Financial Innovation and Climate Change

What is the challenge regarding financial innovation for climate change? 

• Since 2013, the flow of climate finance in the region has been on the order of $20 billion per year, while in East Asia and the Pacific, it has been close to $292 billion per year.
• There remains a gap in the mobilization of resources towards sustainable finance, including the private sector, to address the challenges of climate change and its adverse effects on communities.
• Issuers in Latin America and the Caribbean face barriers to financing and need support to access new investors and lower-cost financing based on performance, as well as on environmental and sustainable impact commitments.
• Exchange rate volatility is considered a major obstacle to long-term Foreign Direct Investment for climate change adaptation and mitigation, especially in emerging markets and developing economies.
• The region needs an average investment of approximately $180 billion per annum to reach net-zero emissions by 2050.
• Only a third of the regional SDG targets are set to be met. The remaining requires new measures and actions.
• Latin America and the Caribbean receives less than 4% of total global impact investments.

How can this challenge be met? 

• It is important to establish innovative financial mechanisms that promote decarbonized and climate-resilient infrastructure, as well as initiatives to halt deforestation.
• Collaboration and coordination between various stakeholders is crucial, including the public and private sectors, in conjunction with multilateral development banks.
• Private investment is vital as a source of capital essential for the transition to economies with low greenhouse gas (GHG) emissions and adapted to climate change.
• Much like the IDB, multilateral institutions must commit to seeking innovative financial mechanisms to boost investment. That is, especially in regions such as Latin America and the Caribbean, where there are new opportunities to finance low-carbon sectors, such as biodiversity. Multilateral institutions must also support the need to understand and overcome the limitations and challenges to scale up sustainable sovereign and public investment.
• Thematic instruments play a key role in addressing the environmental and social challenges affecting the region. Innovative strategies that link sustainability with debt instruments, such as sustainability-linked bonds (SLBs), offer significant advantages for the development of sustainable markets, contributing to achieving sustainability goals with tangible environmental impact.
• Governments play a key role in the implementation of sustainable agendas, from thematic or sustainability-related issuances to the development of market infrastructure such as taxonomies and regulation.
• Currently, investors are mandated to invest in sustainable activities with increasingly stringent regulations and standards in certain regions, creating opportunities for issuers in Latin America and the Caribbean to finance sectors and activities with potential positive impact.

What is the IDB Group doing to face this challenge?

• The IDB Group has developed a holistic portfolio containing tools and instruments that address main climate change financing barriers. We work on the entire life cycle in terms of generating sustainable financing, from issuance support, through market infrastructure (taxonomies and regulation), to anchor investment, guarantees and impact reporting, through our Green Bond Transparency Platform.
• Some of these tools and instruments include:
• Thematic and sustainability-linked bonds are critical to helping countries meet current challenges. Despite being standard market instruments, over time innovative structures have been developed, which enable issuers to close gaps and create new debt mechanisms. This makes it possible to increase the ambition and impact of policies and actions to address the environmental and social challenges that affect the region. It also enables boosting market development, promoting that national financial institutions and companies incorporate sustainable financing within their agendas, becoming a local reference and generating opportunities for replication.
• For example, we supported Colombia to issue its first green bonds with a twin bond placement mechanism in the local market and to issue its first social bonds in the foreign market.
• We also supported Uruguay with technical assistance to structure and issue its first sovereign Sustainability-linked Bonds (SLB). This bond has a mechanism to lower the cost of its debt (step down) against compliance with the climate and environmental goals of its first Nationally Determined Contribution (NDC) to the Paris Agreement. It attracted 188 investors from Europe, Asia, the United States and Latin America, a fifth of whom had never held Uruguayan debt.
• In 2020, we supported Ecuador's first Sovereign Social Bond, which also had a partial credit guarantee from the IDB. It was also the first sovereign social bond in history, awarded by Environmental Finance as the structured and sustainable sovereign bond of the year.
• The following graphic shows the total number of bonds the IDB Group has supported, by country and by bond type:

• The IDB worked on designing risk mitigation instruments as part of the initiatives to increase private capital mobilization. This is the case of "Debt-for-nature swap", an innovative instrument that enable countries to release fiscal resources to face climate change without creating fiscal deterioration or sacrificing spending on other development priorities.
  • Barbados completed a debt-for-nature swap backed by a $150 million guarantee from the IDB and The Nature Conservancy (TNC). In this operation, IDB Invest played a key role as anchor investor.
  • In 2023, Ecuador completed a debt-for-nature swap. The operation consisted of granting a $85 million IDB guarantee and a $656 million political risk insurance from the U.S. International Development Finance Corporation (DFC) to Ecuador for purchasing existing public debt with better terms. The conversion will generate total savings of more than $1.126 billion and mobilize nearly $450 million to protect biodiversity in the Galapagos and Hermandad Marine Reserves, and improve the quality of life of Ecuadorians.
• In these debt-for-nature swaps, the IDB supports issuers to access new investors and lower-cost financing. The IDB sovereign guarantee offers the opportunity to create innovative financial structures aimed at mobilizing resources from the private sector, to promote sustainability in various sectors, such as social housing or biodiversity, and climate resilience. It can be applied at the regional or national level and is a good mechanism to incorporate strategic partners, such as Development Financial Institutions, NGOs, or private investors. This facilitates improved efficiency, through technical synergies and better resource mobilization.
• The Inter-American Development Bank (IDB) has implemented innovative products to promote the construction of financial resilience and manage the risks of natural disasters faced by countries in Latin America and the Caribbean. Through the Climate-Resilient Debt Clause (CRDC), countries in the region can defer principal payments for a period of two years in the event of an eligible natural disaster, providing them with financial relief during times of financial stress. This clause, known in IDB loan contracts as the Principal Payment Option (PPO), has currently been activated by 6 out of 12 eligible countries 
• In Brazil, the IDB will support the Foreign Private Capital Mobilization and Currency Hedging Program under Brazil’s National Climate Change Fund with a $2 billion line of credit and technical support. With the Central Bank, the IDB will support the development, liquidity and efficiency of the long-term exchange-rate protection market in foreign currency. The IDB will offer the Program a limit of $3.4 billion for exchange-rate coverage; capacity to acquire derivatives for coverage under better conditions, facilitated by its AAA rating; and Treasury services. This support will allow the Central Bank and financial institutions to offer investors more access to, and lower costs for, exchange-rate protections. See more details in this link. 
• The new mechanism linked to Biodiversity and Climate, IDB CLIMA, is the first Multilateral Development Bank financing tool that offers discounts on loans to achieve objectives related to nature and climate, incentivizing the reforms needed by countries to access sustainable debt markets and mobilizing capital at the required scale. Under this innovative mechanism, the discount is given as a grant for 5% of the credit principal. The initiative aims at providing price incentives for a loan portfolio of up to $1 billion for 10 pilot projects. Nine countries will join: Barbados, Belize, Brazil, Chile, Colombia, Paraguay, Dominican Republic, Suriname, and Uruguay.
• The IDB is supporting countries to expand access to credit for MSMEs with an emphasis on bio-business in the region in our Amazonia Forever initiative. The use of loans to strengthen the financing of the sustainable productive sector and the direct financing of Credit Guarantee Funds for MSMEs is key to promoting productivity and sustainability. To date, we have approved two operations with this objective, one in Ecuador and another in Suriname.