Climate finance primer – What is blended finance and what does it mean for climate change?

COP28 opened with a major breakthrough: an agreement was reached on the so-called "operationalisation" of the Loss and Damage Fund, meaning a deal to drive forward plans agreed during COP27 to set up a fund to assist developing countries most exposed to the adverse effects of climate change.

Commitments to the Fund have already been made by, among others, the UAE ($100 million), Germany ($100 million), the UK ($40 million) and the US ($17.5 million). However, these amounts pale in comparison to the estimated overall financing needs for climate change adaptation and mitigation. The United Nations Framework Convention on Climate Change’s recent analysis estimates at least $6 trillion is needed by 2030 to allow developing countries to meet less than half of their existing nationally determined contributions, state action plans to tackle global warming. Climate adaptation activities in particular are only becoming more expensive as the magnitude of climate change sets in: the United Nations Environment Programme estimates countries may need to spend up to $300 billion a year by 2030 and $500 billion by 2050 on adaptation measures.

How to fill this funding gap is therefore almost as pressing a topic as the establishment of public funds themselves. While the injection of private capital appears the obvious answer, a major challenge is private capital's differing attitude to risk and return compared to public capital, with many activities that public and non-profit entities would be willing to fund being perceived as too risky for private investors. Investors may, moreover, lack the technical or management expertise to address the vast scale of such emerging climate challenges.

A major topic in this conversation is the use of blended finance, or the combination of private and public capital, to remedy this. In this article, we explain what blended finance is and what this means for the future of climate finance.

Climate finance – Where do we stand at the outset of COP28?

Policy makers and business has long recognised the challenges of marrying private and public investment at the vast scale needed to tackle climate change.

COP16 in 2010 led to the establishment of a Green Climate Fund set up to support developing countries reduce greenhouse gas emissions and enhance their ability to deal with climate impacts. By December 2022, the Green Climate Fund reported a portfolio of $11.4 billion, funding 209 projects focused on adaptation and mitigation of climate change. Among others, the Green Climate Fund's role is to act as a catalyst for private investments alongside the fund.

However, calls continued to help unlock funding to address the effects of climate change and to involve private markets in compensating developing countries for loss and damage caused by climate change. COP27 and COP28 have brought significant breakthroughs on this front with the agreement, and now the deal for a future operational launch of the Loss and Damage Fund. The fund is expected to act as an additional catalyst for private commitments, to some extent by channelling investments, but mostly by helping to support private risk-bearing capacity, eg, in the context of insurance.

In basic terms, both funds are financed by public money, primarily from developed countries, and sit under the trusteeship of a multilateral development bank; the Green Climate Fund sits with the World Bank, although the proposal for the World Bank to also host the Loss and Damage Fund is an important point of debate in current negotiations.

Nevertheless, there is an acknowledgement that public funding alone will not be able to cover funding and risk-bearing needs. For its part, the Green Climate Fund describes its role as not only contributing to the direct funding of projects from the money it manages but also in creating an enabling environment where private funding can fill the gap.

An important question is how private finance can be mobilised alongside public investment and the concept of blended finance provides a model for both forms of finance working in tandem.

What is blended finance?

Blended finance refers to a structure where private funding is combined with public, development or philanthropic funding (also called concessional capital).

The core idea is that the injection of public money mitigates private capital risk thereby encouraging private funders to back projects which may otherwise not be commercially viable and ultimately increasing the total capital available to the recipient.

This can be done, for example, by the concessional funder providing capital at below market terms or on a less preferential basis than the private funder. Examples in an equity context could include a private funder being given preferential equity or, in a debt context, by the concessional funder taking on a junior debt tranche, or by the concessional funder providing some other type of financial support such as a guarantee or insurance on below-market terms. This can also happen in other ways, such as by the concessional funder offering technical assistance.

The stated benefits of blended finance are:

• Risk reduction for private capital: the concessional funder may be willing to take on a higher risk tranche of the debt, or simply the presence of a concessional funder in the structure lends credibility to the investment;
• Access to new funding sources for recipients and new markets for funders: blended finance may allow recipients to access private capital which would not otherwise be available, while allowing private investors to access markets which they may otherwise not be able to operate in;
• Encouragement of recipients and private capital towards higher sustainability standards: concessional funders may have heightened sustainability performance requirements and the use of blended finance gives funding recipients and sometimes also private capital providers experience with these;
• Developing and reinforcing local financial markets: the presence of blended finance opportunities within a market encourages increased private finance presence and confidence in that market as a whole. Blended finance is often deployed through or in cooperation with local financial institutions, which also develops local markets and the expertise of local funders to manage projects.

The role of the concessional funder in lending transactions

One of the unique elements of blended finance, particularly on the debt side, ie, where the concessional funder is acting as a lender, is the supervisory character the concessional funder often takes.

This is a feature of the structure for several reasons. First, the concessional funder will often agree to be junior to the private funder to de-risk the structure and incentivise private sector participation but in return the concessional funder may seek protections in other ways such as having enhanced oversight over the ways its funds are used. Secondly, the concessional funder may request this to achieve wider social or environmental goals, and compliance with strict conduct requirements becomes a criterion for funding.

This latter aspect can be controversial, as developing countries often raise the argument that this gives extraterritorial organisations such as multilateral development banks undue influence in domestic matters. This is one of the issues for debate over the future of the Loss and Damage Fund as part of COP28 and the discussion surrounding the World Bank acting as host for the Fund.

In terms of what this looks like for typical structures, a blended finance transaction may include:

• Enhanced covenants: Public capital may be more concerned than private counterparts with the environmental and social impacts of a project and may require more thorough obligations on a borrower in areas stretching beyond financial performance. The International Finance Corporation's Performance Standards on Environmental and Social Sustainability and the World Bank Group Environmental, Health and Safety Guidelines are influential examples of such performance frameworks with which borrowers need to comply to access capital.
• Monitoring: It is common for debt instruments to include periodic reporting obligations on borrowers but these are often stricter where public or multilateral organisations are involved. Many development banks require borrowers to complete periodic reporting on topics such as the environmental or social impact of projects, following standard in-house forms developed by these organisations. The standards set by multilateral development banks have found their way into private capital (the Equator Principles, for example, have been based on the IFC Performance Standards since the launch of the former in 2003).
• Reserved discretions: Both private and concessional funders may require a borrower to consult with them or get their consent on certain key decisions during the life of the loan. However, concessional funders may have heightened attention to environmental and social decisions and may ask for consent or first refusal rights for decisions which go beyond the purely financial.

The examples of heightened attention to non-financial performance listed above also extend to the triggers for defaults under the loan. Whereas in a purely commercial context, defaults would typically be limited to financial non-performance, stricter conduct requirements for environmental and social performance mean more opportunities for a borrower to default for non-financial metrics. This gives lenders a certain amount of power to influence borrower behaviour.

The future of blended finance to support climate finance

Blended finance can be an element of speeding up much-needed climate investments because it offers opportunities for private capital to scale up public commitments but for the reasons above these are not always straightforward investment options from a recipient perspective. In addition, the influence given to concessional funders - both outside blended finance structures and within them - has caused debate in the leadup to the COP28 summit.

From the private capital perspective, an important question for COP28 will be how to foster interest in funding climate adaptation and not only climate mitigation.  There has so far been far more enthusiasm for the use of blended finance to fund climate mitigation – that's to say in funding technologies which make the impacts of climate change less severe by preventing or reducing emissions, such as renewable energy projects or carbon capture technology. The enthusiasm of private capital is fuelled in large part because investors can see the economic prospects of these solutions and early injections of concessional funding have been key to transitioning several mitigation projects to positions where they can attract enough private capital without needing concessional funding in future.

However, adaptation activities, in particular those that focus on addressing damage caused by climate change, are traditionally considered less attractive projects, especially from the perspective of private capital. In this context, it will be crucial to select projects and structures which are able to meet the commercial expectations of private funders.

The Green Climate Fund has been supportive of blended finance and has taken roles as a concessional funder in blended finance transactions. Now it is expected that the Loss and Damage Fund will aim to act as a similar catalyst to involving private markets, to some extent in relation to investments into loss and damage remediation, but mostly also to create private risk-bearing capacity.

However, the Loss and Damage Fund is only one step in the wider drive to meet funding needs for climate action and it is crucial the conversation continues on how markets and structures can evolve to encourage private capital to come in alongside public funding.