In This Content
A. Context
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.
There is a difficult choice for governments in the Global South that want to increase climate finance for their most important projects.
They are encouraged to borrow in hard currency, particularly US dollars, in order to access global markets. However, high levels of sovereign FX debt deter many governments from doing so, as additional borrowing risks further downgrades their credit ratings. Several nations already have hard currency accounting for three-fourths of their long-term debt. In the meantime, those who wish to borrow in local currencies must pay 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. In most developing nations, local capital markets are insufficient to finance the necessary speed and scale of the climate transition. 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. In emerging markets, independent project producers must frequently borrow in hard currency while their future income streams, which frequently consist of end-user tariffs, are denominated in local currency. Due to this mismatch, project developers or state power utilities bear more risk. 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.
The currency hedging solution TCX and the energy FX coverage facility ERCF are two examples of mechanisms that already exist. 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. The establishment of a brand-new facility and institution ought to be one of the other options that are considered simultaneously. 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.
B. Guiding Questions
- How do climate finance flows become distorted by currency risk? How can we redistribute transaction costs and risks among governments, private lenders, project developers and utilities?
- How can MDB reforms as proposed be leveraged to increase climate finance flows to developing world and manage currency risk for cross border climate finance flows?
- Which institutional mechanisms offer the most promise for hedging currency risk in climate finance, and what trade-offs do they have in terms of cost, scale, and sustainability? Examples include TCX, ECRF, Eco Invest Brazil.
- In what ways can India leverage its global green finance initiatives taken from G20 leadership such as Triple Agenda, Green Pact etc. and intergovernmental institutions like ISA and CDRI and relatively low FX debt to increase demand for rupee-denominated green finance, protect renewable projects from currency shocks, and position itself as a climate finance leader for the Global South?
- What lessons can be drawn from existing mechanisms such as TCX, ERCF, Brazil IDB FX Risk Management Facility and how can currency swaps be used to design large-scale solutions?