that they perceive to be higher risk. For example, small grants can complement the use of less and non-concessional financial instruments and greatly increase impact by enabling private investments to achieve their target returns without increasing costs to end-consumers (ODI, 2014). Partial local currency guarantees can mobilise local capital for projects without inducing moral hazard. Guarantees and insurance were linked to 39% of USD 38B in private financing mobilised by development finance institutions in 2017 (CPI, 2019). Technical assistance can facilitate action that needs to be taken at the government level in order for the instrument to become fully effective (IPCC, 2014).

2.5.2        Host country conditions

Positive host country conditions are fundamental to the likelihood of adoption of climate finance instruments. Such positive conditions mean that the political economy, market failure and enabling environment barriers are low. This is made possible when a) climate change is an important and mainstream policy issue for the government, and there is a high degree of accountability with respect to climate expenditures; b) civil society, firms and local government have a say in planning, tracking and monitoring climate interventions; and c) opportunities to invest in climate-mitigation and resilience are available and attractive to the private sector.      Climate change is an important and mainstream policy issue for the government

High-level political attention and transparency in decision-making processes helps raise national awareness of the importance of climate action and signals serious intent. In India, national and state action plans on climate change as well as the government’s financial investment were seen as strong indicators by donors of domestic commitment to climate adaptation (Doshi and Garschagen, 2020).

Integration of climate mitigation and adaptation into national plans and budgets as a mainstream issue makes adoption of climate finance more likely. For climate finance to be effective, climate change cannot be treated as a “niche” policy area (OECD, 2016). Government ministries responsible for national planning and budgeting must  mainstream climate actions and finance into the decision-making of sectoral government entities (OECD, 2016). This also encourages donors to channel funding through country-owned systems, reducing transaction costs by avoiding the creation of parallel processes (OECD, 2016).

Well-organised accountability systems help track climate-related expenditures. Granular tracking helps monitor outputs and outcomes. Applying a budget code to track climate related expenditures across sectors increases climate finance accountability and helps overcome transparency issues between donors and recipient governments. Strong national statistical systems also help track finance, assess impacts as well as measure progress towards GHG reductions across broader portfolios of investment activities such as in energy (OECD, 2016).      Civil society, firms and local government have a say

Civil society, local government, and private sector engagement in planning, tracking and monitoring increase climate policy adoption and improve implementation efficacy. Recipient national governments find that engaging civil society, local government and the private sector in the formulation of national action plans, as well as tracking and monitoring help. Enhancing the enabling environment for the private sector, demonstrating the commercial viability of climate-smart technologies and mobilising investments via financial instruments such as loan guarantees help mobilise private investments, especially for infrastructure with long-term investment horizons, for both mitigation and resilience (UNDP, 2013; OECD, 2016). Involving civil society and local government helps ensure that adaptation finance is targeted to the needs of the most vulnerable to climate change (OECD, 2016).      Opportunities to invest in climate-mitigation and resilience are available and attractive to the private sector

The danger with public finance intended to “crowd in” private finance is that it may in fact “crowd it out” (ODI, 2014). Public institutions (multilaterals and national DFIs) provided 66% of project-level market-rate climate finance debt in 2017/18, which suggests that they could be crowding-out private finance (CPI, 2019). Judgement therefore needs to be exercised as to when the private sector would be interested in investing, releasing public funds to address provision of public goods where there are market failures.

Having major trading partners that are aligned with respect to climate objectives helps the host country government adopt climate finance instruments to meet its intended climate objectives. Harmonised action with trade partners or an ability to issue import tariffs enables governments to implement emissions reduction targets without harming local industry.Membership of climate clubs with trade partners or an ability to impose import tariffs on the products and services of countries not participating in emissions abatement can help alleviate free-riding and prevent harming local industry through climate policy (Nordhaus, 2015; Vivid Economics, 2020b).

Box 1 Thai government policy has aimed at mobilising private capital into mitigation infrastructure    

  The Thai government has implemented a broad array of climate policies to create host country conditions that address political economy, market failure and enabling environment barriers. The result has been that it has managed to mobilise USD 9.7 billion of investment into renewable projects since 2010.     The government has relied heavily on subsidies to mobilise this investment, in the form of feed-in-tariffs and low-interest loans and grants, tax exemptions and a carbon credit guarantee facility to help develop the Clean Development Mechanism.   One major market failure that remains is that local banks lack the technical capacity, knowledge and experience to finance renewable energy projects. An enabling environment barrier that remains is accessibility of transmission-line information.   As of 2018, renewable energy only accounted for 1% of Thailand’s power generation. If this is to increase, the Thai government will need to decide whether it wants to set carbon prices through tradable allowances or carbon taxes and whether it wants to set policy on decommissioning thermal power generation assets. The power sector is not currently included in Thailand’s voluntary emissions trading pilot.        

Source:        The Joint Graduate School of Energy and Environment, 2013; UNDP, 2013; Smart Energy, 2020; IEA, 2020b, 2020a

Box 2 Policies that help a host country harmonise its carbon policies with its trade partners

  LCCR trade liberalisation: The reduction or elimination of tariffs and quotas for LCCR goods and services lowers barriers for their exchange. Climate clubs: Trade agreements that lower trade barriers for countries that commit to climate action, and exclude admission of countries that do not. Border carbon adjustments: Issuance of import tariffs on emission-intensive goods and services from countries with lower carbon prices or looser carbon regulations than the importing country.   

Source:        Vivid Economics, 2020

2.5.3        Capacity of implementing entities

Administrative capacity in the state’s national and subnational implementing entities will provide donors the confidence that the state is ready to access climate finance. The entity’s staff should be able to uphold high standards of governance, plan, structure blended finance products, monitor, evaluate and learn from experience. National development finance institutions often represent entities ready to access climate finance.

Implementing entities should have high governance standards in order to conform to donor requirements and in order to effectively implement programmes and policies. They should have strong fiduciary capabilities and environmental and social safeguards in order to circumvent multilateral implementing bodies. It should also be able to blend financing sources to leverage resources fully (UNDP, 2012). Institutions should have staff who have financial management capabilities.

Implementing entities should be competent at planning the use of climate finance in an efficient and equitable manner. Planning for the supply, management and use of financial resources for mitigation and adaptation aims allows decision-makers to articulate their climate-related priorities and the financial resources required to meet them (UNDP, 2012).  Assessing the climate finance flows against the requirements allows policy-makers to match their priorities with available resources, and so allows them to plan how to integrate resources and sequence them over time (UNDP, 2012). Thus, implementing entities should have staff who are able to formulate projects and programmes, conduct baseline assessments; make investment and financial flow assessments; conduct expenditure reviews; and perform cost-benefit analysis (UNDP, 2012).  

Implementing entities should be capable of catalysing private finance. As discussed earlier in 7.1, adoption of climate finance instruments depends in part on how well it mobilises private capital for positive climate outcomes. The success of this will depend on how well implementing government agencies are able structure finance solutions that give private investors the risk-adjusted returns that they seek. Staff at the implementing entity should be able to structure blended facilities to catalyse private investment and have expertise in private sector pricing incentives (UNDP, 2012). 

Implementing entities should be capable in delivering finance to execute mitigation and adaption activities. Delivering resources requires national systems that provide financial oversight and management as well as execution services such as procurement, contracting and hiring (UNDP, 2012). These systems must have a local supply of expertise from which to procure skills and undertake project activities. Further, coordination among entities (UNDP, 2012), as discussed in 6.1.1, ensures that project-level activities are in line with national development planning and strategies. As such, implementing entities should be capable of transparently evaluating and prioritising projects well on an ex-ante basis, making the necessary procurements and supervising the day-to-day administration of project activities (UNDP, 2012). They should have staff with specialist technology skills; project management skills (UNDP, 2012). 

Implementing entities should be able to monitor expenditures and evaluate impacts in order to strengthen the credibility of programmes funded by climate finance. The monitoring, reporting and verification of financial flows, expenditures and results is critical to building and maintaining a consistent level of transparency and accuracy (UNDP, 2012). Entities charged with this responsibility should not only be able to demonstrate results, but also build an evidence base of what, how, and why an intervention worked in order to inform better policies and interventions in the future (OECD and IEA, 2013). The results provide evidence to donors that their climate funds are being made good use of, and help justify or scale-up commitments (OECD, 2014).The entities should have staff who are able to conduct expenditure reviews, staff who can inventory greenhouse gases, and staff who are able to independently verify results  (UNDP, 2012).

Implementing entities should be able to draw lessons from experience in order to scale-up successful pilots and make adaptations where improvements can be made to climate-financed programmes. In addition to providing donors with evidence that they should scale-up their commitments, positive results should inform recipient governments of the potential to scale-up pilot trials (OECD, 2014). Where interventions have not worked as well as they could have,  implementing entities should be able to take prompt corrective actions and incorporate learning into the design of future actions (EDF et al., 2011). Such proactive learning prevents institutional path dependent lock-in and inertia (Mahoney, 2000).

Experience with past climate projects should also equip implementing institutions with the capability to meet donors’ standards (Doshi and Garschagen, 2020).

The existence and use of national development finance institutions with climate project experience help with accessing finance because they usually meet the governance standards required of donors, and also have long-standing relationships with private sector organisations and communities (Doshi and Garschagen, 2020; Bhandary, Gallagher and Zhang, 2021).

Box 3 India’s development finance institution had strong governance and strong local networks      

  Having a development finance institution in the form of National Bank for Agricultural and Rural Development (NABARD) enabled India to efficiently access adaptation finance because of its strict fiduciary standards, rigorous rules and regulations, compliance with high environmental and social standards, transparency, but also because of its extensive presence at the district level and its vast network of 5,600 cooperative, regional, commercial and rural banking partners, which is essential in increasing the impact of funding. NABARD was also uniquely resourced with the capacity to manage complex financial modalities such as loans and blended projects.   Multilaterals are confident of the quality and relevance of NABARD proposed projects because of its selection criteria reflect theirs. For example, it checks for the risks and vulnerability of adaptation projects, and requires comparisons against business-as-usual scenarios. It also requires projects to align to the National Action Plan for Climate Change and the State Action Plan for Climate Change priorities; it assesses the urgency of action; it assesses the transformational impact and the opportunity for scaling-up; it checks for stakeholder consultation and community involvement.   Importantly NABARD has also earned the commitment and trust of communities, having spent time with community members, which has resulted in the successful implementation of its projects. .  

Source:        Doshi and Garschagen, 2020

2.6 Deep dive: strength of cooperation

Successful cooperation between the recipient government and its donors requires internal coordination within the government and amongst its donors as well as alignment and coordination between the government and its donors. Within government, there should be clearly allocated roles and responsibilities among ministries to enhance communication and transparency, enabling donors to identify domestic priorities and to align financing behind these. Among donors, coordination improves resources allocation by avoiding duplication and identifying synergies across initiatives. Cooperation between international climate donors and recipient governments helps with the adoption of international climate finance. It requires government-led coordination, alignment of priorities, objectives and time horizons, and agreement on frameworks for reviewing.

Figure 6 Internal and external coordination enables donor-government cooperation

Source:        Vivid Economics

2.6.1        Internal coordination

Prerequisites to cooperation between governments and their international donors are 1) internal coordination within government and 2) coordination amongst donors (OECD, 2016). To enable donors and recipient governments to be able to effectively communicate with one another and execute programmes together, they must first be internally aligned. Inconsistent messages and practices among donors impose a cost on partner governments. Similarly, arms of a government acting towards competing objectives can also subvert the agreements settled between another government arm and donor.      Coordination within government

Intra-governmental coordination and agreement on roles and responsibilities are key to the effective allocation of domestic and external resources. Clearly allocated roles and responsibilities among ministries enhance communication and transparency, enabling donors to identify domestic priorities and to align financing behind these (OECD, 2016).

Coordination between the Ministry of Finance, the Ministry of Environment, as well as the Ministry of Planning are of particular importance to improve the effectiveness of resource allocation. Although roles allocated to each ministry may vary across countries, frequently allocated responsibilities are (i) the establishment of a coordination mechanism, (ii) the formulation of a national climate change plan, and (iii) the monitoring of national emission reductions and the tracking of climate related expenditures (IDB, 2013). In Bangladesh and Cambodia, for example, the responsibility for management of multi-donor trust funds resides with ministries of environment, while resources are channelled through the finance ministries (UNDP, 2013). Having a venue for these ministries, such as a central steering-committee or joint task force, to meet regularly and have a functioning secretariat for formal coordination helps achieve this end (von Lüpke and Well, 2019).

Focus on a small number of key sectors by a small number of ministries might enable greater impact in tackling climate change. While a ‘whole of government’ approach is often recommended to respond to climate change, the UNDP (2013) recommended that governments may be able to stay more strategically focused by concentrating resilience efforts in a small domain of key sectors.      Coordination amongst donors

Coordination across donor agencies in-country can improve the effectiveness of resource allocation and reduce the burden imposed on partner governments. Lack of donor coordination results in duplication and missed opportunities to identify synergies across initiatives(OECD, 2016). Inconsistent messages and practices from donors impose administrative costs on partner governments (OECD, 2003).

To make resource allocation as effective as possible and to avoid unnecessarily burdening partner governments, donors should use partner government systems where possible, share information and agree on their respective roles. Sharing information on their operations within a sector with one another,  internally resolve their differences before approaching partner governments for consideration of policy choices and setting out explicit agreements on their respective roles and setting consultation mechanisms and behaviours expected of each donor in a multi-donor activity outweigh the costs of negotiation and the administrative burdens imposed on partner governments (OECD, 2003). Using partner government systems where possible, and otherwise use common systems and procedures or adopt joint working arrangements that include shared decision-making also reduce administrative burdens on partner governments. Donors should consider appointing a lead institution amongst themselves to achieve greater coherence, as they did in the case of Bosnia and Herzegovina. KfW was designated as the lead agency and representative of other donors because of its specific sector knowledge and capacity. This made administration quicker and simpler. One progress report was commissioned every six months, submitted to the other donors (OECD, 2003). 

2.6.2        External coordination

Cooperation between governments and their donors requires alignment of priorities as well as coordination. Alignment means agreement on common objectives and approaches to monitoring and evaluation, as well as on time horizons and timing of disbursements. A good framework for aid coordination will enable leadership by partner governments, simplify working relationships and create flexibility where it is missing.

2.6.2      Alignment between donors and recipient governments

Donors and partner governments should agree on their common objectives. Governments and donors will need to align approaches to climate financing to support the necessary coordination mechanisms and incentives frameworks across government’s planning and budgeting (OECD, 2016). Governments should own their own strategies and play an active role in their design (OECD, 2008). From this point, the literature starts to diverge.

On the one hand, there is literature that says that external funding should match national priorities, rather than the other way round (OECD, 2016). International climate finance should be participatory and nationally owned, otherwise transformational change ‘risks being perceived as and becoming a pressure imposed on developing countries’ (Winkler and Dubash, 2016). For many developing countries, climate policy is embedded in a larger context of sustainable development objectives, defined through a national process. There is therefore a potential tension between mitigation-focused climate finance and nationally driven sustainable development (Winkler and Dubash, 2016).

On the other hand, there is literature that allows for advocacy groups to identify the drivers that change policy process and strategically influence the political will of the government. Advocacy groups influence discourse and negotiation processes by providing timely and precise information to the right actors at the right moment in time (Crewe and Young, 2002; von Lüpke and Well, 2019).Political will to change policies is essential for effective policy assistance, but there are many cases where this political will has to be generated (FAO, 2002). These are difficult situations where the donor and the government are not in agreement and continued efforts are needed to negotiate and persuade the government to change its views to allow the possibility of jointly developing and modifying policies to make them more effective (FAO, 2001, 2002). Identifying drivers of change and leadership methods and conducting advocacy and capacity-building for government and stakeholders can help generate the will and a domestic constituency for change (FAO, 2002). To what extent international donors can legitimately finance civil society organisations that match their agenda to influence policy discourse is an unanswered question that needs to be explored further.

Donors and partner governments should agree a framework for reviewing & monitoring impact; donors should use simple and common indicators, and base conditionalities upon a common national framework. It should use simple, measurable, easily verifiable performance indicators. Where several donors are funding the same operations, they should use common indicators. To avoid a proliferation of conditions, donors should agree on a common conditionality framework. This should draw from a national framework on climate change where one exists (OECD, 2003, 2008). The budget support review should be integrated into the partner government’s review process (OECD, 2003).

2.6.3      Coordination between donors and recipient governments

Effective working relations between donors and governments must be built on an institutional framework for coordination that reconciles different interests, internal rules and cultures in a constructive way. A good framework for aid coordination will enable leadership by partner governments, simplify working relationships and create flexibility where it is missing. It will facilitate dialogue between donors, the government, civil society and firms. It will set out a consensus between governments and donors on objectives and strategy, agreement on the fora to manage dialogues, rules and timetables (OECD, 2003).  

Partner governments should coordinate donors to link aid to development planning & budgeting. Partner governments should chair and provide the secretariat for consultative groups of donors to better coordinate aid between donors and themselves (OECD, 2003). 

Intended aid flows should be communicated by donors with partner governments in a timely manner to allow governments to integrate the aid into their budgets. Communication is a two-way process;it should not just flow from the recipient government to the donor for the purposes of monitoring and evaluation (OECD, 2003). For example, at the Accra Agenda for Action, donor and recipient countries recommended that donors provide 3-5 year forward information on planned aid to partner governments (OECD, 2008). Recipient governments have in the past sought clarity regarding planned activities, procedures, reports and evaluation results (OECD, 2003). Donors should set out the objectives, and indicative operations they plan to support for each of their substantive country programmes.

Donors should programme their aid over a multi-year horizon and time disbursements to match governments’ budget cycles. Multi-year programmes enable partner governments to plan for the longer-term increases in service delivery capacity. The timing of disbursements should enhance the partner governments’ macroeconomic management. Donors should onlysuspend support within-year in exceptional circumstances that are clearly defined and should be transparent about the circumstances under which aid flows may vary (OECD, 2003).

Donors and partner governments should willingly engage in collective and transparent dialogues on concerns. To facilitate this, there should be a process for raising concerns (OECD, 2003).


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