Innovative financial instruments for decarbonization in Latin America

Author’s: Margarita Cabrera, Manager Climate Finance Program, Center for Clean Air Policy (CCAP), Jorge Hinojosa, Climate Finance Policy Associate, CCAP and Samantha Youngeun Shin, Climate Finance Policy Intern; CCAP

Summary

The 2015 Paris Agreement emphasizes the need for rapid and large-scale transition towards net zero-carbon emissions across all sectors. To achieve climate ambition and full decarbonization in Latin America, receive international climate financing, develop innovative solutions that go beyond traditional financial instruments, and collaborative action among different sectors and stakeholders – that some Latin American countries already begun to adopt - are still more imperative.

Introduction

The IPCC 1.5C Global Warming Report highlighted the urgent need to limit the temperature rise “well below 1.5°C” by 2030 to avoid adverse impacts of climate change for people and ecosystems. This requires a deep and rapid decarbonization across all sectors and regions, calling for large scale inance and investment in climate mitigation. Accordingly, the need for collective and strategic actions in both financial and non-financial sectors, and from both public and private actors was highlighted as necessary to achieve the goal using a wide range of financing options.

Latin American countries have plenty of opportunities to reduce carbon emissions in multiple sectors, such as power, transport, agriculture, and industry with abundant clean energy resources. Energy (46%) and agriculture (23%) represent most GHG emissions in LAC (Bárcena, et al., 2018[1]). Besides, achieving a carbon neutral region seems plausible with nature-based solutions, such as carbon sinks and biodiversity conservation (LAC represents 50% of global biodiversity[2]). In fact, the region has already made a greater effort to reduce GHG emissions and build a pathway towards net-zero levels. Yet, some challenges related to macroeconomic, financial, and institutional risks hinder the process of NDC implementation and a greater level of stakeholders engagement including private sectors. To overcome these urgent challenges and achieve national climate goals, collective action from both public and private sectors, including financial and non-financial actors, access to climate finance, and innovative solutions in line with national climate priorities will be crucial.

In this paper, we review currently available financial instruments able to catalyze low-carbon economy in Latin America. By analyzing the best practices of introducing innovative financial instruments and scaling up public and private sector climate finance in some Latin American countries – Brazil, Colombia, Chile, and Argentina – we intend to provide benchmarks and inspiration with regard to climate-related financial instruments to relevant stakeholders.

Financial instruments and mechanisms for green projects in Latin America

To date, the public sector, multilateral institutions, and bilateral agencies play a crucial role in providing necessary financing and enabling green investments by establishing norms and standards of financing options. Given the larger scale of funding needed to meet climate goals, further efforts to unlock climate finance flows and access to more innovative financial solutions are essential. These efforts include de-risking green investments and making them more bankable, while removing barriers in financial markets. A wide range of financial instruments for promoting green investments currently exists in Latin America are listed below.

As shown in Table 1, there is a wide range of financial mechanisms and instruments available. Nevertheless, considering that each country has different financial policies, markets, and stakeholders, more sophisticated design and tailored financial solutions in line with country contexts and national priorities are critical to reduce risks while creating synergies between public and private sectors in achieving climate goals.

Challenges of filling up the financial gaps

A lack of risk mitigation financial instruments, an immature market and a lack of institutional and technical capacities are seen as factors that make it difficult to secure various and large-scale crucial sources of funding for the transition towards decarbonization.

Although several financial instruments above have been considered effective for promoting investments in green projects, economic actors, notably micro, small, and medium-sized enterprises (MSMEs), comprise 99.5% of all businesses in LAC region (Herrera, 2020) have had difficulties adopting such practices due to limited capital sources and access to financial instruments such as credit lines, refinancing, and guarantees. The percentage of financial resources transformed from the financial sector to non-financial sector (i.e., the capacity of the financial sector to finance real sector activities) in the LAC region is less than 50 percent, whereas the one for the United States is around 200 percent (Herrera, 2020). Moreover, the lack of experience and networks of local financial markets to create pipeline of feasible projects and evaluate climate funding options make it even more challenging to access climate finance. In the case of capital markets, including the bond market, the LAC region still lacks depth and liquidity, and therefore, only a few marketplaces exist in the region. Under financial limitations, the financial gap between funding supply and demand from financial institutions for MSMEs in the region is significant at US $1.8 trillion (Herrera, 2020).

Furthermore, a lack of updated financial information communicates low levels of transparency to borrowers. This raises the cost of financing and reduces access to financing (Herrera, 2020). Finally, a lack of knowledge and institutional framework development for innovative financial mechanisms hinders the stakeholders from accessing additional financing.

In order to overcome these existing financing barriers to green investments from both supply and demand sides, some countries in the region have put innovative financing solutions in place as follows:

Best practices in Latin America of advancing financial flows toward low-carbon growth

In addition to innovative mechanisms, countries should define climate change in their budgets, creating a specific line where green investments can be tracked, which allows for a climate finance overview and decarbonization milestones in each country. Best practices have shown us that each country needs a tailor-made mechanism considering specific climate needs, goals, and market conditions. This is essential when climate finance instruments are being developed in response to national policies and NDC financing strategies.

I. Brazil, a leading country in green bond issuance in the region

Since its first introduction in Latin America in 2014, the green bond market has been growing notably in Brazil, Chile, and Mexico. It is noteworthy that the green bond market in Brazil has been largely dominated by non-financial corporations. Brazil is leading the market with the highest number of non-sovereign (corporate) bond issuances (Amundi and IFC, 2021) (International Finance, 2020). Since the introduction of new mechanisms for green bonds issuance by the Ministry of Mining and Energy, the green bond market has attracted more financial sectors. The first issuance from the private banking sector was announced by Banco BV, one of the Brazilian private banks in 2020. Aiming at fostering the green finance market, the bank issued bonds with a 4-year maturity, which will support renewable energy projects and assets (Fatin, 2020).

Successful factor 1: Regulations/protocols

Several protocols and regulations including – framework for the creation and implementation of a socio-environmental responsibility policy, sustainable banking protocol, and guidelines for issuing Green Bonds – enable Brazilian Financial industry to incorporate the principles of the Green Economy into its operations (UNEP FI, 2020). In addition, central banks introduced a new sustainability policy and committee and evaluates banks’ E&S risk evaluations since 2018.

Successful factor 2: Knowledge/experience sharing platforms

The Green Finance Council plays a critical role in attracting more bond issuers into the market by providing information and guidelines on bond issuance requirements.

- Brazil Green Finance initiative creates the discourse among diverse stakeholders including pension funds, public and private banks, insurance companies, local market institutions, and private sectors and promote market mechanisms to catalyze green investment opportunities (Climate Bonds Initiatives, n.d.).

- In order to promote sustainable finance in the country, Brazilian Development Association (ABDE), IDB, and the Securities Commission (CVM), in partnership with GIZ launched the Financial Innovation Laboratory (LAB) and encouraged government and society representatives to participate.

II. Colombia, an effective engagement of IOs, private financial, and non-financial institutions for successful NDC implementation

Scaling up climate finance by catalyzing new private climate finance has been recognized internationally as crucial to accelerating the transition to a low-carbon economy. Accordingly, a wide range of international finance community members, including multilateral development banks, bilateral agencies, and other international organizations, have collaborated to facilitate private investment in green technology and sustainable infrastructure (Bloomberg, 2021). In a similar vein, the Colombian government established an institutional and regulatory framework for the national climate change system (SISCLIMA) – run by the Ministry of Environment and Sustainable development and the National Planning department – that facilitates public and private actors’ engagement and NDC implementation (GIZ, n.d.) (Cisneros, Gomez-Villota, & Alvarado, 2021). By incorporating incentives to foster private sector engagement, the framework contributes to raise Colombian NDC targets[4]. The financial sector promptly responds to these national climate policies and actions by integrating environmental and sustainability criteria into financial services. For instance, the private financial institution BVAintroduced a green guarantee facility for 90 million US dollars to build a 100 percent electric public transportation system which will contribute to a significant amount of GHG emission reductions (BBVA, 2020).

Successful factor 1: Establishment of Standards Framework[5]

Collaborating with international experts from multilateral and bilateral institutions, Colombia introduced a private sector engagement framework which enables private actors to participate in public green infrastructure projects, while stimulating private sector investments with smooth risk management.

Successful factor 2: Win-win strategy through the introduction of financial sector-led incentives

A financial institution contributes to the national climate goal by creating a new banking sector for sustainable finance and exclusively supporting climate-related projects. It allows private sector to mitigate their business risks involved in during the execution of green infrastructure projects.

III. Chile, a creation of a long-term, scaled-up financial solution through the alliance between non-financial and financial sectors

In 2021, IDB Invest decided to provide a $125 million financial package ($74 million senior loan from IDB Invest, $15 millions of blended finance from the Clean Technology Fund (CTF), and $36 million from the Chinese fund) to a private firm, ENGIE Energia Chile, seeking to contribute to the decarbonization from the energy sector (IDB Invest, 2021). By establishing a minimum price for GHG emission offsets, the package aims to accelerate clean technology projects, while inducing to close coal plants in the region. It is a successful example of joint efforts between the financial sector and private sector actors in supporting national climate goals.

IV. Argentina, “Scaling approach with a Public-Private Partnership (PPP) model (RenovAr-IFC-WB)”

A holistic approach that creates a pipeline of infrastructure projects was introduced with the purpose of producing 20 percent of Argentina’s electricity from renewable sources, by attracting 1,000 MW worth of new projects (ultimately, more than 2,400 MW were awarded). The Renewable Energy Auction (RenoAr) agency launched by the Government of Argentina covers payment obligations from the public utility. The WB and IFC are involved in consulting on the structuring and implementation of a new tender process to advance the objectives set out in the legislation. The WB guaranteed these payments from exchange rate volatility.

Successful factor: Enablers such as Blended financing or PPP model to carry out large-scale projects

It is vital to secure a large scale of investments and minimize investment risks through risk sharing in order for the infrastructure projects that require large initial capital and a lengthy period of construction – especially in energy sector (e.g., construction of large-scale renewable based power plants, replacement of coal power plants) –. Chile and Argentina are good examples of the use of PPP model and joint investments; and blended financing for decarbonization in the energy sector.

Conclusion

Climate finance is an essential component to achieving national climate goals. Unfortunately, the current level of investment in sustainable projects is still insufficient to reach the “well below 1.5°C” goal. Hence, there is an urgent need for more innovative and creative approaches to supplementing conventional financial instruments, as shown in the case of Chile and Argentina. Referring to the case of Brazil and Colombia, institutional mechanisms and arrangements, climate laws and policies should target support relevant actors that carry out climate initiatives and projects. The increasing role of the private sector, impact funds, and blended finance mechanisms also mean an improved financing landscape for SMEs in the region. The examples above demonstrate that there is no single financial instrument that is perfect and universally applicable. Instead, introducing suitable financial instruments that align with a national climate goal (i.e., NDC) will be effective in achieving policy goals. Integrated and cooperative support, including both financial and non-financial instruments along with a customized instrument considering a country’s needs and goals must be combined to achieve a successful transition to decarbonization.

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