1. The Climate Finance Problem
The effects of climate change are becoming ever more evident around the globe: extreme weather events (droughts and storms), rising sea levels and extreme land surface temperatures are upsetting agriculture, inducing longer seasonal fires covering broader areas and making new regions uninhabitable. Some of the most climate vulnerable nations and peoples live in the “Global South”, where the economies are too weak to cope with the risks, compounding the vulnerabilities to climate change with a lack of the resources to adapt to or mitigate the problems. While there is a general need for scale and efficiency in allocating both public and private capital to climate, this need is particularly acute in countries that are among the most disrupted by global warming and often the least capable of coping with the impact. It is widely accepted that the financial resources required to meet the climate needs of developing countries are far too great to be met by their governments, even with official development assistance from bilateral and multilateral aid agencies. The World Economic Forum estimates climate investment requirements for developing countries (excluding China) to be approximately $2.4 trillion per year by 2030, of which roughly 40% annually will need to be financed externally. 1
If the cost of action is large, it is becoming clear that the social costs of inaction are equally large. Using estimates of the 2016 US Interagency Working Group on the Social Cost of Carbon and the International Energy Agency estimates of global carbon emissions to extrapolate recent trends, the annual global social cost of carbon will exceed $2.6 trillion in 2025. Estimates of real unit emissions costs are projected to continue rising at an average annual rate of 1.7% through the end of the decade.2 As the populations of countries in the Global South continue to grow, some becoming poorer, the risk of political disorder, emigration, famine and disease will increase – with direct impact on the “Global North”.
Consequently, there is a broad interest to attract private capital for climate projects in developing countries. COP28 established a Task Force on Credit Enhancement, an important step to make multilateral development bank (MDB) and development finance institution (DFI) credit enhancement more readily available to attract private capital for climate. The World Bank has since set up a “one stop shop” for its guarantees. But such MDB and DFI measures are likely to take time to increase private investment and their scale is a small fraction of the trillions of dollars needed to meet the looming and urgent climate challenges that call for market innovations.
2. History Suggests Credit Enhancement Can Increase Efficiency of Climate Financing
To scale up private capital flows for climate, it may be helpful for developing countries to consider the lessons of well-established private sector credit enhancement instruments and companies in developed markets that date back centuries. Beyond personal and corporate guarantees, bank letters of credit (LOCs) have long been a feature of commerce. In the twentieth century, such traditional bank LOCs evolved to standby LOCs.3 Insurance companies developed surety bonds to backstop personal or commercial performance obligations. In the last third of the twentieth century, the traditional surety bonds morphed into a related form of credit enhancement, the financial guarantee insurance policy, issued by licensed single-purpose insurance companies. State insurance laws and regulations in the United States both formally and in practice moved to restrict the providers of such credit enhancement policies to the financial guarantee insurance companies.
It is not an accident that the first US financial guarantee insurance policies, issued since the early 1970s, enhanced the credit performance of US public finance debt obligations. While some governmental authorities were frequent issuers of debt in substantial amounts, most US municipal borrowers were small governmental bodies and infrastructure authorities. Their US issues typically were tax advantaged and, therefore, retail “buy-and-hold” investors constituted a critical segment of the investor base for such US municipal bonds.4 The combination of small-size issuance and retail purchasers represented an effective barrier to efficient secondary trading: public bids or asks were rarely quoted. Once acquired, an exit from these long-term obligations was not readily available, despite the generally excellent credit performance of the sector in the post-war period. Prior to the entrance of financial guarantee insurers, municipal debt was largely illiquid and bore wide spreads, reflecting the high potential costs of investor exits.
Financial guarantee insurance radically transformed US municipal bond markets. Debt issues insured by large, highly rated financial guarantee insurance companies were viewed as roughly comparable to “two-name” corporate obligations, for which there was a much wider investor base and stronger quoted secondary bids. While this new form of financial insurance represented credit substitution, the practical effect was the expansion of investor exit opportunities. Even though the growing volumes of guaranteed financing led to wider spreads than on “natural” triple-A issues, financial guarantors monetized not only a portion of the credit spread but also a portion of the liquidity spread. This made the early financial guarantee insurance business initially very profitable, attracting competition, which, in time, squeezed their margins, causing an increased share of the spread savings to accrue to the municipal issuers, materially lowering the cost of their public works in the US.
Among the initial competitors in the market for municipal financial guarantee insurance were bank standby LOC providers. Historical credit missteps by leading banks providing LOCs and their strategic decisions to increase leverage led to lower bank ratings. This made bank LOCs less effective competition for highly rated financial guarantee insurers.
With the entry of new financial guarantors, increased competition in the municipal market led most of the financial guarantee sector to diversify into both the international and the structured finance markets. Credit missteps in structured finance markets in the run up to the Great Financial Crisis of 2008 compelled the financial guarantee industry to shrink. Still further contraction was wrought by persistent and historically low interest rates during and after the Great Recession. The volume of transactions backed by such financial guarantees has fallen from a peak of some $3 trillion pre-2008 to a little under half a trillion today in gross insured par. Survivors in the industry have largely reverted back to the sector’s municipal finance roots. While diminished in volumes, financial guarantees continue to play a key role in US public finance markets for the same reasons that brought them into the market in the first place: credit substitution and investment bucket transformation of the guaranteed obligations leads to better secondary market pricing in capital markets and thus more efficient primary executions. Financial guarantees continue to be used in structured finance and international financings, albeit with fewer providers.
3. Credit Enhancement: A Promising Innovation in the Climate Finance Tool Kit
Some portion of climate connected financing can be supported by developing countries from their national budgets, their development partners or from their own capital markets borrowings. The bulk of the remaining funding will likely need to come from private investors. The focus today must be on leveraging existing funding sources (national and local governments, MDBs and DFIs, and the private markets) to scale up climate financing. While MDBs and the private sector have a successful history of leveraging each other’s strengths, today’s challenges require more innovative public-private partnerships.
To the extent that climate projects in developing countries are financially viable, a portion could achieve capital markets access (as in developed markets). But there is a scarcity of a secondary market bid or offer for developing country capital markets debt, which suggests opportunities for financial guarantors. For example, African governments routinely complain about the “African sovereign debt premium” relative to similarly rated non-African financings.
When climate projects are well-supported by tax and/or project revenues, financial guarantees can be used to transform developing country sovereign, sub-national and project debt into corporate like forms to attract better secondary liquidity, leading to more cost-effective primary debt capital market executions at scale. In addition, innovations in credit enhancement, such as first loss guarantees from MDBs or DFIs, can be deployed to derisk projects to reduce investors’ internal and regulatory risk capital costs significantly below those on direct exposures to the host country, municipality or project. To the extent that such MDB/DFI first loss protection allows projects in non-investment grade countries to be rated investment grade (as is the case with a combination of MIGA and EBRD guarantees for a renewable energy project (Virtuo) in Egypt and a hospital project (ELZ) in Türkiye), such projects could attract financial guarantees for less expensive and longer term capital.
For these reasons, the establishment of climate-focused financial guarantee companies (CFGs) focusing on developing countries should be encouraged. Reflecting decades of experience in credit enhancement and the lessons learned from past financial crises in Asia, Europe and the US, robustly structured CFGs can work in partnerships with on-going efforts by national and local governments, MDBs, DFIs and project sponsors in the Global South. Successfully deploying financial guarantees in emerging markets could also provide a path to long term financial sustainability. If their guaranteed transactions are paid off without the guarantees being called, such successful sovereigns, municipalities and projects could amass a positive market track record, improving their credit ratings and further lowering their capital costs. Thus, CFGs could enhance developing country capital market access, helping provide a part of the global response to the very real and rising climate risks.
- “How Maximizing Green Finance Flows to Developing Countries Could Tackle Global Warming,” World Economic Forum (July 11, 2024).
↩︎ - See “Technical Support Document: Technical Update of the Social Cost of Carbon for Regulatory Impact Analysis Under Executive Order 12866,”Interagency Working Group on Social Cost of Greenhouse Gases, United States Government (August 2016); “CO2 Emissions in 2023,” International Energy Agency (March 1, 2024). The $2.6 trillion social cost estimate is calculated based on the real dollar cost of carbon converted to nominal dollars by applying the GDP deflator through 2023, and assuming a GDP deflator of 3% in 2024 and 2% in 2025. On this basis, the 2025 nominal cost of carbon is $68.40 per metric ton. The IEA 2023 estimate of global CO2 emissions is 37.4 billion metric tons, an increase of 1.1% from the previous year. Assuming carbon emission growth at the same rate for the next 2 years leads to a 2025 emissions estimate of 38.2 billion metric tons. ↩︎
- LOCs involve an irrevocable payment obligation upon the occurrence of a triggering event and the presentation of appropriate documents. With traditional LOCs, the payment obligation was triggered by a performance success (e.g., the delivery of goods or services). In the case of a standby LOC, the payment obligation is triggered by a performance failure (e.g., a payment failure). ↩︎
- Household municipal securities ownership has remained steady in recent years at 40% but is down from 54% in 2004. Households invested three times as much as funds in 2004. Their investments are now still twice as high as those of funds. See MSRB, “Trends in Municipal Securities Ownership”. June 2022. ↩︎
Featured Author:
Mahesh Kotecha is President of Structured Credit International Corp, a former senior vice President at S&P for sovereign ratings, and author of The River Finds Its Course.
Mark Gold is a consulting economist with over thirty five years of experience. During the Great Financial Crisis, Dr. Gold was the point person for consulting work and model development under his firm’s contracts as financial agent to the US Treasury for the TALF program.
The authors would like to thank Keith Martin and Andre Cappon, the former an expert on MDB and DFI guarantees and the latter a long time consultant to financial guarantors and other financial institutions, for detailed comments and suggestions.
All views expressed by members are their own and not reflective of the views of the Bretton Woods Committee.