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Introduction to Climate Finance in Developing Countries


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Written by: Alexander Tong, Felix Culas, Yee Tung Yeo and Yong Sin Ng

Edited by: Kah Yau Lim and Yun Qiu Wong

Edit: This post was originally published on July 16th 2023.

Climate change is one of the most pressing issues of our time, with the potential to cause significant impacts on our environment, economy, and society. Addressing climate change requires collective action, and financing plays a crucial role in this effort (The European Commission, 2023). Climate finance, defined as financing that supports mitigation and adaptation actions to address climate change, is a key component of the global response to this challenge.

Developing countries are particularly vulnerable to the impacts of climate change, such as rising sea levels, droughts, floods, and extreme weather events. These countries often have limited financial resources and inadequate infrastructure to adapt to the effects of climate change. Climate finance can provide the necessary funding for developing countries to transition to low-carbon and climate-resilient economies (Éléonore, Rob and Grantham Research Institute, 2023).

The United Nations Framework Convention on Climate Change (UNFCCC) was established in 1992 to address the global challenge of climate change. The UNFCCC recognises that developed country Parties have a responsibility to provide financial resources to assist developing country Parties in implementing the objectives of the convention. The Paris Agreement, adopted in 2015, reaffirms this obligation and encourages voluntary contributions by other Parties. The polluter pays principle is a key tenet of climate finance, which holds that those who cause emissions should bear the costs of its impacts. The principle of making polluters (emitters) pay can be implemented for greenhouse gas emitters by utilising a ‘carbon price’, which refers to a fee imposed on the release of greenhouse gases equivalent to the projected cost of potential damage caused by climate change, thereby compelling emitters to assume or internalise the financial burden of pollution. This concept is known as the Social Cost of Carbon (SCC), which is widely recognised by mainstream economists as the most effective means of pricing carbon. Alternatively, the carbon price can be established based on desired outcomes, including to achieve a specific emissions target by a certain date, such as net-zero by 2050. This is commonly referred to as a ‘target consistent’ approach. In either case, a financial incentive is created for polluting entities, such as factories, to reduce their emissions (Grantham Research Institute, 2022).

Like many emerging topics, there is no single definition of climate finance (Maya and Naurin Nuohan, 2016). However, the UNFCCC Standing Committee on Finance do provide a common definition on climate finance in their 2014 report (UNFCCC Standing Committee on Finance, 2014):

“Climate finance aims at reducing emissions and enhancing sinks of greenhouse gases and aims at reducing vulnerability of, and maintaining and increasing the resilience of, human and ecological systems to negative climate change impacts.”

Other than climate finance, there are several interrelated terms in the field. A good description of what each refers to is given by the United Nations Environment Programme (UNEP) (ISO Central Secretariat, 2022):

• Sustainable finance includes environmental, social, governance and economic aspects.

• Green finance includes climate finance but excludes social and economic aspects.

• Climate finance is a subset of environmental (green) finance.

Figure 1. Linkages Between Climate, Green and Sustainable Finance. Modified from ISO Central Secretariat (2022).

Climate finance can come from both public and private sources. Public sources include government funding, international aid, and multilateral development banks. Private sources include investment from institutional investors, such as pension funds and insurance companies, and impact investors who seek to fund projects with both financial returns and environmental benefits (UNFCCC, n.d.).

Enshrined in the 1992 Rio Declaration on Environment and Development in 1992, the Common but Differentiated Responsibilities and Respective Capabilities (CBDR-RC) principle recognises the historical responsibility of developed countries for climate change and their obligation to provide financial resources to developing countries. The Paris Agreement includes a mechanism for mitigation and a provision for climate finance, which calls for developed countries to mobilise $100 billion annually by 2020 to support developing countries (Ian, Euan and Atousa, 2021). However, the COP27 revision in 2022 fell short of reaching an agreement on the new climate finance target (Hodgkins, 2022).

Article 6.4 To contribute to the mitigation of greenhouse gas emissions and support sustainable development
Article 9.3As part of a global effort, developed country Parties should continue to take the lead in mobilising climate finance from a wide variety of sources, instruments and channels, noting the significant role of public funds, through a variety of actions, including supporting country-driven strategies, and taking into account the needs and priorities of developing country Parties. Such mobilisation of climate finance should represent a progression beyond previous efforts.
Table 1. Key content from the Paris Agreement on climate finance.

Article 6.4 of the Paris Agreement establishes a mechanism to support voluntary cooperation between countries in meeting their climate change goals, including mitigation (see Table 1). The mechanism allows for the transfer of mitigation outcomes from one country to another, creating opportunities for emissions reduction projects.

Article 9.3 of the Paris Agreement calls for developed countries to provide financial resources to assist developing countries in implementing their commitments under the agreement. The provision aims to mobilise $100 billion annually by 2020, with a focus on supporting climate mitigation and adaptation in developing countries.

Despite the challenges, progress has been made in climate finance. The Green Climate Fund has already mobilised more than $7 billion in pledges, and other initiatives, such as the EU’s sustainable finance taxonomy, are supporting the transition to a low-carbon economy. However, more needs to be done to ensure that climate finance is effectively and transparently used to support the transition to a sustainable and climate-resilient future (Directorate-General for Climate Action, 2023).

A quick recap:

What does climate finance include: Mitigation
On what basis?– The Polluter Pays Principle (PPP)
– Social Cost of Carbon (SCC)
Key Concept– Common but Differentiated Responsibilities and Respective Capabilities (CBDR-RC) principle
Common pricing methods (non-exhaustive)– Putting a price on carbon (carbon pricing)
– Invest in ways to reduce greenhouse gas emissions (i.e., carbon offset)
Sources of climate funds (non-exhaustive): Public funds:
– Green Climate Fund
– EU’s Sustainable Finance Taxonomy
– Compliance carbon markets
– Carbon taxonomy and border adjustment mechanisms
– Transnational climate pacts

Private funds:
– Voluntary carbon markets
– Climate-related loans

Role of Climate Finance in Developing Countries 

In the Southeast Asian context, climate finance is essential especially considering the projected adaptation costs in the future. Developing nations, being more vulnerable to climate change impacts, will face significant adaptation expenses, ranging from 1% to more than 10% of the nation’s GDP in 2030 (Aligishiev, Matthiew & Emanuele, 2022). Climate finance plays a crucial role in supporting these countries by providing financial resources and technical assistance for climate adaptation and mitigation.

Development of financing solutions for climate mitigation is also a key aspect of climate finance. By encouraging financing transactions to incorporate Environmental, Social, and Governance (ESG) and climate-related risks into credit risk assessments, climate finance ensures that investments are directed towards sustainable and low-carbon projects.

In Malaysia, financial institutions are emerging as key drivers of capital flows in the transition towards a greener and more sustainable future. Recognising the significance of integrating climate considerations into their operations and investment decisions (Yap, 2022), these institutions are actively taking steps to embrace sustainable practices. At the national level, both Bank Negara and Securities Commission Malaysia have joined forces to establish the Joint Committee on Climate Change (JC3). Comprising members from various financial industry players, the JC3 aims to foster collaboration and build climate resilience within Malaysia’s financial sector. This collaborative effort underscores the shared commitment of these institutions to address the challenges posed by climate change. 

The growing adoption of green financing principles by financial institutions also has indirect positive effects, encouraging the market to prioritise climate change mitigation and ESG factors. A noteworthy example of this trend is Bursa Malaysia’s launch of the Bursa Carbon Exchange. This innovative platform facilitates transparent voluntary market exchanges of high-quality carbon credits, effectively promoting carbon avoidance and removal projects in the region (Chhabria, 2023).

Technical assistance is another crucial aspect of climate finance. It involves capacity building, knowledge sharing, and technology transfer to support developing countries in implementing climate change projects effectively. Technical assistance for developing regions is often funded by developed countries, international organisations, and private entities. For instance, developed countries such as the UK have utilised funding from the International Climate Finance to provide GBP 12 million worth of technical assistance programmes to assist middle-income countries in reaching their national climate plans and Nationally Determined Contributions (Climate finance accelerator, 2023). More examples of climate finance opportunities available with technical assistance can be viewed here.

Capacity building programmes enhance the skills and capabilities of local institutions and communities to manage climate-related risks and implement adaptation measures. Knowledge sharing initiatives facilitate the exchange of best practices, lessons learned, and scientific research, enabling countries to make informed decisions. Furthermore, technology transfer facilitates the adoption of cleaner technologies and sustainable practices, enabling developing countries to transition towards low-carbon economies. Importantly, climate finance serves as the financial backbone for these vital programs, ensuring that developing countries have the necessary resources to implement and sustain these initiatives effectively.

Challenges and Opportunities in Climate Finance for Developing Countries 

The article has raised points on the importance of climate finance. However, before countries and institutions can utilise climate finance to support their efforts, they must access it. There are challenges with climate finance access in terms of funding gaps, application and disbursement mechanisms, and obtaining the necessary buy-in. 

Firstly, there are substantial gaps in the pledged versus actual amount of climate finance provided by developed countries. For example, the Organisation for Economic Co-operation and Development (OECD) estimates that only $83.3 billion was mobilised in 2020, 16.7% short of the target of “$100 billion per year by 2020”, set at COP15 in 2009. 

Second, the process to receive climate finance is complex. A study by the Independent High-Level Expert Group on Climate Finance (IHLEG) found that countries with low risk profiles tend to have easier access to climate finance. These tend to be middle-income countries, while low-income countries have a more challenging time securing funds. Additionally, the applicants are expected to navigate a layered application process to gain access to the funds. 

Third, there is debate and discussion over what is the adequate level of funding that should be pledged and delivered by developed countries. For example, there are differing perceptions on whether climate finance should be seen as ‘aid’ or ‘entitlement’; there are different answers depending on which side is asked. 

In conclusion, climate finance is vital for supporting climate change mitigation and adaptation in developing countries, offering financial resources, promoting sustainable investments, and providing technical assistance. Nevertheless, the existence of funding gaps, complex application processes, and varying perceptions of funding adequacy pose significant challenges. By addressing and overcoming these obstacles, we can unleash the complete potential of climate finance, enabling the effective implementation of measures to combat climate change in developing countries.


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