Chairman’s Message

At COP 29, a pledge was made to transfer at least $300 billion per year from advanced economies to Emerging Markets and Developing Markets (EMDM) by 2035. But have we looked closely enough at the barriers to financing? I would like to share my takeaways from this conversation at the Davos meeting this year.

<Main Points>

The scope of financing by advanced economies is too narrow to support growth.

There are limits to the role of financing in the energy transition.

Many projects lack bankability; electricity rate-setting policies and carbon credits are key.

High cost of capital
　　　　a. Perceived risk maybe higher than reality.
　　　　b. Stability and predictability are lacking.
　　　　c. Local currency risk must be addressed creatively.
　　　　d. Blended finance should play a larger role.

Local financing must be strengthened. Japan’s history may provide a lesson.

1. The scope of financing by advanced economies is too narrow and strict to support growth in emerging markets.

Emerging economies, especially in Asia, are expected to experience strong economic growth in the coming decades. They also aspire to raise their living standards, which will certainly drive a significant increase in energy demand. While these countries will be promoting renewable energy, they still need to expand their gas-fired power plants to meet growing energy demand. Improving energy efficiency—even in the use of fossil fuels—will be necessary. Moreover, they will need to continue operating their young fleet of coal-fired power plants to ensure a sufficient power supply and to avoid major write-offs.
　However, the Just Energy Transition Partnership (JETP) is seen as too narrow and rigid, particularly by Asian countries, as it essentially allows financing only for renewable energy projects that include a solid plan to retire coal-fired power plants. Multilateral Developments Banks (MDBs) and international private financial institutions, under the Glasgow Financial Alliance for Net Zero (GFANZ), are also reluctant to finance fossil fuel-related projects.
　I believe that financing from advanced economies, including MDBs, should be broader and more flexible to support growth and rising living standards in emerging economies. To contain CO2 emission growth, projects that facilitate the transition from coal to gas and enhance energy efficiency should be supported. This “transition finance” is in high demand in the emerging economies. While it may not reduce CO2 emission to zero immediately, it can significantly reduce them. I believe that we should not let the perfect be the enemy of the good.

2. There are limits to the role of financing: it alone cannot drive the entire energy transition.

The Asia Development Bank (ADB) is promoting a program for the early retirement of coal-fired power plants. This program offers preferential lending for projects that retire coal-fired power plants early while simultaneously expanding renewable power. Older plants, being fully depreciated and inefficient, can be retired without hesitation.
　However, for newer coal-fired power plants, prevalent in the emerging markets, the situation is very different. Retiring these plants would require major write-offs and could affect power supply, so power companies cannot retire them solely for the marginal improvement in interest rates. This highlights a limit of financing. It would be a mistake to rely solely on financing to drive the early retirement of newer coal-fired power plants.
　Provided there is sufficient power supply, substantial grants might encourage power companies to absorb major write-offs. Another approach is to recognize carbon credits for early retirement and allow the power companies to monetize them. Although some may resist recognizing carbon credits for coal-related projects, this is yet another example of the perfect being the enemy of the good.
　We should acknowledge that financing has its limits in driving the energy transition.

3. Many projects in the developing markets lack bankability

It is often noted that many projects in developing markets lack bankability. The fundamental premise of financing is that the money lent must be repaid within a predetermined fixed timeframe, with interest. There must be sufficient cash flow to ensure repayment, yet many projects in developing markets do not meet this test.
　In many developing markets, the tariff for electricity is lowered due to political reasons. In such cases, it will be hard to expect sufficient cash flow generation from the investment in power plants. Governments in the developing markets must understand this reality and change the way they determine the electricity rate.
　To minimize increases in electricity costs, carbon credits could be used. By generating carbon credits through projects that help reduce CO2 emissions, these credits can improve project bankability. The basic agreement on Article 6 of the Paris Agreement may pave the way for a creative combination of financing and cross-border carbon credits.

4. High cost of capital
　4.1. Perceived risk maybe higher than reality.

Many point out that the cost of capital, especially in the developing markets, is too high. However, an interesting argument at Davos suggested that the actual default rate in the Global South is not necessarily higher than that in advanced economies. It appears that there is a perception problem: lenders from advanced economies tend to believe that financing in developing markets carries a higher default rate, which may not be true.
　I do not have the necessary data to confirm this argument, but I believe it would be beneficial for MDBs to provide data comparing actual default rates in developing markets with those in other regions. Perception can only change by providing facts.

　4.2. Stability and predictability are lacking.

Another cause for the higher capital cost in developing markets is the frequent, abrupt changes in the political environment. When power shifts, the business environment change drastically. Even without a change in leadership, policies may change abruptly, and even under the same regulations, their implementation can change. In many cases, predictability in the application of policies and rules is very weak.
　While outsiders cannot do much to ensure political stability, technical assistance and capacity building can help enhance policy and regulatory predictability. Most advanced economies have dedicated government agencies to provide technical assistance, and MDBs offer similar functions. It is unfortunate that the Trump Administration announced the closure of USAID, which had long been a global leader in providing technical assistance to developing markets. I believe it is time for other advanced economies and MDBs to step in to fill in this gap.

　4.3. Local currency risk must be addressed.

Financial institutions from advanced economies, including MDBs, generally resist providing finance in local currencies in developing markets. Because they raise capital in dollars and other major currencies, they do not want to be exposed to local currency risk when lending in the local currency. On the other hand, borrowers in developing markets are exposed to local currency risk because their cash flows are in local currency while their repayments are in dollars and euros. This currency mismatch can lead to more defaults as borrowers may be squeezed by fluctuating exchange rates.
　This local currency risk is a major factor contributing to the high cost of capital. So, what can be done? An interesting idea floated at Davos was that MDBs could raise funds in local currencies by tapping into local savings in developing markets, then lend to local borrowers in their own currencies. Since there is no currency mismatch, neither MDBs nor local borrowers would be exposed to this risk. Given their high credit ratings, MDBs should have little difficulty raising funds from local markets. In effect, MDBs can complement the role of the capital markets, which may not yet be developed in these countries. In addition to MDBs, international private financial institutions can play this role.

　4.4. Blended finance should play a larger role.

At Davos, there was considerable interest in blended finance. If public sector institutions, such as MDBs or government-affiliated financial organizations, assume the riskier portion of financing by providing guarantees, for example, commercial banks might be more willing to extend credit to projects. This blend of public and private financing, known as “blended finance”, is believed to lower the cost of capital.
　Although blended finance has achieved some meaningful successes, its overall impact may not be meeting the high expectation of many. The discussion at Davos suggested that while MDBs and government-affiliated financial organizations are willing to assume more risk than the private sector, they do have limits on how much risk they can absorb. They need to protect their balance sheets, which allow them to raise funds at low cost. If they must maintain their AAA credit rating, the risk they can assume through blended finance will be limited.
　To overcome this bottleneck, I believe that some allowance should be set aside to cover potential losses incurred through risk assumption in blended finance. To enable this loss-taking while preserving their AAA credit ratings, member countries should consider providing grants in addition to equity investments to these financial institutions. This might represent a departure from the traditional financial arrangements of these organizations, but such grants could leverage a significant amount of funds for developing markets. If successful, these grants would be a well-spent investment.

5. Local financing must be strengthened.

The idea mentioned earlier regarding local currency risk requires the accumulation of local savings. Without local savings, MDBs cannot raise funds in local currencies. Relying solely on financing from advanced economies or MDBs has its limits. It is therefore desirable to develop domestic sources of funding to support the energy transition.
　Japan’s history provides an interesting example. After World War II, Japan faced a serious shortage of funding but had a strong appetite for financing essential investment projects. At the time, Japan did not have sufficient funding for its largest hydropower plant and for its bullet train. You might be surprised to learn that Japan had to receive funding from the World Bank for these projects in the late 1950s and early 1960s.
　However, Japan recognized that it needed to develop its own domestic source of funding. It began by strengthening its mechanisms for collecting savings from its citizens. Post offices, which were deployed throughout Japan, served as an interface for collecting savings from the public. In addition to providing postal services, they also offered postal banking. The collected savings were managed by the Japanese Government and allocated to finance many investment projects. Thanks to the success of this domestic financing mechanism, Japan transitioned from being a recipient of the World Bank lending to becoming one of its largest contributors.
　I believe that, in addition to expanding financing from advanced economies and MDBs to developing markets, we should start developing systems for local financing in developing markets. This should begin with introducing mechanisms similar to Japanese postal banks for collecting local savings. Next, MDBs can help complement local banks and capital markets by serving as a bridge. Eventually, local banks and capital markets can be further developed. While this approach applies broadly to the entire economy, it is especially important for financing the energy transition.
　The $300 billion annual transfer from advanced economies and others to EMDM, pledged at COP 29, is important, but I believe it is time to start developing domestic financing systems as well. Advanced economies and MDBs can and should assist in this process. It is not just financing; technical assistance and capacity building are also crucial.