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Is Climate Finance Fixable?

Climate finance is a disaster. COP29 ended with a hotly contested and almost universally loathed agreement for rich countries to provide $300 billion each year to developing countries, to defray the costs of adapting to and mitigating the effects of anthropogenic climate change. Commentators from the developing world (and my colleagues) have been scathing in their assessment of the inadequacy of this deal. My colleague Charles Kenny has described the existing structure of climate finance as “the worst of all worlds,” that disadvantages the poorest countries. He argues that the greater legal and political standing for climate finance, compared to development finance and the tight-fisted attitude of rich countries means there is no good solution available. All of this has roots in one of the most pernicious errors that development and climate activists routinely make: the misapprehension that because two things are both good things for the world, and matter very much for poor countries they need to be tackled together, through the same mechanisms.

But the stakes here are high. Both global poverty and development and climate change are too important for human welfare to accept that both will just be done badly for the foreseeable future. In this piece, I do four things. I set out the underlying economics that make action against climate change and its negative consequences complicated to fund; I explain what a perfect—utopian—financing structure would look like and how it differs from what we currently have in place; I look at what trade-offs must however be confronted under the existing set up; and I make three specific recommendations that would at least improve matters for now.

Econ 101 for climate action

There are two things we do in response to anthropogenic climate change: deal with it, and try to stop or reverse it.

Dealing with it is what’s known as adaptation; working out how to maximise welfare despite an expected increased frequency of storms (or drought, or heat). If, for example, we expect a place to become drier or for rainfall to become more variable, how should we best respond? The range of possible adaptations to this change is wide, and the only thing they have in common is that they all aim to make sure people affected by the change in climatic conditions have the best life possible. They could switch to more resilient crops or seed varieties of the same crop, protecting yields and returns to farming; we could collectively invest in irrigation so that variation in rainfall matters less for farmer outcomes; they could build roads connecting to areas that are less affected by climatic changes (or affected by a different pattern of climatic changes), so food crops can be traded from areas with relative abundance to those with shortages, dampening the effect on food security. We might alternatively help people take non-agricultural jobs that depends less on the weather and provide better livelihoods; or even just to move to different parts of the country or world. We could even simply give them cash every year to increase their economic freedom to do any of these things. Ultimately, higher incomes and better post-change welfare are the object of adaptation—whether or not the actions taken are a direct response to the changing climate.

Adaptation is inherently flexible. The optimal adaptation strategy will vary by hazard or stress, over time and across communities and individuals. Economically, adaptation strategies can be private (that is, an individual moves or changes the seeds they sow, or switches jobs, and reaps the benefits of that change) or collective (for example, a road that benefits a whole community is built, or irrigation schemes are implemented). The benefits of adaptation are, however, local: they are not global public goods, in that adaptation in one place benefits only that place. Nevertheless, there are clear economic reasons to intervene to support adaptation. Intervention can be justified by imperfect information (often, individuals and communities do not know what the right actions to take, or how the climate is changing); imperfect credit  markets (they cannot borrow to undertake adaptive actions); coordination failures (if adaptation requires collective action that is difficult to achieve); or equity (if those worst-affected are the poorest, and the richer individuals or countries feel or have some moral obligation to support them). Intervention may also be justified in upstream markets: for example to support the development of technologies that widen the adaptive choices available, if those technologies are underprovided by the market. Each of these justifications is generally stronger in and for lower income countries.

Ultimately, all adaptation is a form of development (and, if higher welfare post-changes to the climate are the objective of adaptation, vice versa). Adaptation is not difficult to fund; the problem is that it is difficult count: virtually anything that improves human welfare given expected changes in the climate is a climate change adaptation.

The economics of mitigation are completely different. Climate change is a global public bad: actions that contribute to it through the emission of greenhouse gases affect all countries, in ways that they cannot control or opt out of. Actions that reduce emissions or remove greenhouse gases from the atmosphere then provide a global public good: they reduce the severity of anthropogenic climate change for all countries, in ways they cannot be excluded from, and in ways that do not depend on how many countries in the world are benefiting from them. But the investments that generate these public bads or goods are not themselves public bads or goods. A green energy project that displaces dirty energy generation in country X, for example, is both excludable, since other countries can easily be prevented from benefitting from it, and rival in that use of the energy generated or stored by one country or person means less is available for others. It is only the externality of the project—the emissions displaced—that is globally non-rival and non-excludable (the two characteristics that define a public good). That means that advancing the global good requires providing private goods in specific places. Coupled with the fact that the externalities to providing these private goods are not the same size everywhere, these economic characteristics of mitigation have three consequences:

  1. First, a mitigation project only contributes to the global public good if it actually displaces or removes greenhouse gas emissions. That is, a new green energy plant in Malawi—in the absence of any concrete plan to generate energy using a carbon-emitting fossil fuel source—is not a climate mitigation project, but simply a national private good. But a green plant in China that displaces coal power (either existing, or that would otherwise have been built to fulfil the same energy demand) does contribute to the global public good, so long as the coal power would not have been displaced anyway on purely private economic grounds (for example, if it was so much cheaper to provide energy using renewable sources that decommissioning existing power generation or replacing it with stored renewables makes economic sense).
  2. Second, since the global public good/bad aspects of climate change are completely place-independent (a ton of carbon abated in the US is the same as a ton of carbon abated in Nigeria, or China for that matter), action to bring about the global good of climate change mitigation can happen anywhere a project has large global public good implications.
  3. Finally, scale, not breadth, matters. That is what determines the good achieved by mitigation finance is entirely determined by how much greenhouse gas is removed from the atmosphere (and how fast), not how widely these improvements are spread.

Collectively, these characteristics suggest that the justification for public investment is strongest where the greatest (but cost effective) impact on emissions can be made: this is generally in richer middle-income countries, or high-income countries which are yet to substantially decarbonise industry and energy systems.

Utopian climate financing

Given the very different economics of adaptation and mitigation spending, what would optimal climate finance look like? Public finance should only be used where there is an economic case for it; and how it is used should be determined by the nature of this case.

For adaptation the case for public finance is strongest in low-income countries (where credit market failures are most severe, the market is least developed and able to provide technological solutions, and where the equity case for spending is strongest). And since optimal strategies for adaptation are inherently heterogeneous (that is, different people at different times and with different preferences will choose to adapt in different ways), it should be judged by the outcome achieved, rather than the method used to achieve it. The outcome should be income or welfare, and results should be compared to a counterfactual trajectory under changed climatic conditions, without the proposed adaptive action. That means that almost anything should be able to count as adaptation, provided it has the effect of improving welfare, compared to the existing trajectory, given expected climate trends. So, policies that make movement easier are adaptation strategies for people who want to move to avoid climate stress. Cash transfers or routine social protection support are adaptation when they allow people to invest in lessening the effect of climate disasters or even just slow changes to the climate. Mechanisation of farms is adaptation if it maximises the expected welfare of a farmer given the changes to the climate expected, even if the same strategy is optimal in the absence of any change to the climate. What matters is that the action is taken to improve the welfare of those who are vulnerable to climate change, and that it works. The finance would be place-specific, targeted at those who would benefit and for whom market failures and equity concerns dictate support be channelled to.

Optimal mitigation finance would look totally different to this. The benefits of mitigation are totally place-independent. What we care about is whether an investment displaces emissions, or removes them from the atmosphere. We care about the scale of such changes, and we care about how much it costs (with broad economic costs considered, including any opportunities foregone). This suggests a mitigation finance approach that allows for spending anywhere, so long as it achieves sufficient net emissions reduction, at sufficiently low cost. The precise activities would be determined based on the scale and costs versus the net emissions reductions expected. That could include everything from intensive investment in the development and scale-up of green technologies that displace emitting technologies on price and effectiveness grounds (so cheap renewable energy generation, storage solutions for renewables and transmission systems; or decarbonised industrial processes that beat traditional processes on cost and quality); accelerated displacement of legacy capital (which could also be achieved by negative finance, i.e. a carbon tax); or specific solutions to problems like stubble burning in South Asia, which is a major emitter and which some solutions to involve simply paying farmers not to burn. It also suggests that spending would be internationally coordinated: solving some of these problems, including bringing technologies to market at scale, will involve very large initial investments. Given the non-rival and non-excludable nature of the benefits to displacing emissions, it makes sense for all funders to pool their resources and then allocate them according to impact and cost, rather than to have their own micro-strategies and funding approaches.

Where would this money come from? Adaptation financing and development aid, done well, should be virtually indistinguishable. Good social protection, public investments, and expanding the effective space of individual choice (including through growth and job creation) are all good adaptations that are part of mainstream development thinking. If anything, adding adaptation simply makes development slightly more expensive, as the need to understand and respond to the changing climate adds a layer of complexity to spending choices.

Mitigation, on the other hand, would need a new funding mechanism; something much more akin to UN assessed contributions than to the voluntary structure of aid spending. It could not be merged with aid spending because so many of the most impactful investments will not be in or for developing countries. Doing mitigation well may involve some investments in poor countries, with local benefits that have some overlap with the traditional domain of aid spending, but this is not a necessary characteristic of public financing for mitigation.

Impossible trade-offs

This is not remotely what existing climate finance looks like. Climate finance was developed through a political process, not a technocratic one, and the pursuit of political aims has forced the adoption of a bad system. Higher-income countries, wanting to minimise their fiscal effort, pushed for all international climate money to count as foreign aid. Lower-income countries, pursuing their objective of maximising the amount of overall funding available to them, demanded that public international finance be “new and additional” to existing development aid. Well-meaning global institutions adopted definitions of adaptation and mitigation financing (including measuring whether spending was “principally” or only “significantly” about either of these) that make it harder to count existing activities as either, to encourage new money to flow.

The result is a complete mess, with unhelpful distortions and trade-offs that we have forced ourselves into making. It deviates from the optimal situation (outlined above) in four important ways. First, by limiting the overlap between “development” and “adaptation”, we distort resource allocation choices away from the most effective adaptations that will actually help the poor. Cash transfers are a key form of adaptation but are not always counted as such; roads, which can be critical to adapting when volatile weather affects food shortages are also often omitted. And by defining “principally” and “significantly” targeted finance by its intent, we distort effort away from impact. A road that is built primarily to smooth trading may nevertheless be a better adaptation to the same climate hazards than a basic irrigation channel that is built primarily to protect against drought. When donors aim to meet a numerical target but find some high impact activities don’t count, they meet the target in less-good ways.

Secondly, it forces an unresolvable trade-off between mitigation and development. Since both the location and the specific activities of many of the best mitigation actions are different to those of the most welfare-improving development actions, we are, on average forced to choose between good development work and good climate action. If we choose to protect the quality of climate spending, much of it will be in places where we cannot realistically do anything about development. If we choose to protect development, much of it will be in places or on things that do not matter for the climate. The middle ground, to compromise the quality of both, is the tepid bath in which we currently wallow.

Thirdly, we spend far too little on affecting relative prices. To make a serious dent on mitigation, absurdly large amounts of investment are required. The only serious way of getting there is to make it cheaper for the private sector to go green and to retire emitting technologies on price grounds. Since carbon prices and taxation show few signs of springing suddenly to life at levels necessary, this means needing to make green tech much cheaper and much better than emissions-heavy tech. We can do (or at least accelerate) that through investments in innovation and scaling but to work, these investments need to be geographically neutral—which makes it hard to call them aid.

And lastly, because aid has traditionally been organized through a mix of individual bilateral programmes and a large number of multilateral organizations, the money is too fragmented. The few really market-moving, serious big investments we can do are much less likely to happen because each pot of climate money, on its own, is small potatoes.

Better is achievable

Politically, there is no way of achieving the utopian outcome. Doing so on mitigation would almost certainly mean throwing the world’s poor under the bus, effectively rerouting a large chunk of what little development aid that actually makes it to them to mitigation efforts in richer places. Nevertheless, there are three practical steps we can take to improve climate finance.

The first is simply to stop defining adaptation finance through effort: focus only on (expected) impact, measured through welfare given a climate path. This means abandoning the “principal” or “significant” markers, and accepting that adaptation finance will be used to finance things that would otherwise have happened already. That is ok: those things are the things we should be doing most of all. We should not disincentivize them.

Secondly, pool mitigation spending much more. There will be a huge fight over this, but it makes sense. The World Bank should focus on poverty and growth; any mitigation money it spends should be rerouted elsewhere. Wherever it lands (and the Green Climate Fund should be a leading option, simply because it actually reports on the effectiveness of its spending), it should focus on doing big, market moving investments. The volume of mitigation finance can fall but its effectiveness can increase through this step.

Finally, shift the narrative. Mitigation efforts in tiny places with virtually no emissions footprint are a waste of time and an embarrassment. Let them focus on development; and use climate money to solve technological problems so when they do scale up energy use, it can be done as cleanly as possible.

The radical version of the first two of these suggestions is to stop having any adaptation financing target, subsuming it entirely under the development budget, and to shift effort towards advocating for development aid as “preparedness for a changing climate”. Done well, this should not change the optimal actions undertaken (they are the same for adaptation and development), but would possibly be more effective in raising funds. This could be supplemented by negotiating a separate, smaller mitigation fund, used exclusively for the development and pricing of technologies, and the accelerated replacement of dirty tech.

This is achievable. Not immediately, but in the medium term. But only if the political fights over climate and development spending begin to take the economics of it seriously.

This blog has been improved by comments and criticisms from Charles Kenny, Malcolm Smart and Ian Mitchell. All views, errors and omissions are my own, however.

Disclaimer

CGD blog posts reflect the views of the authors, drawing on prior research and experience in their areas of expertise. CGD is a nonpartisan, independent organization and does not take institutional positions.


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