Funding climate resilience with innovative financial instruments
In 2018, the Seychelles became the first country to finance conservation through a debt-for-nature swap. It exchanged USD21.6 million in debt for the creation of two major marine nature reserves. Part of its national debt was sold at a discounted rate to the Nature Conservancy and other philanthropic foundations. This allowed Seychelles to increase its climate resilience while saving some USD2 million a year in debt service charges.
Debt-to-nature swaps are just one example of innovative financial instruments that developing countries need to adapt to a changing climate. Such out-of-the-box thinking is required to address the climate crisis, as public sources of financing — such as national budgets and global aid funding — and private investment remain limited. The private sector has been slow to respond because financial risks and returns are uncertain, especially for investments that will help communities in developing countries to adapt.
Filling the climate financing gap
The cost for developing countries to adapt to climate change is now 10 to 18 times greater than current flows of public finance, according to the latest assessment by the United Nations Environment Programme. The gap between what is needed and what is available ranges from USD194 billion to USD366 billion per year.
To fill the gap, there is increasing global interest in innovative financial instruments, which also include pooled investment funds, climate-resilient bonds, green loans and insurance services. These instruments provide new ways to acquire, structure, govern and allocate financing for climate action. Instead of relying on public sources, they enable governments and project developers to tap funds from new sources — such as private investors, pension funds, socially minded impact investors or philanthropists. In some cases, they are blended with traditional sources of financing such as grants and loans.
IDRC-supported research is producing tools and guidance to help developing countries and their funding partners explore innovative approaches to financing national climate action priorities. And in South Africa, research is helping to test a new funding approach that will let municipalities better manage climate risk.
Tools to explore innovative climate finance
Recent IDRC-supported research by the International Institute for Sustainable Development (IISD) produced new resources on innovative financial instruments to help developing countries make better use of them. The team produced the first analysis of national financing strategies for adaptation, giving guidance on how to use these strategies to increase financing that is aligned with national development and adaptation goals.
The IISD-led research also filled a crucial knowledge gap for those seeking new ways to finance adaptation by producing a comprehensive inventory of innovative financial instruments. Case studies linked to the inventory give users concrete examples of how these new approaches to financing can address specific adaptation challenges.
IISD also undertook the first systematic evaluation of how the investment portfolios of multilateral development banks (MDBs) align with the climate action goals of developing countries. With G20 leaders calling upon these banks to increase their role in climate finance, this research takes on new relevance. Among other things, the research highlights the need for MDBs to make greater use of innovative financial instruments.
A new way to finance climate action at the local level
New financing approaches are also needed to build resilience at the local level. Towns in South Africa, for example, are struggling to manage the rising costs of flooding. In 2020, the University of KwaZulu-Natal explored the feasibility of a municipal risk-pooling facility to manage flood risks in six South African municipalities. For infrequent catastrophic events, risk pooling offers a cheaper, more flexible alternative to traditional forms of insurance. It allows cities to avoid catastrophic costs by paying into a shared pool that compensates members against loss or damages.
Researchers developed a framework — the first of its kind — for sub-national risk pooling. With technical assistance from the project team, the Drakenstein municipality is now working to establish a risk-pooling facility with support from the Western Cape provincial treasury. Meanwhile, through a partnership with the C40 Cities network, the team is exploring wider use of the framework to manage flood risks.
A wealth of research on climate finance
IDRC has supported research and capacity strengthening to increase developing-country access to funding for climate action since 2012. The synthesis brief Mobilizing knowledge and capacity to fund climate action in the Global South provides a summary of findings from this body of research, including on:
- climate finance needs, barriers and opportunities
- private-sector funding, especially for adaptation
- capacity building on climate finance
- inclusive approaches to financing climate action