Unlocking Climate Finance: Tackling Currency Risks in Emerging Markets

Emerging market economies face a critical obstacle in scaling up climate finance - currency risk. A new report by the Climate Policy Initiative (CPI) highlights the urgent need to expand local currency lending and affordable hedging mechanisms to reduce capital costs and unlock the necessary climate investments.

Bridging the Climate Finance Gap in Emerging Markets

Emerging markets and developing economies (EMDEs) require approximately $2.4 trillion annually in climate finance by 2030, but domestic markets can only provide around half of this amount under current conditions. While long-term solutions involve strengthening macroeconomic conditions and deepening local financial markets, the financing gap must be filled by international sources in the near-term.

The Challenge of Currency Mismatch

The primary obstacle is the currency risk arising from the mismatch between hard currency debt and local currency revenues, particularly for renewable energy projects with long lifespans, high upfront capital needs, and local currency-denominated revenues. When local currencies depreciate, it increases debt repayment costs, threatening project viability and debt sustainability. This is a significant concern, as foreign currency lending makes up 70-85% of low-income countries' debt.

Barriers to Sustainable Climate Financing

The report identifies two key hurdles for EMDEs seeking sustainable climate financing: the lack of affordable, long-term local currency lending and the high costs of commercial hedging products. Hedging costs can add 6-7 percentage points to foreign currency loan costs, often negating the benefits of lower interest rates on hard currency loans.Investors' perceptions of currency risks in emerging markets also tend to exceed actual risks, further increasing the cost of capital and commercial hedging products. This self-reinforcing cycle weakens local currencies and financial markets, deterring much-needed climate investment.

Innovative Approaches to Mitigate Currency Risk

The report examines five innovative approaches to mitigate currency risk, each with unique strengths, limitations, and trade-offs:1. Donor-funded guarantee facility: A mechanism to absorb part of the losses incurred by The Currency Exchange Fund when providing foreign currency hedging products to countries typically excluded from commercial hedging, allowing for below-market rates for climate projects.2. Eco Invest Brasil: A partnership between the Brazilian government and the Inter-American Development Bank, which includes a long-term FX liquidity component to support climate projects capable of increasing local currency revenues in line with inflation.3. Delta: A proposed onshore development bank hedging platform that would borrow local currency from multiple sources on a short-term basis, a portion of which would then be lent to development banks over longer terms, using the excess as a buffer to manage associated currency risks.4. Multilateral development bank (MDB) transfer mechanism: A proposal from FSD Africa to sell established loan portfolios from MDBs to local investors, freeing up MDB capital for new climate lending in local currencies.5. Climate Policy Initiative's FX Hedging Facility: A proposed mechanism to manage currency risk for renewable energy projects by dividing depreciation risk into tranches allocated to different stakeholders.

The Path Forward

Many of these solutions rely on concessional and/or donor capital to absorb tail risks, which could be seen as a threat to long-term financial viability. The report also notes that the climate-focused proposals primarily target high-emitting emerging economies with more developed financial markets, highlighting the importance of long-term financial market development and tools that address the immediate currency risk-related needs of the lowest-income countries.The authors suggest areas for future research and policy work, including enhancing the affordability of hedging instruments, developing local currency bond markets, promoting risk-sharing, and developing blended finance approaches that work for EMDEs. They emphasize the need for collaborative, nationally-tailored solutions and advise multilateral development banks to expand local currency lending and provide technical assistance.