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How ‘Climate Investment Traps’ Create A Vicious Cycle For African Nations

The high cost of accessing sustainable investment is preventing developing countries from decarbonizing their economies, but levelling the finance playing field could help accelerate poorer nations’ climate readiness by a decade, new research has shown.

In the race against time to cut emissions and prepare for the effects of global warming, nations are seeking to decarbonize their economies in ways that bring multiple benefits to their people. But the report, from University College London (UCL) and published in the journal Nature Communications, finds that developing countries could be caught in “climate investment traps,” whereby the higher cost of capital in those countries combines with increasingly extreme climate impacts to make credit even less accessible. The effect of these traps will be felt most acutely in the poorest African nations such as Madagascar, which is currently undergoing a catastrophic, climate-driven famine (link may be paywalled).

The scenario exemplifies the phenomenon of climate injustice: simply put, the nations that have done the least to cause climate change are those that will suffer most from its effects, as highlighted by the Intergovernmental Panel on Climate Change.

But the UCL report reveals that making adjustments to the way big financial institutions provide money to these nations could break this cycle, accelerating a green transition in the developing world by a decade.

Lead author Nadia Ameli, principal research fellow at University College London’s Institute for Sustainable Resources, told me that while some observers have predicted the developing world—in particular Africa—could become a “renewables powerhouse” owing to an abundant supply of renewable resources, financial realities had often not been taken into consideration.

“There is a belief that, with the dramatic decline in the cost of renewables and the abundance of natural resources such as the sun, it will be much easier for the developing world to decarbonize,” Ameli said. “However, one of the biggest challenges in sustainable energy transitions is likely to be precisely in developing countries, given the difficulties that many of these countries have in accessing and securing capital on the same terms.”

It’s now widely accepted that investing in a low-carbon future can bring huge rewards, both environmentally and financially, for any nation willing and able to upgrade. 

But Ameli and her colleagues note that the cost of capital is far higher in poor countries than it is in the West, owing to huge differences in everything from macroeconomic conditions to business confidence and legal infrastructure. 

“This is why, in order to invest in risky contexts, investors will demand higher premiums and interest rates and developing countries will find it very difficult to secure and access capital,” Ameli explained.

To arrive at their conclusions, Ameli’s team modelled the effects of changes to what’s known as the weighted average cost of capital, or WACC, which indicates variations in the costs of investment in different regions.

In some African nations, such as Congo, Madagascar and Zimbabwe, the cost of capital can reach 30%, while in wealthy countries such as Germany and Japan, the cost can be as low as just 3%.

“The geographical distribution of low-carbon finance, defined as capital flows directed towards low-carbon interventions with direct greenhouse gas mitigation benefits, is highly unequal,” the authors write. Developed countries are “by far the largest recipients” of climate investment money, while African nations and central American countries like Mexico receive only a small proportion.

The scenarios modelled show that reducing the WACC by 2050 “would lead to an almost 50% increase in low-carbon electricity generation by this time,” and further “would also allow Africa to reach net-zero emissions roughly 10 years earlier.”

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In discussing their findings, the authors consider what should be done to lower the cost of investment and break the cycle. They note that the sustainability performance of companies tends to lower the cost of capital, “which would prefigure a virtuous loop with the cost of capital gradually dropping as firms become increasingly present in low-carbon energy.” Yet the EU’s Sustainable Finance Action Plan, described as the most ambitious sustainable investment plan available, “overlooks the impact of financing and investment outside Europe and towards developing economies in general.” China’s own answer to the plan goes somewhat further, “defining how Chinese financial institutions may foster low-carbon finance overseas through green bonds, South-South cooperation and the Belt and Road Initiative.” But none of the plans currently in place specifically target developing economies.

The UCL researchers recommend the development of local green bond markets in developing countries, supported both by governments and the big international development banks.

They also suggest that wealthy countries and multilateral development banks should coordinate their efforts more closely to focus on “large-scale low-carbon investments instead of multiplying small projects not achieving transformational impact.”

Lastly, they say, the International Monetary Fund (IMF) should play “a core role in facilitating developing countries’ access to low-carbon finance,” highlighting other studies that suggest the IMF should take steps to include climate risk analysis in its monitoring activities, and specifically support climate-vulnerable countries suffering debt sustainability problems.

“We don’t believe it is fair that regions where people are already losing their lives and livelihoods because of the severe impacts of climate change also have to pay a high cost of finance to switch to renewables,” Ameli said. “Radical changes in finance frameworks are needed to better allocate capital to the regions that most need it.”

Such finance was a hot-button issue at the recent G7 meeting of rich nations. But by the end of the summit, the member states had conspicuously failed to reach an arrangement on how and when they would deliver on a 12-year-old promise of $100 billion per year in sustainable finance to the developing world.

The UCL paper can be viewed here.

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