Balancing the Climate Transition with Economic Growth: A Tug of War or a Surge in the Same Direction?

The impacts of climate change have become increasingly dire. Rapidly increasing atmospheric carbon pushed global average temperatures 1.4°C above pre-industrial levels in 2023, the hottest year since records began in the 1850s. And 2024 is expected to be even hotter.

The climate change induced by this global warming has created severe and frequent weather events that have inflicted staggering economic losses, totaling close to USD 1.5 trillion over the decade leading up to 2019. Moreover, the world’s poorest nations are disproportionately affected – despite producing the smallest share of global emissions – which underscores the urgency for an equitable low-carbon transition.

Namita Vikas

Economies worldwide are now faced with the challenge of balancing growth and the climate transition. This is especially the case for emerging markets, which stand at the crossroads of economic progress and sustainability, with their emphasis on rapid growth and enhanced exposure to physical risks.

This article examines how these tensions are exacerbated by significant economic barriers that prevent countries from accelerating the transition and introduces several innovative financial mechanisms which can create win-wins for growth and the transition.

Emerging Markets Challenges

The upfront costs of deploying clean energy technologies, upgrading infrastructure and implementing emissions-reducing measures can be staggering. Capital spending globally on physical assets for energy and land-use transition could amount to USD 9.2 trillion annually between 2021-2050, according to McKinsey & Company. Moreover, expenses related to reskilling, social safety nets and new technology add additional budgetary strain.

This creates an immediate immense financing challenge for emerging markets which need approximately USD 2 trillion annually by 2030 to achieve a transition to net zero — a five times increase from the current USD 400 billion in capital flows.

Risk premiums for emerging countries, which drive up their borrowing costs, also reduce the fiscal space for transition-related investments. The opportunity cost of shifting away from carbon-intensive but economically vital industries presents a further obstacle.

Financial Challenges

This situation is also making it increasingly difficult for financial institutions to ignore the impacts of climate risks on their portfolios. Exposure to high-emitting, hard-to-abate sectors that are inadequately aligned with the transition is likely to cost financial institutions approximately USD 2.2 trillion — even with an early transition in 2026. Furthermore, every year that the transition is delayed could result in financial institutions accruing an additional USD 150 billion annually in costs due to transition-related changes in market and credit risk.

Mitigating these impacts requires a transformational change in financial institutions’ own risk management, credit underwriting processes, investment strategies, sectoral decarbonization protocols, stakeholder engagement and internal capacity building in mainstream functions.

Investments in transition-related activities also need to be accelerated. However, there are critical gaps in the overall transition financing environment that are discouraging industry players.

These include:

• Lack of Bankable Projects: The dearth of proven business models and the perception that new transition-related sectors (such as hydrogen) are high risk hinders investment. Often transition projects (such as those for fast changing technologies) fail to meet the required risk-return profiles or lack sufficient de-risking elements (such as guaranteed offtake contracts) to be considered bankable. Transition-related projects, especially renewable energy ones, may also have high upfront costs and long payback periods, according to the World Economic Forum. This creates a significant mismatch between financiers’ time horizons and project tenures.
• Ambiguous Information: A lack of clarity permeates through the whole financial system. Policymakers and regulators in different countries have created varying reporting regimes and taxonomies which is an obstacle to efficient investing. For example, seemingly complex and overlapping non-financial disclosures have led to reporting fragmentation and confusion which diminishes comparability of information from different companies. Additionally, a lack of consistent definitions and labels for ‘green’, ‘sustainable’ or ‘transition’ is giving rise to greenwashing. Companies that create their own standards to overcome some of these issues risk being divergent with future market standards, according to RMI.
• Obscure Transition Finance Instruments/Missing Labels: While there are no sacrosanct definitions, transition finance is generally thought of as the funding of high-emitting economic businesses/activities to decarbonize. Both green and sustainability-linked bonds are often used for transition activities, with labeled transition bonds cornering a small piece of the larger thematic bond market. A lack of standardized labeling in many emerging markets blurs the boundaries between ‘green’ and ‘transition’ products, worsening confusion and resulting in fears around regulatory Further, due to lack of transition asset tagging, these loans often sit under a general-purpose loans category, hindering quantification of the amount of transition lending.
• Data Deficiencies: Gaps in transition-relevant data availability, its comparability, and a lack of consensus on appropriate benchmarks and timelines to assess it all form key barriers to For example, the lack of comparability of data hinders assessments of project credibility, and consequently financial decision-making for financial institutions. Additionally, the absence of data collection at the sectoral, regional and national level makes it even more challenging to assess projects/activities in specific emerging markets with unique conditions, thereby reducing finance.
• Nascent Technologies: Financiers often lack knowledge or expertise in evolving low-carbon technologies, making them hesitant to invest. Technologies failing or underperforming have also given rise to investor concerns. For example, a 2022 analysis from the Institute for Energy Economics and Financial Analysis found that carbon capture and storage (CCUS) projects often fail to meet their stated targets. The Institute found that 10 of the 13 prominent CCUS projects studied failed to perform or significantly underdelivered by wide margins, raising concerns around the project’s viability and bankability.

Faced with these substantial risks, financial institutions often opt for financing conventional sectors with proven payback histories, shying away from the challenges of financing emerging market decarbonization efforts. Overcoming this risk aversion is vital to unlocking the scale of investment needed for transition.

Opportunities in Innovative Financing

Substantial gaps in investment to fund the transition exist. Traditional financing mechanisms continue to fall short, as emerging markets grapple with limited access to capital, higher borrowing costs and investor hesitation over financial and economic uncertainties.

Innovative finance models address market failures, institutional barriers and provide the required scalability in the wake of the quantum of finance required. To bridge the finance gap, innovative finance often goes beyond commercial debt finance to attract private and institutional capital, bundled with public funds. This produces market-based financing instruments that are focused on reducing risk and creating an enabling investment environment.

These innovative financing strategies have also provided flexibility to investors and new ways to mobilize the required resources to enhance project viability, foster capital flows and achieve developmental and transition goals.

There are several mechanisms that have successfully de-risked investments and have enabled collaboration between public agencies, the private sector and financial institutions, including:

• Asset securitization (the process of converting assets into tradable securities) and public private partnerships (PPP) (collaborative arrangements between government entities and private companies to deliver public services or infrastructure) have worked for financing mitigation or transition projects and are known for their robust risk distribution between the public and private sector.
• Green, social, and sustainability funds are financial instruments designed to finance projects with environmental or social benefits and have been issued to attract the private sector to support large scale investments. They often deliver a greenium.
• Government green funds and transition funds are financing the transition with several financial structures, such as private, sovereign and non-sovereign guaranteed loans or direct equity, and equity funds, targeted to increase environmental sustainability.
• Sustainability-linked bonds or loans (SLBs or SLLs) tie issuers/borrowers interest rate or coupon to the achievement of predefined sustainability performance targets across environmental and/or social key performance indicators (KPIs). Failure to meet these KPIs may result in coupon step-ups, premium payments upon maturity, obligations to purchase carbon offsets, or an increase in the interest rate on the loan.
• Municipal bonds unlock capital from multilateral development banks (MDBs) or institutional investors to fund public projects undertaken by cash rich utilities which demonstrate robust cash flows. These are utilized to decarbonize municipalities’ own operations or their works.
• Convertible debt structures include grants that can be converted into loans and loans that can be converted into equity and linked to transition-related milestones. These also address the lack of a track record, technology standards and comparable benchmarks for the project being invested in.
• Currency risk hedging mechanisms mitigate currency volatility, which affect project costs, revenues, debt serviceability and profitability, enhancing the financial viability of transition projects.
• Debt-for-nature swaps typically purchase discounted foreign debt, convert it into local currency and utilize the proceeds to fund environmental projects. Such structures enable debt-stressed countries to free up capital to meet their development goals and fiscal obligations.

The applicability and relevance of these innovative financing mechanisms depend on factors such as the nature and objectives of the project, volume of capital required, the profile of existing and potential capital providers, favorable sectoral policies, regulatory frameworks within the geography, the potential to scale and the willingness of capital providers to de-risk the investment.

Blended Finance

Blended finance is a comprehensive and flexible innovative finance mechanism that has risen in popularity over the last decade. It leverages public and philanthropic capital to de-risk private investment, making previously unviable projects attractive to commercial financiers. Blended finance can help bridge gaps in project bankability, provide patient capital for longer-term projects and crowd in private sector participation — all of which are critical to scaling up the capital required for the climate transition.

A fascinating example comes from Uzbekistan’s Zarafshan wind project, a 500-megawatt public-private partnership (PPP). It was the country’s biggest step towards sustainable infrastructure development and decarbonization, bringing together international developers, lenders and advisers, and securing financing of USD 580 million. This made it the largest renewable energy project in Central Asia. Early in the project, multilateral development banks such as the Asian Development Bank (ADB), European Bank of Reconstruction and Development (EBRD), Japan International Cooperation Agency (JICA), and IFC provided term-lowest-cost capital and enhanced pricing, leading to further investment by Dutch development finance institution, FMO. Further diversification of the funding pool involved the UAE export-credit agency’s inaugural “non-recourse untied cover”, and two private investors acting as covered lenders.

Additionally, to strengthen the structure, one of the private investors issued a short-term letter of credit to enhance the off-taker’s credit and the project was backed by a partial risk guarantee by the ADB to cover any default risk by the National Electric Grid of Uzbekistan. The EBRD also provided a revolving VAT facility to cover construction period VAT payments, a first for an MDB, undoubtedly setting a constructive precedent for any future transactions.

This innovative, but complex, financing structure holistically addressed common problems faced by many emerging markets which often have high inflation, delays in power purchase agreement signing and financial closures, moratorium and tax payout burdens, and high project commissioning risks. This project has become a model to attract future investment from private companies in similar projects. Here, the MDBs played a significant role in providing both direct and indirect support through lending, concessionality (financing with terms more generous than market rates, often including lower interest rates and longer repayment periods) and de-risking, which facilitated international public and private sector participation. In addition, this project is expected to avoid 1.1 million tonnes of CO₂ emissions per year, electrify 500,000 houses and contribute to Uzbekistan’s target of generating 25% of its electricity from renewables by 2030 — setting a significant milestone for the country.

Parting Thoughts

Blended finance structures have demonstrated their ability to mobilize capital at a large scale and create partnerships among real economy players along the risk-capital spectrum. They are especially useful to reduce risks for low carbon projects that are unable to directly secure commercial bank financing.

As emerging markets navigate the complex landscape of financing the climate transition, their choices and actions will reverberate across the world. The challenges outlined in this article — from reporting ambiguity and data deficiencies to the shortage of bankable projects — underscore the urgency for innovative, collaborative financing solutions. Emerging markets can unlock capital for accelerated decarbonization and sustained economic growth by leveraging innovative financing mechanisms.

The path forward will require a delicate balance, supported by strategies to decouple economic growth from greenhouse gas emissions. The stakes are high, and the time to act is now.

Namita Vikas, founder and managing director at auctusESG, is an award-winning senior business leader with over 33 years of diverse global experience in sustainable finance, ESG, climate transition and public policy across banking, finance, and technology. Previously, she served in a CXO role, at one of India’s largest private sector banks, where she was instrumental in launching several first-to-market sustainable wholesale and retail products, including India’s maiden green bond in 2015 and green deposit in 2018.