Securing Climate and SDG Financing is Only Half the Battle

There is a broad consensus that achieving the Sustainable Development Goals (SDGs) and addressing the costs of climate change in developing countries will require substantial financial resources. But just how great are the needs? Estimates converge on trillions of dollars annually (Table 1). For instance, the G20 Independent Expert Group estimated last year that achieving these goals will require a staggering $3 trillion in annual additional spending between 2025 and 2030. The Independent High-Level Expert Group on Climate Finance projects comparable amounts, with increasing costs in later years if resource flows fail to materialize by 2030.

The G20 Independent Expert Group envisions that a sizable portion of these resources will originate from higher taxes in developing countries and from the private sector. However, a significant share—around $500 billion annually—will still need to come from external official development finance, which includes non-concessional bilateral and multilateral finance.

In this blog post, we argue that while mobilizing additional financing is challenging, effectively absorbing and utilizing these additional resources presents an equivalent challenge for recipient countries. Our analysis reveals that for many low-income countries (LICs) and low-middle-income countries (LMICs), the volume of incoming funds would vastly exceed current levels of revenue, expenditure, and external financing. This underscores the urgent need to focus on enhancing institutional and operational capacities in recipient countries to ensure resources are utilized effectively and achieve their intended impact.

Allocating additional flows to low- and lower-middle-income countries

To illustrate the scale of the challenge, we estimated annual additional inflows that a typical LIC and LMIC would need to absorb if the $500 billion in annual official development finance flows were allocated among recipient countries. Following the G20 Expert Group’s approach, we assume 60 percent of funds are allocated to climate adaptation and mitigation and 40 percent to achieving the SDGs. The allocations to countries are based on the following considerations:

For SDGs: Funds for SDGs were allocated based on the number of people living below the international poverty line ($2.15 per day) in a country. We adjusted for purchasing power differences given that the cost of meeting the SDGs is not the same across countries (i.e., hiring a teacher is much more expensive in Argentina than Burundi). To do so, we divided a country’s GDP in US dollars by its GDP in PPP dollars. This gave us an adjustment coefficient, which was then multiplied by a country’s population in extreme poverty taken from the World Bank. New finance was then distributed based on each country’s price-adjusted extreme poverty population as a share of the whole.

For climate change: Allocations were based on a country’s population, climate vulnerability, and readiness for adaptation as indicated by the Notre Dame Global Adaptation Initiative (ND-GAIN) index. ND-GAIN index scores range from 0 to 100, with higher values representing greater readiness and lower vulnerability of a country. We divided the group’s average ND-GAIN score by each country’s score to obtain an adjustment coefficient for each country (so that if a country’s ND-GAIN score were lower than the average, implying greater needs, they would get more finance, and vice versa). Each country’s adjustment coefficient was then multiplied by its population. New finance was then distributed based on each country’s climate-adjusted population as a share of the whole.

Our findings reveal that for a typical LIC, the additional inflows would amount to over 30 percent of GDP annually, significantly exceeding current revenue and expenditure levels as well as official development assistance (Figure 1). In some LICs, the annual inflows will exceed 40 percent of GDP (e.g., Burundi, Central African Republic, Democratic Republic of Congo, Madagascar, Malawi, Mozambique). For LMICs, the challenge appears more manageable, with additional aid constituting around 5 percent of GDP on average (Figure 2).

These estimates align with the IMF’s projections made in 2019, which indicate that LICs require additional resources amounting to 16 percent of GDP annually to achieve the SDGs in five key areas (education, health, roads, electricity, and water and sanitation), while emerging markets (including LMICs) require about 4 percent of GDP. In a 2021 analysis, the IMF indicated that these costs have increased in the aftermath of the COVID-19 pandemic. It is important to note that the IMF estimates exclude financing needs for climate adaptation and mitigation and cover only five key SDGs.

Are LICs and LMICs ready to effectively spend more?

To explore this question, we analyzed data from the Public Expenditure and Financial Accountability (PEFA) framework, using scores from 31 indicators. These indicators assess the strengths and weaknesses of a country’s public financial management (PFM) systems across areas such as the transparency of public finances, accountability, and reporting. PEFA scores range from 1 to 4, with 4 indicating an effective PFM system.

Figures 3 and 4 depict the relationship between PEFA scores and estimated additional resource inflows for LICs and LMICs. The data reveals a generally negative correlation between PEFA scores and external inflows: countries receiving more funds tend to have relatively lower PEFA scores. Only a handful of countries have scores above 3, highlighting significant room for improvement in the absorptive capacity of their PFM systems. For example, countries with high-quality PFM systems tend to have the lower maternal, under-five and noncommunicable diseases mortality. They also have higher growth and improved service delivery.

This finding highlights the urgent need to strengthen PFM systems in recipient countries to ensure that additional resource flows are efficiently used to achieve development objectives. It also emphasizes the importance of capacity-building support from development partners, including the IMF, World Bank, and multilateral development banks, in enhancing PFM capabilities.

Macroeconomic management challenges

Policymakers in LICs and LMICs are likely to face two macroeconomic challenges, particularly concerning the impact of increased aid on the exchange rate and domestic revenue collection, which will need to be managed by a country’s policymakers. Additional aid is likely to raise demand for both imports and domestically produced nontradable goods, including public services such as healthcare and education. This will lead to upward pressure on the prices of nontraded goods and the familiar “Dutch disease” of an appreciation of the real exchange rate, hurting tradeables vis-à-vis exports. While these effects may be mitigated over time if higher aid inflows stimulate the supply side of the economy, some inflationary pressures will still need to be managed.

Another challenge is ensuring that increased concessional external flows do not undermine domestic tax collection efforts. Higher aid can undermine the incentive for making politically difficult but necessary changes in tax systems, such as reducing exemptions and broadening the tax base. Between 2012 and 2022, tax-to-GDP ratios in LICs and LMICs stagnated, making it even more important to ensure that domestic taxation plays its intended role in financing the SDGs and the climate transition, alongside concessional flows.

It is crucial for the international community to support LICs and LMICs in securing additional concessional financing for the SDGs and climate transition. On November 24, COP29 announced that developed nations will transfer at least $300 billion a year by 2035 to facilitate the green transition in developing countries. Our analysis assumes a $300 billion increase in official external finance for climate, underscoring the importance of ensuring that these funds are used effectively to achieve the intended outcomes. This necessitates a dual focus—not only on securing additional financing, but also on strengthening the institutional and operational capacities of recipient countries.

We wish to thank Mark Plant for helpful comments.