Developing countries are highly vulnerable to the effects of climate change, although they have lower historical and current per capita greenhouse gas (GHG) emissions than developed countries. The Independent High-Level Expert Group on Climate Finance (IHLEG) estimates that developing countries, excluding China, will require USD 3.2 trillion per year by 2035 in investments for climate action and nature, of which USD 1.3 trillion per year will need to be sourced internationally. Governments in the Global South seeking to expand climate finance for their priority projects face a difficult choice.
To tap the global markets, they are encouraged to borrow in hard currency, particularly US dollars. However, high levels of sovereign FX debt deter many governments from doing so, as additional borrowing risks further downgrades their credit ratings. In several cases, countries are already in the position of having three-fourths of their long-tenor debt in hard currency. Those who wish to borrow in local currencies, meanwhile, have to offer high premiums. Further, demand from global capital for such issuances is not an easy alternative as many investors are deterred by currency risk.
Cost of capital is defined as the risk-free rate of return plus the macro- (country-level) and micro- (project or sector-level) risk premia applying to investments in a specific country and macro-risk premia are significantly higher in emerging economies, therefore accounting for the higher cost of capital in such countries. This presents a significant barrier to scaling up trillion-dollar gaps in foreign investment in green transition projects across developing developing countries, and subject to currency risk which acts as a proxy for macro risk. Local capital markets are insufficient to finance the climate transition in most developing countries at the speed and scale required. Currently, local capital markets in many developing countries lack depth and are characterized by limited savings and lack of domestic investment vehicles to support large-scale, long-term borrowing. On top of lower accumulated wealth than advanced economies, developing countries have bank-dominated financial systems and underdeveloped bond markets which offer fewer options for domestic savings and investment, and lack the capacity to develop offerings and deepen the market. As a result, the cost of capital for private projects is often high enough to make them non-viable—or financing is unavailable in longer tenors. These factors limit incentives for local renewable energy related investments and can contribute to a self-reinforcing dynamic wherein a scarcity of savings leads to requirements for returns that are too high for many climate-related projects.
These challenges are even more acute in the energy sector. Independent project producers in emerging markets must often borrow in hard currency, while their future streams of income – often end-user tariffs – are denominated in local currency. This mismatch shifts risk either onto project producers or state power utilities. As a result, incentives to adopt renewable energy are reduced, which in turn undermines one of its key advantages – the predictable variable cost of production of a unit of electricity. Addressing this
issue provides a strong case for global institutional innovation, and efficient use for catalytic public finance. Some mechanisms already exist, such as the currency hedging solution TCX and the energy FX coverage facility ERCF. While TCX has operated for more than a decade, lessons learned from its experience, as well as from the use of currency swaps during the pandemic can help inform the design of scaled-up solutions.
Potential interventions could be advanced through the ongoing reforms of multilateral development banks (MDBs), particularly within the framework of the current capital adequacy review. At the same time, the other options should also be on the table, including the construction of a new institution and facility. While such an approach may involve higher initial costs, it will also serve as an indication of political commitment and render efforts to mitigate currency risk more sustainable over time. The global development financing landscape has undergone significant transformative initiatives over the past three years, reflecting a critical re-evaluation of MDB operational paradigms. These reform efforts have been strategically positioned across multiple high-level platforms, addressing fundamental structural challenges in development finance – (a) Boosting MDB Capacity: An independent review of MDB Capital Adequacy Frameworks, 2022 – G20 and COP (b) Climate Finance Framework: Independent High-Level Expert Group on Climate Finance – COP (c)The Triple Agenda: Strengthening Multilateral Development Banks.
Given the context, the Observer Research Foundation is organizing a roundtable discussion to explore institutional and policy innovations that can address currency risk in mobilizing climate finance. The discussion seeks to identify scalable solutions that can support emerging markets in accessing affordable finance for their climate priorities. It will also explore how India, with its global leadership role, can shape interventions that strengthen its domestic financing system and provide pathways for the wider Global South.
11:00 - 11:30 (IN)
11:30 - 11:35 (IN)
Mihir Swarup Sharma, Director, Centre for Economy and Growth, Observer Research Foundation
11:35 - 11:45 (IN)
Dhruba Purkayastha, Advisor, Observer Research Foundation.
11:45 - 12:00 (IN)
12:00 - 12:55 (IN)
12:55 - 13:00 (IN)
Mihir Swarup Sharma, Director, Centre for Economy and Growth, Observer Research Foundation
13:00 - 14:00 (IN)
