The need to bolster financing for global climate adaptation efforts has ramped up to an unprecedented level. Estimated adaptation costs and needs for developing countries have risen to a staggering range of $215-387 billion per year this decade. Yet, attracting commercial climate financing to these regions remains a significant challenge. Institutional investors, who hold the bulk of commercial capital, tend to favor investment grade jurisdictions. Meanwhile, perceived risks, such as country risk, political instability, and macroeconomic challenges, continue to deter private sector investments into developing countries.
By mitigating these risks through mechanisms such as concessional capital, guarantees, and technical assistance, blended finance can be a transformative force for climate adaptation in emerging and developing countries, helping to leverage private financial flows to where they are needed most.
Overcoming the hurdles to boost blended finance for climate in developing countries involves ensuring flexible and patient capital flows, aligning concessional capital with broader risk mitigation strategies, addressing the macroeconomic challenges, and maximizing credit enhancements. It is important to scale these transactions to allow investors to be able to justify the cost of participating in these transactions. A clear adaptation taxonomy and metrics to evaluate adaptation finance can also help overcome some of these barriers.
Learning from Blended Finance Models:
Initially funded by the Ministry of Finance, FIRA is a second-tier development bank operating under Mexico's Central Bank. FIRA focuses on agricultural and rural sectors, providing crucial support through technological advancements, intermediary funding, and guarantees. Their multifaceted objectives encompass financial inclusion, heightened productivity, and climate sustainability, leaving a substantial impact on Mexico's agricultural loans.
Evolving from its origins as a centrally funded entity, FIRA now functions autonomously, collaborating extensively with international financial bodies and utilizing concessional capital to provide guarantees, structure transactions, and support non-bank intermediaries that cater to smallholders.
Key lessons gleaned from FIRA's journey in blended finance, with regards to environmentally conscious funding, underscore the advantages of its second-tier institutional approach. This strategy facilitates a more streamlined application of methodologies that effectively mitigate risks and actively promote environmentally friendly agricultural practices. Critical to FIRA’s success is the pivotal balance maintained in market prices, ensuring financial sustainability without distorting essential economic factors. Additionally, FIRA's far-reaching presence has been instrumental in aiding smallholders to craft marketable projects and facilitating the transfer of vital agricultural technologies. Collaborating not only with traditional banking institutions, but also with specialized non-bank intermediaries in rural areas, has significantly extended their financial reach, fostering impactful practices in these communities.
Another commendable model worth emulating is Aceli Africa, which functions as a blended finance facility that bolsters African financial institutions in supporting high-impact Agri-SMEs across Kenya, Rwanda, Tanzania, Uganda, and Zambia. Initiated with the backing of USAID, Aceli's inception stemmed from research that highlighted the heightened risk associated with Agri-SME lending, particularly in East Africa, where it was found to be twice as risky as other segments. To mitigate these inherent risks, Aceli strategically introduced innovative measures like a first-loss cover and origination incentives. Operating with a comprehensive framework encompassing financial incentives, technical assistance, and data-driven lending strategies, Aceli has achieved commendable early successes; fostering collaborations with diverse lenders; mobilizing substantial financial assets and witnessing positive shifts such as reduced interest rates and collateral requirements among partnering financial institutions. Aceli's impactful progress serves as a testament to the potential of blended finance in catalyzing significant transformations, particularly within sectors as vital as agriculture.
The Crucial Role of Supervisors and Policymakers in Embracing Blended Finance:
Blended finance transactions demand careful handling, emphasizing the need for meticulous management of various types of risks, like credit risks and operational risks. Policymakers need to ensure robust governance, transparency, standardized disclosure methodologies, and greater regulatory clarity, to align blended finance with financial stability objectives. Supervisors can also play a pivotal role in identifying spaces where blended finance can flourish, while ensuring the risks to the financial system are rigorously assessed and mitigated.
Aceli's learning report on the effect of central bank policies on lending to agricultural SMEs in East Africa highlights significant issues like IFRS 9's expected credit loss formula, capital adequacy ratios, loan classification, SME collateral requirements, and guarantee treatment. Aceli advocates for a shift in focus beyond mere risk evaluation and special regulatory provisions for agriculture, highlighting the need for nuanced policies, conducive to blended finance in emerging markets.
Important Takeaways for Supervisors and Policymakers:
Overcoming barriers to blended finance for climate solutions necessitates a multifaceted approach that addresses financial and non-financial risks. Policymakers and supervisors hold the key to creating an environment conducive to private sector participation, ensuring financial stability and sustainable development. Blended finance offers a path to steering private capital towards climate endeavors, but its transformative power requires vigilant risk management. Balancing investment pursuits with rigorous supervision, stands as a linchpin in charting a sustainable and resilient path forward, amid the dual challenges of climate change and economic stability.