Blended Finance: Is This A Game-Changer for Climate Action in Emerging Markets?

In 2021/2022, the average annual climate finance flows reached a record high of almost $1.3 trillion, yet this amount remains insufficient to meet the estimated $8.1 - $9 trillion required annually (till 2030) to achieve the Paris Agreement targets. This shortfall is particularly acute in emerging markets, where the need for climate resilience is most urgent, but financial resources are often scarce. As these regions face unprecedented climate challenges, the pressure to mobilize massive financial resources is intensifying. Blended finance has emerged as a pivotal strategy, potentially unlocking the private capital necessary to close this critical funding gap. But can it truly serve as the catalyst for large-scale climate action in these vulnerable economies, or is it merely another financial concept? As extreme weather events continue to batter emerging markets, with devastating impacts on economies and communities, the urgency to find effective solutions has never been greater.

Blended finance, one of the key topics at COP 28, operates by strategically combining concessional finance—typically sourced from public institutions or development finance institutions (DFIs)—with private sector investments to mobilize additional capital for projects that support climate goals. According to the Organisation for Economic Co-operation and Development (OECD), blended finance is the use of development finance to mobilize private sector investment in sustainable development, particularly in areas like developing countries where private capital alone would be insufficient due to perceived risks or inadequate returns.
This approach creates a catalytic effect, where public funds are used to mitigate risks, thereby making projects more attractive to private investors. The reduction in risk encourages private sector participation in financing initiatives that contribute to climate action, such as renewable energy projects, sustainable infrastructure, and climate resilience programs.

A good example of blended finance in action is the Global Climate Partnership Fund (GCPF). The GCPF leverages investments from development banks alongside private sector funding to finance renewable energy projects in developing countries. The fund's success is largely attributed to its ability to de-risk investments through the provision of first-loss capital by DFIs. This first-loss capital acts as a buffer, protecting private investors from potential financial losses and thus encouraging their participation. By combining concessional finance with private investments, the GCPF maximizes the impact of climate finance, facilitating the development of projects that might not have been viable without such support.

Another example is the Africa Renewable Energy Fund (AREF), which similarly uses blended finance to support the deployment of renewable energy projects across the African continent. By integrating concessional finance from the African Development Bank with private investments, AREF has been instrumental in financing projects that reduce greenhouse gas emissions and expand energy access in underserved regions. These projects illustrate how blended finance can effectively channel private sector resources into critical areas of climate action, driving progress toward global climate objectives.

The urgency to address climate change has never been more pronounced, especially as recent international agreements like those made during COP28 highlight the stark financial needs. Despite significant pledges from countries like the UAE, Germany, and the US to the Loss and Damage Fund, these contributions are only a fraction of the immense resources required to combat the climate crisis.

The challenge, however, lies not just in the scale of financing but also in the differing risk appetites between public and private investors. While governments and nonprofits are often willing to take on higher-risk projects with significant social or environmental benefits, private investors typically seek more secure returns. This discrepancy hinders the flow of private capital into sectors crucial for sustainable development, particularly in low- and middle-income countries, where the financing needs are most acute.

Blended finance emerges as a promising solution in this context, offering a mechanism to align the interests of private investors with the public good by sharing risks and rewards in a way that makes high-impact projects more attractive to private capital. This approach is seen as a key strategy in international discussions, from the G20 to development finance institutions, as a means to close the growing financing gaps for the Sustainable Development Goals (SDGs) and climate action.

Blended finance operates by strategically combining public, philanthropic, and private funds to reduce the perceived risks of investing in developmental projects. This approach uses several mechanisms to ensure that private investors are drawn into projects that they might otherwise deem too risky.

1. Debt Mechanisms: One common approach is the use of concessional debt—loans offered on more favorable terms than the market would typically provide. For example, concessional senior debt, which has repayment priority, is frequently used in blended finance structures. This was seen in initiatives like the FIRA, a second-tier development bank in Mexico. As a second-tier development bank initially funded by the Ministry of Finance, FIRA utilizes concessional capital to offer guarantees and intermediary funding, thereby advancing climate sustainability in agriculture and rural areas.
2. Equity Mechanisms: Another strategy involves equity investments, where investors take ownership stakes in projects or companies. In blended finance, these equity stakes are often structured with different tiers of risk, with public or philanthropic funds taking on junior or subordinated positions—meaning they accept lower priority in case of financial losses. This structure was employed in the AfricaGrow Fund, which channels investments into African small and medium-sized enterprises, indirectly supporting local entrepreneurship while providing returns to private investors.
3. Risk Layering: By using a mix of senior and junior positions in both debt and equity investments, blended finance can alter the risk-return profile of a project. Development finance institutions often take on the higher-risk junior positions, absorbing potential first losses and thereby protecting private investors who hold senior positions. This risk layering encourages private sector participation by making the overall investment less risky.

Blended finance, though widely promoted as a mechanism to mobilize private capital for development and climate initiatives, carries inherent risks that can undermine its effectiveness. In a paper written by Eurodad, they share two prominent examples—the Just Energy Transition Partnership (JETP) in South Africa and the Scaling Solar Programme in Zambia— to illustrate several potential pitfalls.

The South African JETP, launched to transition the country from its coal-dependent energy grid to more sustainable sources, has faced significant criticism for its lack of transparency. Despite initial commitments, the majority of the $8.5 billion pledged has not been clearly allocated, and only a fraction (around 4%) has been offered as grants. The rest comes in the form of commercial and concessional loans, contributing to South Africa’s public debt. This financial opacity not only obscures the real costs of the transition but also raises concerns about the long-term fiscal sustainability of such initiatives. The limited grant component further highlights a broader issue within blended finance: the risk that these arrangements may prioritize debt over development, burdening recipient countries with financial obligations that could outweigh the benefits of the projects.

The Scaling Solar Programme in Zambia, orchestrated by the International Finance Corporation (IFC), exemplifies another set of challenges. Intended to accelerate the deployment of solar energy in developing nations, the programme has instead been criticized for its high costs to the public sector and questionable developmental outcomes. The reliance on multiple explicit and implicit subsidies, such as cheap debt financing from development finance institutions (DFIs) and tax incentives renegotiated post-award, underscores the complexity and opacity often associated with blended finance projects. These subsidies, while designed to attract private investment, can lead to substantial public costs that may not be fully transparent or justifiable. In Zambia, the cost of mobilizing private finance was estimated to exceed $3.50 of public international finance for every dollar of private capital secured, suggesting that the model may be more extractive than developmental.

Both the JETP in South Africa and the Scaling Solar Programme in Zambia highlight the risk of blended finance contributing to public debt, especially in countries already struggling with economic challenges. In Zambia, the confidentiality surrounding power purchase agreements (PPAs) has made it difficult to assess the true impact of the programme on the nation’s debt burden. This lack of transparency, combined with the ongoing economic distress, raises questions about the appropriateness of blended finance in contexts where debt sustainability is already a concern. Moreover, in South Africa, there is a growing concern that the focus on mobilizing private finance for decarbonization may overlook critical social justice issues. The transition to renewable energy, if not carefully managed, risks marginalizing vulnerable communities and exacerbating existing inequalities.

Blended finance has shown potential as a tool to mobilize private capital for climate action in emerging markets, helping bridge the significant funding gap that hinders progress on sustainable development goals. It has facilitated critical projects in renewable energy and climate resilience that might have been considered too risky for private investors alone.

However, challenges like lack of transparency, the risk of increasing public debt, and potential neglect of social justice issues reveal that blended finance is not without its pitfalls. To truly serve as a catalyst for large-scale climate action, blended finance must be carefully structured to ensure transparency, manage debt levels, and prioritize equitable outcomes. While it is a promising approach, its success will depend on addressing these risks and aligning its implementation with the broader goals of true sustainable development.