Decoding Climate Finance for Easy Understanding of Key COP29 Terms

The global ambition to reduce greenhouse gas emissions and achieve net zero by 2050 requires large-scale investment in climate-mitigation technologies, including renewable energy, clean transportation, energy storage, green hydrogen and direct air capture. Countries and regions especially vulnerable to climate-induced events such as heatwaves, storms, floods and droughts, are at a high risk of devastating human and economic loss and, therefore, must ring-fence themselves with climate-adaptation projects, like sea walls, elevated roads and drought-resistant seeds, which require mobilisation of investments on an unprecedented scale – this is broadly termed climate finance.

The United Nations Environment Programme (UNEP) defines climate finance as “local, national or transnational financing drawn from public, private and alternative sources of funding that seek to support climate mitigation and adaptation”. Among the sources of capital are private funders like commercial banks, private equity firms and insurance companies and public entities like governments, multilateral and bilateral institutions, and development banks. The capital could take various forms like grants, subsidies, loans, equities and guarantees.

In international relations, climate finance refers to funds that flows from developed to developing countries for climate action. However, developing countries contend that only public funds, like grants and concessional financing, must count as climate finance as private capital is driven by a profit motives.

Although climate finance is at times referred to interchangeably as green finance, the latter is in fact a broader term that encompasses climate finance and other forms of environmental finance such as those focused on biodiversity and resource conservation. Sustainable finance is an umbrella term that includes green finance and financing for sustainable development activities, such as healthcare and education.

Climate Adaptation Financing

Developing countries are particularly reliant on climate adaptation finance not only because they are more vulnerable to the impacts of climate change but are also far less capable of investing in adaptation efforts.

To date, capital flows for climate finance are significantly less than what is required. Most adaptation projects are not commercially viable and lack business models to attract private investors. Adaptation finance in India and worldwide is largely driven by public finance. However, the funding gap in this space remains substantial, and calls for greater involvement of international public finance institutions and the private sector.

International public finance institutions are well-positioned to extend long-term credit to governments on soft terms, minimising the risk of default. In addition, they could provide grants and risk capital, such as guarantees, that countries may use to attract private capital. 

The fact, however, is that despite the growing need for private capital in adaptation, its flow is restricted by several impediments, including the lack of business models. Among them are the absence of adaptation metrics to quantify the benefits of adaptation projects, inadequate regulatory and policy support, and fragmented information and awareness. However, innovative business models and the prudent use of financial instruments, such as blended finance, guarantees and risk-sharing mechanisms, can help reduce the risks of climate adaptation projects.

Financing for extreme climate situations

Climate change has increased the frequency and intensity of climate-induced disasters, such as hurricanes, floods, droughts and heatwaves. Financial support for affected countries, geographies and individuals can aid in a quick recovery.

Parametric insurance is a robust financial instrument that compensates the insured based on a set of predefined parameters instead of processing the payment after damage assessment, which takes a long time. The key challenge is whether the insured can pay the premium, which is usually higher than in the case of conventional insurance. The insured also needs to spend additional money to buy parametric insurance. Public finance can subsidise the insurance premium to make the premiums affordable. 

Resilience bond is a debt instrument that provides financial support during extreme climate events. It is used to raise money for infrastructure projects that can help build resilience to climate change and its consequent impact. The insurance component protects the project developer (usually local governments) as they receive contingent payment from insurers in case of damage to the project. The more disaster-resistant a project, the lower is the premium, which incentivises the developer to build strong, resilient projects.

A clear understanding of climate finance terminologies can help stakeholders better grasp the subject enabling them to nudge policymakers, regulators and international institutions towards the right interventions to drive capital for urgent climate action.

(Labanya Prakash Jena is a Sustainable Finance Specialist at the Institute for Energy Economics and Financial Analysis)