Where Financial Innovation Meets Sustainable Development

Whenever the world’s financial and political leaders convene – whether at the G20 summit, the United Nations General Assembly, or the International Monetary Fund and World Bank annual meetings – the most urgent development challenges are nearly always on the agenda. 

Increasingly, the solution these leaders propose to such problems, from poverty alleviation and public-health crises to climate change and the energy transition, is more financing.

They are not wrong. Addressing each of these challenges requires more than a trillion dollars. For example, Latin America and the Caribbean need $2.2 trillion to invest in sustainable infrastructure, while emerging markets worldwide require $1.5 trillion per year for such projects. And much of this financing will come from multilateral development banks (MDBs), which have already started to use their balance sheets more aggressively.

But equally important is MDBs’ innovative deployment of instruments – including capital-market mechanisms, structured finance, and sustainability-linked bonds – to mobilize more public and private finance for such investments. Moreover, MDBs are offering guarantees, debt swaps, contingency financing without commitment fees, and climate-resilience clauses to client countries in exchange for commitments to mitigate greenhouse-gas emissions and protect nature.

To be sure, these instruments are not necessarily new. The Code of Hammurabi, which is nearly 4,000 years old, allows for the suspension of debt payments following a flood or drought. The use of green capital-market instruments dates back to at least the 1640s, when Dutch water boards issued perpetual bonds to finance improvements to local canals. And credit guarantees have existed since the nineteenth century.

The innovation is that MDBs have introduced these instruments into cross-border finance. Facilitating further progress requires ensuring that they are integrated into developing countries’ economic policies and become standardized – and thus replicable.

For many emerging and developing economies, balancing economic growth with poverty alleviation and climate objectives is the central challenge. Their governments must deploy the full range of available financial tools to combat global warming while ensuring that these efforts result in productivity gains and growth. Otherwise, their debt will become unsustainable.

The energy transition, for example, requires investing in renewables, expanding transmission networks to overcome the intermittency problem, and mitigating the risk of stranded fossil-fuel assets. 

In the many developing countries where utilities are financially constrained, the burden is unaffordable. Climate finance thus requires economic policymaking that considers the ability of consumers and taxpayers to repay these investments. Policies related to pricing, regulation, sector planning, and the investment environment will increasingly determine financial viability.

The dramatic increase in the frequency and severity of extreme weather also requires a shift in economic thinking. Finance ministers generally rely on emergency-response financing to rebuild after such events, based on the belief that catastrophes are few and far between. 

However, the most intense hurricanes are now more than three times more frequent than they were a century ago, droughts last longer, and more predictable events, such as seasonal storms, are increasingly severe. Worse, disasters – including pandemics – are increasingly overlapping.

Governments must therefore use proactive financial instruments – from loans that finance flood management systems to guarantees that support climate-change adaptation – to build resilience before extreme weather events occur. Each dollar spent on advance planning can save up to $13 in reconstruction costs when a crisis hits, minimizing emergency borrowing.

Another innovation is the standardization of available mechanisms. This includes clarity on their intended use, because markets must understand the benefits accruing from instruments that incentivize sustainable practices in order to price them properly. 

To that end, the United States Commodity Futures Trading Commission recently issued guidance for the listing of carbon-offset derivatives, and the International Sustainability Standards Board is focusing on developing green bond standards. If we want voluntary carbon markets to grow, and the price of green finance to reflect the real value of addressing climate change and supplying global public goods, then how such instruments are used must be verifiable and easily comprehensible.

The cost of not investing in climate mitigation and resilience, as well as other development goals, increases every year, making guarantees and insurance products ever more expensive in the most vulnerable and least prepared countries. MDBs should provide more green financing, but standardizing innovative instruments and encouraging their use in economic policymaking are just as important.

Jordan Schwartz is Executive Vice President of the Inter-American Development Bank.

Copyright: Project Syndicate, 2024.
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