Last week registered the hottest day in recent history.  We are becoming desensitized to this kind of news; for the past 13 months each month has set a new record for global temperature. There’s a fair chance that we will exceed the 1.5C threshold outlined in the Paris Agreement by the early 2030s.  We should all be feeling the urgency of a warming planet to expedite the energy transition. However, heat stress appears to be leading to inaction. Despite the growing crisis, we are still far from mobilising the necessary capital to achieve the energy transition. What needs to be done to accelerate climate finance?

What is needed?

Many view climate finance as a critical bottleneck in accelerating the energy transition. Climate finance encompasses a broad range of financial instruments aimed at addressing climate challenges. These include grants and loans from public institutions like governments and multilateral funds, as well as green bonds, carbon taxes, and private investments. The are all directed either toward mitigating the impacts of climate change or enhancing resilience and adaptation to the new realities we face. 

To meet the Paris Agreement goals, current financial flows need to increase at least threefold. Despite significant efforts, there remains a substantial shortfall in the necessary funding.

This issue is often described as a 'funding gap' - a mismatch between the projects that require financing and the capital available to support them. The Climate Policy Initiative estimates that USD 6.2 trillion in climate finance is needed annually between now and 2030, increasing to USD 7.3 trillion by 2050, to achieve Net Zero - a cumulative total of nearly USD 200 trillion.

Does this mean we simply need to make that much extra capital available for the energy transition? The reality is more complex. 

Innovative climate finance

Due to this financial asymmetry, innovative financial mechanisms are emerging to make climate mitigation finance viable. Markets naturally respond to demand by creating supply, and vice versa. 

The good news is that progress is being made; market volumes are increasing across the board. However, these volumes are still far from what is needed to meet global climate goals.

Blended finance

Firstly, there is a growing shift towards blended finance, where public funds cover initial losses and risks, thereby leveraging private capital. In 2023, blended finance reached a five-year high in 2023, with climate-related blended financing increasing by 107%, from USD 5.6 billion in 2022 to USD 11.6 billion in 2023. While this progress is encouraging, these efforts remain limited in the broader context of what is needed to address the climate crisis.

Green bonds

Secondly, the market for green bonds - loans aimed at funding sustainability projects, including climate initiatives - had a strong first quarter in 2024, following a solid performance in 2023. The total issuance is on track to reach USD 1 trillion in 2024. However, the downside is that the largest issuers, primarily governments, have simultaneously increased their spending on fossil fuel subsidies.

Carbon markets

Thirdly, carbon markets represent an even more innovative approach. These markets exist partly because regulators have introduced carbon caps and pricing, with the largest being the EU Emission Trading System (ETS). In 2023, approximately 12.5 billion metric tons of carbon permitswere traded globally, with the market's value reaching USD 949 billion, a 2% increase from 2022. The ETS accounted for 87% of the global total. This market is expected to expand further if governments implement stricter emissions regulations.

The current focus is on Voluntary Carbon Markets (VCM), where nature restoration efforts create revenue through the sale of carbon credits. However, these markets are fraught with controversy, including concerns about standards, greenwashing, and the profitability of projects. While VCMs offer promise as an innovative solution, they are still in their early stages, with a projected global volume of just USD 3 billion this year. Given the magnitude of the challenges we face, this amount is barely a drop in the ocean.

Governments and the financial sector continue to channel substantial funds into fossil energy. According to the International Monetary Fund, global fossil fuel subsidies amounted to USD 7 trillion in 2022, or 7.1% of global GDP. This isn't about finding more money, but about reallocating existing funds. We need to defrost capital from stranded assets and redirect it toward the energy transition.

But there is a reason why capital is still wrongly allocated. The problem lies in the higher returns from fossil fuels compared to renewables. This reflects an 'asymmetry of finance': it's easy to profit from exploiting nature, where resources and externalities are underpriced, leading to carbon emissions. The opposite - investing in restoring nature - is more challenging, as it often yields limited financial returns, despite creating significant public value. Redirecting capital requires a shift in thinking, recognising that private gains should not come at the expense of public well-being. 

We must keep our heads cool

Climate finance is gaining traction, with innovative solutions drawing even more attention. However, despite the buzz, it’s not enough to cool the planet. The additional funding needed for climate mitigation and adaptation won't just come from financial innovations; it will come from strong policies. These should include a global carbon tax, the elimination of fossil fuel subsidies, mandatory standards for emerging markets like carbon credits, and a firm commitment from governments to phase out fossil fuels. Such measures would create a level playing field, making it easier for mainstream finance to support the energy transition without relying solely on financial innovation.

We must keep our heads cool: financing the energy transition is better supported by reducing fossil fuel investments rather than relying on financial innovations.