Green transition: poorer countries need resources – 06/20/2023 – Martin Wolf

Last week I discussed the dire financial situation of the poorest countries. This week’s “summit for a new global financial compact” in Paris provides an opportunity to address this challenge. It also presents the chance to make the necessary investments to transition to a low-emissions economy.

That is the focus of a new paper by Avinash Persaud, who advised Prime Minister Mia Mottley of Barbados on the influential Bridgetown Agenda for Reforming the Global Financial Architecture. In “Unlocking Green Transformation in Developing Countries with a Partial FX Guarantee”, he looks at how to make sufficient affordable finance available for renewable energy projects in emerging and developing countries, an issue also considered in last year’s expert group report, Finance for Climate Action.

Over the past 270 years, Europe and North America have contributed over 70% of the anthropogenic stock of greenhouse gases. It also depleted almost the entire carbon budget of the planet. But today emerging and developing countries generate about 63% of emissions, a percentage that tends to grow. It concludes that not only must there be large cuts in emissions, but a large part of these cuts, particularly in relation to the trend, must be made by emerging and developing countries. To achieve this, green transition investment in these countries (excluding China) needs to reach around $2.4 trillion per year (6.5% of gross domestic product) by 2030.

In high-income countries, 81% of green investment is funded by the private sector. In emerging and developing countries, private participation is only 14%. It is highly unlikely, even with a successful outcome at this week’s summit, that official foreign assistance will do as well. As Persaud notes, “Global aid spending is less than a tenth of the cost of green transformation.” Furthermore, “developing countries do not have room on their balance sheets for the necessary debt, even if they themselves want to finance it”.

The solution is to secure private funding for potentially profitable projects, which accounts for around 60% of the required investments, with the remainder for things like adaptation. This will not bring direct financial returns and therefore must be funded by official assistance. But, notes Persaud, even where projects are bankable, in theory, the punishingly high interest costs for private loans to emerging and developing countries are prohibitive obstacles. So for a similar solar farm, the average interest cost in major emerging countries is a prohibitive 10.6% a year, versus just 4% in the EU.

However, argues Persaud, the cause of this huge spread is not project-specific risk. A solar farm, as a solar farm, is no more risky in India than in Germany. More than anything, the risk premium represents market estimates of macroeconomic risks (specifically, currency and default). He also argues that these risks are not only exaggerated but also cyclical: in “risky” periods, insurance overpayments are lower than in “riskless” periods.

The document calculates this by looking at the cost of hedging currency risk. This is expressed in terms of the difference between the purchase price of foreign currency with local currency in the future (forward rate) and today (spot rate). This gap can then be turned into an annual fee.

The conclusion of the evidence is that markets are very risk averse: the risks are not as great as they fear. This is particularly true when markets are more risk averse: on average, the “overpayment” for hedges was 2.2 percentage points when their cost is below the three-year moving average, but 4.7 percentage points when the cost is above the moving average.

In short, Persaud argues, we have a free lunch: a stabilizing speculator could make money while doing good by removing excessive risk premiums.

Why does such a free lunch exist? Investors may just feel uncomfortable with unfamiliar markets. They may also be dissatisfied with these volatile markets. In addition, stabilizing speculators need to take large contrarian positions for long periods. Funding such positions to the required scale is risky: it’s easy to run out of cash long before the market makes sense. For these reasons, markets will persistently overvalue hedges.

As Persaud puts it, “Private investors are leaving money on the table. But even more significant are the far greater social gains from… promoting green growth in developing countries that are being bypassed.” This is a “planet-sized” market failure.

His proposal then is that a joint agency of the multilateral development banks (MDBs) and the IMF offer guarantees in foreign currency and a pool of exchange rate risks. Projects could range from BMDs to the guarantee agency. The guarantee agency could then prioritize projects that have the greatest positive impact on the climate. To limit the risks of loss, the agency would wait until the coverage costs are above the three-year average and, therefore, until the risks are considered large.

In short, this smart work makes four points: first, macroeconomic risk makes climate projects unfinancable in developing countries; second, the global climate challenge cannot be met if these projects are not funded on a large scale; third, markets exaggerate these risks, especially in bad times; and, finally, the expected gains from official intervention would exceed the costs, in part because the stakes are high.

If you are not persuaded by this logic, what is your plan for financing the huge investments the world needs? After all, climate change will not be resolved with investments made only in rich countries.

Translated by Luiz Roberto M. Gonçalves

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