This week’s “summit for a new global financing pact” in Paris offers an opportunity to deal with the dire financial situation of the poorest countries. It also offers a chance of making the investments needed for a transition to a low-emissions economy.
This is the central point of a new paper by Avinash Persaud, who advised prime minister Mia Mottley of Barbados on the influential Bridgetown Agenda for the Reform of the Global Financial Architecture. In “Unblocking the green transformation in developing countries with a partial foreign exchange guarantee”, he analyses 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 more than 70 per cent of the stock of anthropogenic greenhouse gases. This has also exhausted almost all of the planet’s carbon budget. But today emerging and developing countries generate some 63 per cent of emissions, a share that is bound to grow. It follows that there must not only be huge cuts in emissions, but a huge part of those cuts, particularly relative to trend, must be made by emerging and developing countries. To achieve this investment in the green transition in these countries (other than China) needs to reach some $2.4 trillion (€2.2 trillion) a year (6.5 per cent of gross domestic product) by 2030.
In high-income countries 81 per cent of green investment is funded by the private sector. In emerging and developing countries the private share is a mere 14 per cent. It is highly unlikely, even with a successful outcome to this week’s summit, that official external assistance will fill it either. As Persaud notes, “global expenditure on aid is less than one-tenth of the cost of the green transformation”. Moreover, “developing countries do not have the space on their balance sheets for the debt required even if they wished to finance it themselves”.
The solution is to secure private finance for potentially profitable projects. which represent about 60 per cent of the needed investments, the rest being for such things as adaptation. The latter will not yield direct financial returns and so must be financed by official assistance. But, notes Persaud, even where projects are financeable, in theory, punitively high interest costs for private lending to emerging and developing countries are forbidding obstacles. Thus, for a similar solar farm the average interest cost in leading emerging countries is a prohibitive 10.6 per cent per annum, against only 4 per cent in the EU.
Yet, argues Persaud, the cause of this huge spread is not project-specific risk. A solar farm is no riskier in India than Germany. More than all of the risk premium represents market estimates of macroeconomic (specifically, currency and default) risks. He also argues that these risks are not just exaggerated, but cyclically so: in “risk on” periods, overpayment for insurance is smaller than in “risk off” ones.
The paper calculates this by looking at the cost of hedging foreign currency risk. That is expressed in terms of the difference between the price of buying foreign currency with local currency in future (the forward rate) and today (the spot rate). This gap can then be turned into an annual percentage rate.
The conclusion from the evidence is that markets are too risk averse: the risks are not as great as they fear. This is particularly true when the markets are at their most risk averse: on average, “overpayment” for hedges has been 2.2 percentage points when their cost is below the three-year moving average, but 4.7 percentage points when the cost is above its moving average.
In sum, argues Persaud, we have a free lunch: a stabilising speculator could make money, while doing good, by removing the excessive risk premia.
Why might such a free lunch exist? Investors might simply be uncomfortable with unfamiliar markets. They might also be unhappy with such volatile markets. Moreover, stabilising speculators have to take large contrarian positions over long periods. Financing such positions on the scale needed is risky: it is easy to run out of money long before the market sees sense. For such reasons, markets will persistently overprice the hedges.
As Persaud puts it, “private investors are leaving money on the table. But even more significant are the far greater social gains from ... boosting green growth in developing countries that are being left alongside.” This is a “planet sized” market failure.
His proposal then is for a joint agency of the multilateral development banks (MDBs) and the IMF to offer foreign currency guarantees and pool currency risks. Projects could come to the guarantee agency from the MDBs. The guarantee agency could then prioritise projects that have the most significant positive impact on the climate. To limit risks of loss the agency would wait until hedging costs were above the three-year average and so until risks are deemed large.
In brief, this clever paper makes four points: first, macroeconomic risk makes climate projects unfinanceable in developing countries; second, the global climate challenge cannot be met if these projects are not financed on an enormous scale; third, markets exaggerate these risks, especially in bad times; and, finally, the expected gains of official intervention would exceed the costs, partly because so much is at stake.
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 solved by investments made just in rich countries. – Copyright The Financial Times Limited 2023
