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PICs need additional financial support from developed countries to build resilience to climate change while transitioning to a green economy
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Pacific Island Countries (PICs) comprise 14 nations that can be divided into three ethno-geographic groups: Melanesia, Micronesia, and Polynesia. Although PICs are close to each other in the same ocean, there is rich diversity in terms of culture, landscape, and climate. PICs are among the most affected by climate change and natural disasters. The adverse effects range from an increase in flooding and drought, cyclones, storms, land erosion, and coastal land loss, loss of biodiversity, and livelihood. The frequency and intensity of climate-induced events will continue to increase if global greenhouse gas emissions are not curtailed.
However, PICs have green transition plans that will not only push global efforts to limit global warming but also make these countries economically resilient. Green transition plans in these countries include investing in low-carbon businesses, including renewable energy and transportation, as these countries are heavily reliant on imported fossil fuels for their energy needs. Transitioning to clean energy will help these countries withstand rising and volatile fossil fuel costs, curb inflation, and save foreign exchange.
The frequency and intensity of climate-induced events will continue to increase if global greenhouse gas emissions are not curtailed.
To respond to climate threats, PICs require a large amount of capital over the next few years to build climate-resilient infrastructure. According to the International Monetary Fund (IMF), the average investment required by PICs for climate-resilient infrastructure alone would range from 6 to 9 percent of the annual GDP, amounting to US$1 billion annually for the next 10 years. The figure goes up further if Nationally Determined Contribution targets and mitigation flows are included.
Limited fiscal capacity and low per capita income hinder the capacity of countries to afford climate-resilient infrastructure and capital-intensive clean energy systems. PICs are dependent on external capital support, especially concessional public capital, to meet their climate finance needs, as domestic capital would not be enough for their climate actions. These countries face a substantial financing gap for climate transition, which could make the region vulnerable to climate change events and derail its green transition plans. Here, international public climate financers play a critical role.
In this article, we recommend some financial instruments that can be deployed in PICs. These instruments can leverage the power of public finance while meeting the specific financing needs of these countries. This will, in turn, help PICs to invest in climate-resilient infrastructure while supporting their green economic transition.
The increased intensity and frequency of climate events make PICs more vulnerable. Insurance solutions to mitigate extreme weather events can provide immediate financial support to countries, and local and vulnerable communities. Conventional insurance solutions cover damage from extreme weather events though putting in a claim for insured losses can be expensive and time-consuming, which is inconvenient for vulnerable communities that need immediate financial support. Hence, parametric insurance is a more suitable solution—it is a type of coverage that compensates the insurance policyholder based on a predefined event (e.g. hurricane), rather than providing a reimbursement after actual losses have been incurred. The key benefit of parametric insurance is quick payment processing. Parametric insurance premiums are costly, making them unaffordable for vulnerable regions. Development financial institutions and developed countries must provide subsidies and financial support to cover insurance premium costs. They can provide capital to institutions that provide parametric insurance solutions to frontier markets where the parametric insurance is non-existent. This will help lower costs, increase accessibility, and ensure that at-risk communities can benefit from timely payouts during climate-related disasters.
Insurance solutions to mitigate extreme weather events can provide immediate financial support to countries, and local and vulnerable communities.
Borrowing foreign capital is critical for PICs, but they face several challenges in garnering finance for climate action. One is currency risk—domestic currency depreciates more quickly compared to foreign currency, mostly observed in frontier markets[1], including PICs. This rapid currency depreciation makes borrowers vulnerable to service foreign currency debt holders. This risk is typically addressed by purchasing a currency swap in the market. Although a currency swap option is available for frontier markets, including countries in the Pacific, the cost is very high for these countries, discouraging them from borrowing foreign capital. One possible solution is subsidising the cost of the swap. Developed countries and foundations can provide capital to subsidise currency swap costs for borrowers in the PICs. An advisory service company can be hired to design the structure. The same model can be replicated in the least developed and small island countries.
As the name suggests, blended financing smartly blends private and concessional public capital to make the project attractive for private investors by improving risk-adjusted returns. There are certain businesses, such as renewable energy and clean transportation, that are close to commercially feasible in the PICs but still need some concessional financing to make them commercially viable to attract private financing. Here, blended financing can be used to deploy public capital to attract private finance. Public finance can be in the form of concessional debt capital, grants, and partial credit guarantees that can attract large-scale private capital for these businesses.
‘Debt for Climate’(DFC) swap (an offspring of debt swap) is another financial solution that alleviates immediate financial challenges of countries while supporting their green transition. Debt swaps are specifically designed for countries reeling under a debt crisis. The debt swap mechanism involves buying back existing debt at a discount or deep discount in exchange for undertaking certain measures by debtors. Especially, the usual mechanism of DFC involves the creditor forgiving or offering a deep discount with the condition that the debtor country invests in climate-friendly projects. Debt swaps infuse much-needed liquidity and reduce the debt burden, which can help these countries mitigate external vulnerabilities. Several PICs are incurring heavy debt burdens that keep them from spending on social and climate-resilient infrastructure. DFC swap can help them build a climate-resilient economy by accessing international finance that can be invested in climate-resilient projects while alleviating debt concerns. A contractual mechanism can be created that incentivises governments in these countries to invest in climate-related projects. For example, PICs can be incentivised to protect coral reefs that might be destroyed by climate change. The coral reefs in the region significantly benefit the Pacific and the world, contributing to biodiversity, the marine habitat, and the global fishing industry. DFC can be designed to incentivise the region to protect the area and, at the same time, contribute to global public good.
The debt swap mechanism involves buying back existing debt at a discount or deep discount in exchange for undertaking certain measures by debtors.
PICs need a structural and institutional transformation of their economies and societies to thwart climate events and achieve their climate mitigation goals. This transformation requires large-scale capital; however, capital mobilisation for climate action has fallen short. These countries need additional financial support from developed countries to build resilience to climate change while transitioning to a green economy. International public climate finance can play a catalytic role in filling this gap by using innovative financial instruments.
Labanya Prakash Jena is working as a sustainable finance specialist at the Institute for Energy Economics and Financial Analysis (IEEFA) and is an advisor at the Climate and Sustainability Initiative (CSI).
[1] Less developed markets compared to emerging markets
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Labanya Prakash Jena is working as a sustainable finance specialist at the Institute for Energy Economics and Financial Analysis (IEEFA) and is an advisor at the ...
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